Quality is in the eye of the beholder: taste projection in markets with observational learning

We study how misperceptions of others’ tastes influence beliefs, demand, and prices in a market with observational learning. Consumers infer the commonly-valued quality of a good based on the quantity demanded and price paid by other consumers. When consumers exaggerate the degree to which others’ tastes resemble their own, such “taste projection” leads to erroneous and disparate quality perceptions across consumers (i.e., “quality is in the eye of the beholder”). In particular, a consumer’s biased estimate of the good’s quality is negatively related to her own taste. Moreover, consumers’ quality estimates are increasing in the observed price, even when the price would have no influence on the beliefs of rational consumers. These biased beliefs result in perceived valuations that exhibit too little dispersion relative to rational learning and a demand function that is excessively price sensitive. We then analyze how a sophisticated monopolist optimally sets prices when facing short-lived taste-projecting consumers. Projection leads to a declining price path: the seller uses an excessively high price early on to inflate future buyers’ perceptions (e.g., creating “hype”), and then lowers the price to induce a larger-than-rational share to buy. When consumers can instead time their purchase, projection causes late buyers to under-appreciate selection effects, thereby exposing them to systematic disappointment. A final application examines how projection of risk preferences distorts portfolio choice when learning from asset prices