A Model of Complexity
Abstract:
Inc
reased complexity has become a hallmark of both financial regulation and fi
nancial products. We consider one channel for complexity: deliberately maki
ng products more difficult to understand. We consider an environment in whi
ch an agent can choose both the quality of a product and its complexity. Ea
ch product must be accepted by a principal who cannot directly observe qual
ity, and whose ability to understand the product’s quality is affected by i
ts complexity. In order to offer products that are acceptable to the princi
pal, agents may increase complexity even when their products are of high qu
ality and their preferences are perfectly aligned with those of the princip
al. Moreover, agents with low quality products and different preferences fr
om those of the principal may simplify their products. We show that the inc
entive to simplify or to complexity depends crucially on how urgent it is f
or the principal to acquire the product and on the beliefs about the alignm
ent of preferences between the agent and the principal.