Prize Purses, Innovation & the Leverage Effect

This white paper introduces prize competitions as a mechanism to generate solutions. It distinguishes prize competitions from other methods of motivating innovation, and isolates a factor that makes prize competitions a superior mechanism for generating solutions to certain types of problems. We will call this relevant factor the "leverage effect," after the capacity of prize competitions to leverage the prize purse to stimulate investment among participants greater than the purse's value. This phenomenon peculiar to prize competitions has been widely discussed and formalized by the X-Prize Foundation. The leverage-effect seems to imply that, given the chances of winning, participants over-invest, taking on more risk than traditional investment strategies suggest is rational. This behavior exhibited by competitors decreases the risks assumed by the prize sponsor--a salutory effect enabling philanthropic and R&D funds to go further--but it is not entirely clear what motivates participants to accept such risk, nor whether such behavior among participants can be expected to persist in the long-term. In this paper, we will identify conditions favorable to the leverage effect, show why this investment pattern occurs, and explain how companies can incorporate prize competitions into their R&D strategy. We include case studes of the X-Prize, Netflix Prize and a competition on hypios.com to explore this leverage effect in several contexts.