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What are the implications on trading activity if investors are not sophisticated enough to understand and evaluate trades that have a complex payoff structure? Can frictions generated by this type of financial complexity be so severe that they lead to a complete market freeze, like that of the recent financial crisis? We show that for smooth convex preferences, including subjective expected utility, even extreme complexity cannot halt trade, unlike what happens for non-smooth preferences, such as maxmin expected utility. In the latter case, policies that make complex securities easier to understand or investors more sophisticated have a positive welfare effect, as they allow for existing gains from trade to materialise.

We report results from a sender-receiver cheap talk game, which explores whether an individual's decision to deceive is influenced by a concern for relative standing in a reference group. We show theoretically that positively biased senders, who think they are higher in the deception distribution than they actually are, will correct their beliefs and increase their cheating, when presented with information on the actual deception distribution. Hence, a predominantly positively biased group of senders will increase its average deception. Moreover, within a group, being more positively biased implies cheating less. The experimental data confirm both of these hypotheses

The value of information and the possibility of speculation are examined in an environment with unawareness. Although agents have “correct†prior beliefs about events they are aware of and have a clear understanding of their available actions and payoffs, their unawareness may lead them to commit information processing errors and to behave suboptimally. As a result, more information is not always valuable and agents can speculate with each other. We identify two specific information processing errors that are responsible for both problems. Moreover, we construct a dynamic model where agents announce their posteriors and update their awareness as soon as they hear a counterfactual announcement. We study how awareness is updated and whether agreement about posteriors is reached.

This paper provides a set-theoretic model of knowledge and unawareness. A new property called Awareness Leads to Knowledge shows that unawareness of theorems not only constrains an agent's knowledge, but also, can impair his reasoning about what other agents know. For example, in contrast to Li (2006), Heifetz et al. (2006a) and the standard model of knowledge, it is possible that two agents disagree on whether another agent knows a particular event. The model follows Aumann (1976) in defining common knowledge and characterizing it in terms of a self-evident event, but departs in showing that no-trade theorems do not hold.