Can fear cause economic collapse? Insights from an experimental study

We study the behavior of experimental subjects who have to make a sequence of risky investment decisions in the presence of network externalities. Subjects follow a simple heuristic – investing after positive experiences and reducing their propensity to invest after a failure. This result contrasts with the theoretical findings of Jeitschko and Taylor (2001) in which even agents who have only good experiences eventually stop investing because they are afraid that others with worse experiences will quit. In theory, this Bayesian fear can trigger sudden economic collapse – even in the most efficient Bayesian equilibrium. In the experiment, subjects are surprisingly fearless of others’ experiences, and simply follow their own experiences, thus averting a total collapse.