On contracting for uncertain R&D

Using a two-stage model, this paper studies auctions of research and development (R&D) contracts when the outcome of research is uncertain. The agent is contracted by the principal to invent a new product or a new process. The principal selects the most capable agent through an auction and writes an incentive contract with the winning agent to share risks. The main finding of the paper is that the generally superior incentive contracts might not be desirable under plausible conditions in R&D contracting. In particular, we find that the principal prefers a cost-plus contract in cases of large R&D projects or rising innovation benefits, but would prefer a fixed-price contract when the number of bidders increases. An alternate elasticity interpretation of results holds promise for empirical analysis. Public policy implications are finally discussed.