I learned the principle behind auditory illusions while taking the Systems Neurobiology class at UCSD.
How the auditory system works: it receives raw sound waves at the ear structure and passes them along through neuronal signaling to subsequent brain structures along the pathway where they are processed for a different quality at each step. The end result is that you unconsciously perceive the qualities of position, intensity, and pitch.
How the position-sense works: sound waves originating from side A of your head will take microseconds longer to reach the ear on side B, with the result being a wave offset and slight difference in intensity at your eardrums. One of the brain structures in the auditory pathway decodes this and sends a signal to a position neuron depending on the offset.
Since headphones can’t produce sound at different distances from your head, they have to recreate the offset. Software varies the timing and intensity of the left and right channels depending on the desired effect.
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