http://www.nytimes.com/2008/03/02/business/02view.html

“How a Bubble Stayed Under the Radar”

–New York Times 

If the price of a good drastically strays from its inherent value, while buyers are buying and sellers are selling at considerably high levels, the market is most likely experiencing an economic bubble. This behavior is no different from the recent housing bubble, in which the market’s buyers ignored their personal intuition to buy houses at prices too high. So, why do otherwise rational people make these irrational decisions? “Were all these people stupid? It can’t be.”

This seemingly irrational behavior can best be attributed to an information cascade. When someone is entirely surrounded by people buying real estate, the temptation to comply with herd behavior sways that person to disregard their better judgment to purchase a house too. The herd behavior of the housing market’s buyers and sellers fueled this economic bubble, resulting in damaging effects.  This housing bubble led to extremely detrimental effects, with the personal consequence of a poor investment and the large-scale consequence of a misallocation of resources. According to Robert J. Shiller of the New York Times, the most harmful force driving this housing bubble was the weakness of the information that prompted the cascade. “The information obtained by any individual – even one as well-placed as the chairman of the Federal Reserve – is bound to be incomplete.” The information prompting a cascade, undoubtedly incomplete, begins the informational cascade; with the decision are made individually and sequentially, if one person makes the wrong decision, all of the following people in the information cascade will follow. And so, the recent housing bubble burst out of control, with each person blindly basing his or her decision on the actions of others.