Auctioning Long-Term Projects under Financial Constraints

Résumé

We consider a procurement auction for the provision of a basic service to which an add-on must later be appended. Potential providers are symmetric, have private information on their cost for the basic service and the winning firm must also implement the add-on. To finance cost-reducing activities related to the add-on, this firm may need extra funding by outside financiers. Non-verifiable effort in reducing these costs creates a moral hazard problem which makes the firm’s payoff function for the second period concave in returns over the relevant range. This concavity has two effects: It makes it more attractive to backload payments to facilitate information revelation and uncertainty on the cost of the add-on introduces a background risk which requires a risk premium. In this context, we characterize the optimal intertemporal structure of payments to the winning firm, equilibrium bidding behavior and reserve prices in the first-price auction with bidders.