Wisdom of the crowd and the Bullwhip effect
December 13, 2007 by Raj Sheelvant
Bullwhip effect is an important concept in Supply Chain Management. This is the phenomenon when a slight change in demand gets amplified as you move away from the customers in the value chain. Let’s say the quantity of office supplies sold by the retail stores in a region has stagnated. But if the demand increases say for four months linearly, the retail stores see this as a trend and begin to anticipate increased future demand even though its just a temporary effect. The retail stores will increase its order size from the distributors. Distributors, who see this trend, anticipate even larger orders from the retail shops and will place larger order with the suppliers. This trend continues down the supply chain amplifying the effect. Bullwhip effect is not new but the ‘Wisdom of the Crowd’ has the tendency to exasperate this issue even further.
As collaborative technology matures, and as the number of people ‘peer’ producing increases, common sense tells that the Bullwhip effect should reduce. More the number of people involved in the process, more ‘eyes’ to identify the potential and probable Bullwhip effect, right? Thats the main selling point of crowd sourcing – “many heads are far better than one”. But, few incidents over the past few years indicate that the Bullwhip effect gets lot worse if the number of people involved increases.
- The US Stock Bubble of 2001: Bull market of late 1990s that led to the dot com bubble highlighted the ‘irrational exuberance’ by the investors. Large number of investors got involved in the stock market because of the democratization of investing brought about by several on-line trading firms. Low trading fees led to frenzied trading. Though Web 2.0 technologies were not available then, primitive technology to support the ‘Wisdom of the crowd’ existed in form of message boards and multiple online web based investment portals. Several smart people like brokers in New York, venture capitalists and tech workers at Silicon Valley were involved in creating an euphoria for the tech stocks. None of them saw the ‘bubble’ leading to crash of NASDAQ in late 2001.
- Global Credit Crunch of 2007: Again very smart investors (both large and small) are getting bitten by the Credit Crunch of 2007. In fact involvement of larger number of people in the real estate market has led to soaring of property value, which in turn led to the sub prime mess. Banks, Mortgage industries and other financial institutions who deal with risk every day got side tracked and surprise – surprise they did not anticipate the coming sub prime and liquidity crisis. From borrowers to lenders, everyone globally is seeing their investments getting decimated.
As seen above, the amplification is strongly correlated with the number of people involved. As more people get plugged directly or indirectly in the global economy, we will see some wild gyrations. Wisdom of the crowd acts in a harmful way doesn’t it. Why is that? Why, when the number of people involved increases, our collective ability to detect anomalies and ‘bubbles’ diminishes? The answer lies in what Warren Buffett calls ‘Institutional Imperative’ (see my blog Traditional Manager and the curse of Institutional Imperative). Buffett describes the ‘Institutional Imperative’ as that need for people to act and do like their peers no matter how irrational it may seem.
This institutional imperative ‘mixed with’ the wisdom of the crowd is the sure recipe for creating an enhanced Bullwhip effect. We will see more volatility in the market as the number of people involved increases. The hype of crowd sourcing and ‘peer’ production needs to be dealt with carefully. Though there are some great applications that can take advantage of user created content, I think there is also an elevated risk of going in a wrong path for a long time without being corrected because of the ‘wisdom’ of the crowd.
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