Optimal auction design and R&D

An indivisible object is to be procured through bidding from one of two prospective suppliers. Firms decide whether to invest in cost-reduction before the bidding. The procurer commits to a mechanism ahead of investment decisions by firms. If the procurer can charge entry fees that may be discriminatory, a sealed-bid second-price auction uniquely implements the first-best outcome and is optimal for the buyer. 'Revenue Equivalence' holds when first-best investments are symmetric; however, it breaks down when first-best investments are asymmetric. Without entry fees, the procurer may want to bid-discriminate between ex-ante identical firms to induce the favored firm to invest and become strong while the unfavored firm not to invest and stay weak. This result runs counter to the earlier findings on discrimination in procurement auctions without pre-contract R&D: the principal favors the weaker agent to induce stronger bid competition. (C) 1997 Elsevier Science B.V.