Effects of limited and heterogeneous memory in hidden-action situations

TL;DR

This paper investigates how limited and heterogeneous memory in decision-makers affects outcomes in hidden-action economic models, revealing that agent utility is sensitive to cognitive constraints while principal utility is less affected.

Contribution

It introduces an agent-based model incorporating cognitive limitations in hidden-action problems, highlighting the impact of memory constraints on utilities.

Findings

Agent's utility decreases with principal's cognitive limitations.

Agent's utility is unaffected by their own cognitive capacity limitations.

Principal's utility remains stable despite the agent's cognitive constraints.

Abstract

Limited memory of decision-makers is often neglected in economic models, although it is reasonable to assume that it significantly influences the models' outcomes. The hidden-action model introduced by Holmstr\"om also includes this assumption. In delegation relationships between a principal and an agent, this model provides the optimal sharing rule for the outcome that optimizes both parties' utilities. This paper introduces an agent-based model of the hidden-action problem that includes limitations in the cognitive capacity of contracting parties. Our analysis mainly focuses on the sensitivity of the principal's and the agent's utilities to the relaxed assumptions. The results indicate that the agent's utility drops with limitations in the principal's cognitive capacity. Also, we find that the agent's cognitive capacity limitations affect neither his nor the principal's utility. Thus, the agent bears all adverse effects resulting from limitations in cognitive capacity.