Limited intelligence and performance-based compensation: An agent-based model of the hidden action problem

TL;DR

This paper develops an agent-based model of the hidden action problem, relaxing ideal assumptions to analyze how limited intelligence and information affect optimal sharing rules and agent-principal utilities over time.

Contribution

It introduces an agent-based, evolutionary model of the hidden action problem with limited information and memory, providing new insights into decision dynamics and utility outcomes.

Findings

Optimal sharing rule does not emerge in the model.

Principal's utility is robust to intelligence variations.

Agent's utility is highly sensitive to intelligence limitations.

Abstract

Models of economic decision makers often include idealized assumptions, such as rationality, perfect foresight, and access to all relevant pieces of information. These assumptions often assure the models' internal validity, but, at the same time, might limit the models' power to explain empirical phenomena. This paper is particularly concerned with the model of the hidden action problem, which proposes an optimal performance-based sharing rule for situations in which a principal assigns a task to an agent, and the action taken to carry out this task is not observable by the principal. We follow the agentization approach and introduce an agent-based version of the hidden action problem, in which some of the idealized assumptions about the principal and the agent are relaxed so that they only have limited information access, are endowed with the ability to gain information, and store it in and retrieve it from their (limited) memory. We follow an evolutionary approach and analyze how the principal's and the agent's decisions affect the sharing rule, task performance, and their utility over time. The results indicate that the optimal sharing rule does not emerge. The principal's utility is relatively robust to variations in intelligence, while the agent's utility is highly sensitive to limitations in intelligence. The principal's behavior appears to be driven by opportunism, as she withholds a premium from the agent to assure the optimal utility for herself.