Subsidizing Technological Innovations in the Presence of R&D Spillovers

We analyze a situation where a principal wants to induce two firms to produce an output, for example electricity from renewable energy sources. Firms can undertake non-contractible investments to reduce production cost of the output. Part of these investments spills over and also reduces production cost of the other firm. Comparing a general price subsidy and an innovation tournament, we find that the principal's expected cost of implementing a given expected output is always higher under the tournament, even though this scheme may lead to more innovation. Copyright 2008 The Authors. Journal compilation Verein für Socialpolitik and Blackwell Publishing Ltd. 2008.