The Mnemonomics of Contractual Screening

Abstract

In many markets, buyers sign advance contracts before actual decisions on transactions or consumptions are made. Therefore, a buyer may have private information on expected payoff at the contracting stage, and as time moves on, new information on other components of payoff may arrive. However, prior information can be losable, forgettable, or unattended. In this paper, we investigate how limited memory may influence the optimal design of contracts for sequential screening. Despite memory loss, the buyer can make ex post inference about her initially informed type from the chosen contract. As ex ante screening facilitates subsequent retrospection, the chosen contract can serve as a self-reminding instrument. This would yield an endogenous demand for separation in ex ante contract choice. In response, distortions in the optimal contract design can be either mitigated or intensified, leading to improved or undermined social welfare, respectively. As a result, the equilibrium buyer surplus can be higher than that under perfect memory. We also show that the buyer can exhibit the so-called flat-rate bias, even though her preference is time consistent and perfectly predicted. In addition, as memory can be perfectly recovered from the equilibrium contract choice, investing on any other memory-improving instrument is redundant. Moreover, the buyer’s demand for screening can induce her to choose dominated refund contract. Nevertheless, when dominance must be obeyed, the seller may offer a menu of refund contracts with two-way distortions. This paper was accepted by Matthew Shum, marketing. Funding: The financial support offered by the Hong Kong RGC General Research Fund [Grant 14500519] is acknowledged.