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, e.g. 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 productioncost 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 are always higher under the tournament, even though this scheme may lead to more innovation.