Working Paper Series, University of Zurich, Department of Economics 200
This paper analyzes the design of innovation contests when the quality of an innovation depends on the research approach of the supplier, but the best approach is unknown. Diversity of approaches is beneficial because of the resulting option value. An auction induces the social optimum, while a fixed-prize tournament induces insufficient diversity. The optimal contest for the buyer is an augmented fixed-prize tournament, where suppliers can choose from a set of at most two prizes. This allows the buyer to implement any level of diversity at the lowest cost.