A Model of Complexity

Abstract:
Increased complexity has become a hallmark of both financial regulation and financial products. We consider one channel for complexity: deliberately making products more difficult to understand. We consider an environment in which an agent can choose both the quality of a product and its complexity. Each product must be accepted by a principal who cannot directly observe quality, and whose ability to understand the product’s quality is affected by its complexity. In order to offer products that are acceptable to the principal, agents may increase complexity even when their products are of high quality and their preferences are perfectly aligned with those of the principal. Moreover, agents with low quality products and different preferences from those of the principal may simplify their products. We show that the incentive to simplify or to complexity depends crucially on how urgent it is for the principal to acquire the product and on the beliefs about the alignment of preferences between the agent and the principal.