In the text we consider an incumbent monopolist faced with entry if it failed to innovate. If the monopolist innovates, he remains a monopolist with lowered costs. If the potential entrant innovates, the two firms compete as Cournot duopolists. Take market demand to be P = 1 - Q
and marginal costs to be ch = 0.4 without innovation and cl = 0.2 after the innovation. Show that consumer surplus when the monopolist innovates is lower than the consumer surplus that obtains when the entrant innovates. Would it be optimal for the government to award the potential entrant an additional lump sum for innovation in order to encourage the entrant to innovate? (Compare total welfare under the two scenarios.)