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Effects of limited and heterogeneous memory in hidden-action situations

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  • Patrick Reinwald
  • Stephan Leitner
  • Friederike Wall

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.

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  • Patrick Reinwald & Stephan Leitner & Friederike Wall, 2021. "Effects of limited and heterogeneous memory in hidden-action situations," Papers 2105.12469, arXiv.org.
    • Handle: RePEc:arx:papers:2105.12469
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    References listed on IDEAS

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    1. Stephan Leitner & Friederike Wall, 2021. "Decision-facilitating information in hidden-action setups: an agent-based approach," Journal of Economic Interaction and Coordination, Springer;Society for Economic Science with Heterogeneous Interacting Agents, vol. 16(2), pages 323-358, April.
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