A Sparsity-Based Model of Bounded Rationality

52 Pages Posted: 8 Mar 2011 Last revised: 18 Mar 2012

See all articles by Xavier Gabaix

Xavier Gabaix

Harvard University - Department of Economics; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

Multiple version iconThere are 2 versions of this paper

Date Written: December 1, 2011

Abstract

This paper proposes a model in which the decision maker builds an optimally simplified representation of the world which is "sparse," i.e., uses few parameters that are non-zero. Sparsity is formulated so as to lead to well-behaved, convex maximization problems. The agent's choice of a representation of the world features a quadratic proxy for the benefits of thinking and a linear formulation for the costs of thinking. The agent then picks the optimal action given his representation of the world. This model yields a tractable procedure, which embeds the traditional rational agent as a particular case, and can be used for analyzing classic economic questions under bounded rationality. For instance, the paper studies how boundedly rational agents select a consumption bundle while paying imperfect attention to prices, and how frictionless firms set prices optimally in response. This leads to a novel mechanism for price rigidity. The model is also used to examine boundedly rational intertemporal consumption problems and portfolio choice with imperfect understanding of returns.

Keywords: anchoring and adjustment, inattention, boundedly rational dynamic programming, price rigidity, hedging demand, sparse representations, L1 minimization, dictionaries

JEL Classification: D03, D8

Suggested Citation

Gabaix, Xavier, A Sparsity-Based Model of Bounded Rationality (December 1, 2011). AFA 2013 San Diego Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1781234 or http://dx.doi.org/10.2139/ssrn.1781234

Xavier Gabaix (Contact Author)

Harvard University - Department of Economics ( email )

Littauer Center
Cambridge, MA 02138
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

European Corporate Governance Institute (ECGI)

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

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