foumal of Economic Perspectives���Volume 12, Number 3���Summer 1998���Pa^ 151-170 Learning from the Behavior of Others: Conformity, Fads, and Informational Cascades Sushil Bikhchandani, David Hirshleifer and Ivo Welch I n 1995, management gurus Michael Treacy and Fred Wiersema secretly pur- chased 50,000 copies of their business strategy book The Discipline of Market Leaders from stores across the nation. The stores they purchased from just happened to be the ones whose sales are monitored to select books for the New York Times bestseller list. Despite mediocre reviews, their book made the bestseller list. Subseqtientiy, the book sold well enough to continue as a bestseller without further demand intervention by the authors.' Presumably, being on a bestseller list helps a book sell more because consumers and reviewers learn from the actions of previous buyers. Reports of the actions or endorsements of one set of economic decisiontnakers often influence the reactions and purchases of others. The transformation of New York's Times Square after long decay was triggered hy an investment by Disney, after which "wait-and-see investors piled in" ("A Star is Reborn," 1996). Often there are opportunities to manipulate the process hy which individuals learn from their predecessors. There is a word, "claque," for those hired to applaud loudly ' It is difficult to calculate the net returns on Treacy and Wiersema's investment, partly because it is likely that they were able to limit the costs by returning books to the publisher, and partly because the bestseller status of the book helped them to obtain speaking and consulting income {"Did Dirty Tricks Create a Bestseller?" 1996). ��� Sushil Bikhchandani is Professor of Decision Sciences and Ivo Welch is Professor of Finance, Anderson Graduate School of Management, University of California, Los Angeles, California. David Hirshleifer is the Merwin H. Waterman Professor of Finance, University of Michigan Business School, Ann Arbor, Michigan.

152 foumal of Economic Perspectives (or to heckle competitors) at musical and stage performances. Ancient Roman families hired professional mourners at funerals. Hennessy Cognac hired actors and models to order their product at fashionable bistros ("The New Hucksterism," 1996). Many of us identify restaurant quality by the fraction of seats occupied perhaps not coincidentally, restaurants often close off back-room peak-load seating capacity until the main and most visible section becomes quite full. Advertisements report the fractions of doctors or dentists that use certain medications and health products. We will argue in this essay that learning by observing the past decisions of others can help explain some otherwise puzzling phenomena about human behav- ior. For example, why do people tend to converge on similar behavior, in what is known as "herding"? Why is mass beha\'ior prone to error and fads? We will further argue that the theory of observational learning has much to offer economics and business strategy. Social observers have long recognized imitation as important in human society. Machiavelli (1514) wrote: "Men nearly always follow the tiacks made by others and proceed in tbeir affairs by imitation." Tbe philosopher Eric Hoffer (1955) asserted: "When people are free to do as they please, they usually imitate each other. . . . A society which gives unlimited freedom to the individual, more often than not attains a disconcerting sameness." This predisposition to imitate is deeply rooted. Gibson and Hoglund (1992) describe evidence that animals imitate each other in choices of mate and territories for example, female guppies are more likely to choose males to mate with whom they have observed being selected by previous females. The propensity to imitate is presumably an evolutionary adaptation that has promoted survival over thousands of generations by allowing indi\iduals to take advantage of the hard-won informa- tion of others. Within minutes of birth, human infants mimic the observed facial expressions of adults. As we grow older, we continue to be influenced by the ob- served actions of others, from the acquisition of Beanie babies and consumption of Prozac, to wider lifestyle, work, and recreation choices. The simplest and most basic cause of convergent behavior is that individuals face similar decision problems, by which we mean that people have similar infor- mation, face similar action alternatives, and face similar payoffs. As a result, they make similar choices. If Ford simply makes a better car than Yugo, and consumers understand this, then they end up buying the same car. Of course, opposing tastes can lead to opposing actions even if information is similar vegetarians and meat- lovers frequent different restaurants. Herding may arise when payoffs are similar even if initial information is not. In this case people communicate with each other or observe tbe actions of others��� or the consequences of these actions. The key issue is how individuals determine which alternative is better. Each individual could decide by direct analysis of the alternatives. However, this can be costly and time-consuming, so a plausible alter- native is to rely on the information of others. Such influence may take the form of

Sushil Bikhchandani, David Hirshleifer and Ivo Welch 153 direct communication and discussion with, or observation of others. We will call influence resulting from rational processing of infonnation gained by observing others observational learning or social learning. This essay focuses mainly on the case where individuals learn by observing the actions of others. There are several other possible causes of conformity which do not require great similarity in individuals' decision problems. These include positive payoff ex- ternalities, which lead to conventions such as driving on the right-hand side of the road preference interactions, as with everyone desiring to wear the tnore "fashion- able" clothing as determined by what others are wearing and sanctions upon de- viants, as with a dictator punishing opposition behavior. A Model of Observational Learning Observable Actions verstis Observable Signals We consider two scenarios. In both, each individual starts with some priv-ate information, obtains some information from predecessors, and then decides on a particular action. In the observable actions scenario, indi\aduals can observe the ac- tions but not the signals of their predecessors. We compare this to a benchmark observable signals scenario in which individuals can observe both the actions and signals of predecessors.*^ Consider an example in which risk neutral individuals decide in sequence whether to adopt or to reject a possible action. The payoff to adopting, V, is either 1 or -1 with equal probability the payofFto rejecting is 0. In the absence of further information, both alternatives are equally desirable. The order in which individuals decide is given and known to all. Each individual's signal is either Hi^ or Low, and High is relatively more likely when adoption is desirable {V = \) than when it is undesirable {V = -1). Specifi- cally, each individual observes High with probability p 1/2 if V = 1, and with probability 1 - p if V= - 1 . To put it a litde differently, after observing only one High, an individual's posterior probability that V = 1 is /, and the probability that y = 1 is only 1 - /j if he observes Low. (This can be confirmed with a calculation using Bayes' rule.) Thus, p is the (posterior) probability that the signal is correct. All private signals are identically distributed and independent conditional on V. Naturally, an individual's posterior belief about V also depends on information derived from predecessors, in ways that will differ in the two scenarios. In the observable-signals scenario, the information signals enter the pool of public information one at a time as individuals arrive. Because all past signals are publicly observed, information keeps accumulating so that individuals, all of whom have the same payoffs from taking the same action, eventually settle on the correct ^ See Welch (1992), Bikhchandani, Hirshleifer, and Welch (1992), and Banerjee (1992).