Prizes versus Contracts as Incentives for Innovation

Abstract

Procuring an innovation involves motivating a research effort to generate a new idea and then implementing that idea efficiently. If research efforts are unveriable and implementation costs are private information, a trade-off arises between the two objectives. The optimal mechanism resolves the trade-off via two instruments: a cash prize and a follow-on contract. It primarily uses the latter, by favoring the innovator at the implementation stage when the value of the innovation is above a certain threshold and handicapping the innovator when the value of the innovation is below that threshold. A cash prize is employed as a supplementary incentive only when the value of innovation is sufficiently high. These features are consistent with current practices in the procurement of innovation and the management of unsolicited proposals.

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Reference

Yeon-Koo Che, Elisabetta Iossa, and Patrick Rey, “Prizes versus Contracts as Incentives for Innovation”, TSE Working Paper, n. 16-695, September 2016, revised November 2020.