Decomposing the Variance of Consumer Ratings and the Impact on Price and Demand

Consumer ratings play a decisive role in purchases by online shoppers. Although the effects of the average and the number of consumer ratings on future product pricing and demand have been studied with some conclusive results, the effects of the variance of these ratings are less well understood. We develop a model where we decompose the variance of consumer ratings into two sources: taste differences about search and experience attributes of a durable good, and quality differences among instances of this good in the form of product failure. We find that (i) optimal price increases and demand decreases in variance caused by taste differences, (ii) optimal price and demand decrease in variance caused by quality differences, and (iii) when holding the average rating as well as the total variance constant, for products with low total variance, both price and demand increase in the relative share of variance caused by taste differences. Counter to intuition, we demonstrate that risk-averse consumers may prefer a higher-priced product with a higher variance in ratings when deciding between two similar products with the same average rating.