Heed the Herd

by Elaine Schwartz    •    Jan 25, 2012    •    718 Views

By Mira Korber, guest blogger.

Just the other day, I walked outside to find all six of my horses facing the exact same direction, muscles tensed, ears pricked, nostrils flared…Clearly their horsey intuition was picking up on some obscure, equine-eating bogeyman undoubtedly lurking just on the other side of the pasture fence.

I’ve seen it more times than not. One horse is startled, the others follow suit. Pretty soon, you have a stampeding herd of animals feeding off the fear of one.

So what does this have to do with economics, anyway? It turns out that people aren’t so different from our four-legged friends.

The very same behavior can describe the housing bubble at the heart of the most recent economic crisis. Prominent economist Robert Schiller discusses how the influence of the herd contributed to the real-estate bubble’s burst.

Here’s the Scenario: Jack decided a truly low value house was a good investment because he individually misinterpreted its market value. So he decided to buy the house. Jill sees the transaction. She then assumes that buying a house is a good idea just because Jack did, not realizing that Jack overvalued his new home.

And the cycle continues. The rational expectations hypothesis — that people make decisions considering all known economic conditions — has instead given way to irrational exuberance.

Herd behavior could also factor in to the euro-zone crisis and Greece. According to The Economist, Europeans want to avoid making any decisions that might lead to a mass (herd-mentality) panic. Widespread concern abounds that if the recent debt swap deals fall through, the euro-zone would be at risk for collapse.

In these two situations, you can see how an optimistic or pessimistic groupthink mentality affects mass behavior. In the housing situation, blind confidence in the upward surging (and likewise imaginary) home values ultimately lead to disaster. In Greece, private creditors and legislators alike are tiptoeing around negative expectations to avoid financial ruin.

The Economic Lesson

Herd behavior leads to what is known as information cascades. Such cascades are behavioral imitation of a certain activity, whether it be buying a home, selling stocks, or even choosing a restaurant for dinner. In other words, people base their decisions on the judgments of others, and mimicry ensues. This shows how we often turn to our social instincts in times of economic uncertainty.

For a comical take on the behavior, check out this video of a herd of horses. Then, look at this satire of humans exhibiting herd mentality.

An Economic Question: When and where have you experienced herd behavior? Have you ever decided to do something just because a friend or neighbor has? 

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