Procurement of an innovation often requires substantial effort by potential suppliers. Motivating effort may be difficult if the level of effort and quality of the resulting innovation are unverifiable, if innovators cannot benefit directly by marketing their innovations, and if the buyer cannot extract up-front payments from suppliers. We study the use of contests to procure an innovation in such an environment. An auction in which two suppliers are invited to innovate and then bid their prizes is optimal in a large class of contests. If contestants are asymmetric, it is optimal to handicap the most efficient one.

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We develop a methodology for analyzing the revenue and efficiency performance of auctions when buyers have private information about their willingness to pay and ability to pay. We then apply the framework to scenarios involving standard auction mechanisms. In the simplest case, where bidders face absolute spending limits, first-price auctions yield higher expected revenue and social surplus than second-price auctions. The revenue dominance of first-price auctions over secondprice auctions carries over to the case where bidders have access to credit. These rankings are explained by differences in the extent to which financial constraints bind in different auction formats.

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