Incentive Procurement Contracts with Costly R&D

This paper provides a model of both R&D and production in procurement processes where firms invest in R&D and compete for a government procurement contract. The optimal incentive procurement contract is characterized to maximize the government's expected welfare. Explicit consideration of the R&D process changes the standard results in several ways. If the traditional Baron-Myerson (1982) type contract is used where there is costly R&D, the government buys too little from the contractor and pays too little. Raising the price paid encourages private R&D and raises the government's welfare. The form of the optimal procurement contract depends on the number of firms. With R&D and optimal procurement the government prefers more than one firm to invest in R&D and to bid for the production contract. But too much competition may discourage private R&D investment and leave the government worse off. Other features of optimal procurement and R&D expenditures are also discussed.