Auctioning long-term projects under financial constraints (Q6930536)

In this paper, the authors consider a procurement auction for the provision of a long-term service to which an add-on, whose costs are ex ante uncertain, must later be appended. Based on the possibility for the firm to enhance the value of the add-on through its R\&D activities, it is shown that costly financing based on agency frictions of such R\&D investments makes the firm behave as if it was risk averse in the second period. To facilitate outside funding of the R\&D investment, it is optimal for the procurement agency to backload payments even though there is a cost of public funds associated with doing so. This is in sharp contrast to the case of frictionless finance, in which case all payments are shifted to the initial period, thus avoiding additional costs of public funds. This implies that the public procurement agency (and ultimately society) bears the cost of easing the incentive problem and the financial constraint of the firm. To reduce this cost, participation in the auction is restricted for high-cost firms.\N\NIn this context, the authors characterize the optimal intertemporal structure of payments to the winning firm, equilibrium bidding behaviour and reserve prices for a first-price auction.