Complexity and Sophistication

Leandro Carvalho and Dan Silverman

Journal of Political Economy Microeconomics, 2024, vol. 2, issue 1, 43 - 76

Abstract: Many financial situations present individuals with simple alternatives to solving complex problems. The value of such alternatives depends on whether individuals are sophisticated and know when they are better off opting out of complexity. To test complexity’s effects and evaluate sophistication, we randomized the complexity of portfolio problems and the offer of a simple alternative to portfolio choice. Under complexity, the less skilled opt out when the simple alternative is dominated, earning lower returns. To interpret these findings, we develop a novel method for estimating the structural parameters of a rational-inattention model. The structural estimates are consistent with substantial sophistication.

Date: 2024
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