Observational learning in environments with multiple choice options

​We study the formation of market shares in environments where customers choose from multiple options for which they observe the aggregate choices of previous customers (the sales of each option).

With imperfect information regarding the true quality of the different options, the choices of better informed customers turn sales into informative signals, allowing less informed customers to learn about the options’ quality.

Besides such informational externalities, we consider possible direct negative externalities that characterize many economic environments – customers often derive lower utility from options chosen by more customers, ceteris paribus.

Our equilibrium analyses demonstrate a moderating, and counterintuitive, effect of negative externalities on observational learning. For example, when the negative externalities are negligible, the ‘majority’ option with the highest sales might seem like the obvious choice as it is a cheap signal of quality, but we find that selecting a ‘minority’ option with lower sales is rational.

We test our theory in a controlled laboratory environment with human subjects, and find strong evidence for observational learning predicted by our equilibrium analyses, with one notable exception: with negligible negative externalities, uninformed subjects ignore minority options and choose majority options instead. We explain this behavior via random choice theory.