DP3080 Informational Externalities, Herding and Incentives

Author(s): LluĂ­s Bru, Xavier Vives
Publication Date: November 2001
Keyword(s): coordination, information aggregation, mechanism design, rational expectations, teams
JEL(s): D82, L13, L40
Programme Areas: Industrial Organization
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=3080

A version of the herding prediction model with a rational expectations flavor is reexamined in the light of incentive theory. The welfare loss at the market solution with respect to the incentive efficient solution can be decomposed into an information externality term minus an incentive cost term. It is found that the inefficiency of herding at the market solution is low when the cost of providing incentives is high. When the cost of providing incentives is low (and this happens when prior information is diffuse) the incentive efficient solution approaches the team solution that fully internalizes the information externality. Then the herding problem at the market solution is at its worst.