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)

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Date Written: December 1, 2011


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 )

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National Bureau of Economic Research (NBER)

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Centre for Economic Policy Research (CEPR)

United Kingdom

European Corporate Governance Institute (ECGI)

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