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.
German Economic Review (GER), the official publication of the German Economic Association (Verein für Socialpolitik), is an international journal publishing original and rigorous research of general interest in a broad range of economic disciplines. The scope of research approaches includes theoretical, empirical and experimental work.