The fundamental philosophy underlying contests such as these is what U.C. Berkeley professor Henry Chesbrough terms open innovation. It's open, not restricted to a company's internal R&D staff, and it's innovation, not merely the repetitive execution of standard processes.
Open innovation may not always be the right approach, of course. Some areas of the business require in-depth knowledge of company practices, processes and proprietary information to advance the technology. However, open innovation is an approach well-suited to one-time challenges that can range from grand, such as landing a robot on the moon, to specific, such as "calculation of the intrinsic maximum birefringence of molecules."
Expanding the team working on a problem from merely a handful of researchers on payroll to thousands or to potentially millions of solvers is likely to improve the quality of the solution. Companies can't employ every expert in a given field; more importantly, outsiders can develop breakthrough ideas. Consider Einstein, a patent clerk who devised special relativity, or Ramanujan, the great self-taught mathematician. The Netflix Cloud Prize is fairly broad, addressing areas such as improvements in availability, robustness and performance.
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The economics of such contests are appealing. In terms of benefits, an additional participant at worst generates no marginal value, but at best, might be the individual with the breakthrough solution. Although having a million participants in a contest may not generate one million times the value of one participant, surely the solution can be no worse. With a fixed prize award, the costs are invariant regardless of the number of participants.
For contestants, the value comes from the potential for a direct payout from winning in one of the categories, but also strongly from potential increase in reputation, the relationship building that comes with participating in a community, and the intellectual challenge of problem-solving. Since no one is forced to participate, any participant presumably feels that the expected value of benefits exceeds the investment of effort. In fact, in the few days since the Netflix prize was announced, many hundreds of developers have begun to participate, with more considering.
Contests are not new to the digital age or the cloud, of course. The British government offered the Longitude Prize in 1714 to solve a pressing challenge of the time: identifying a ship's precise location, not just its latitude. They need not even be formally structured: in the Age of Discovery, explorers searched for better routes to the Indies to access exotic spices, with the prize being untold wealth and immortal fame. However, today's unprecedented connectivity and global reach open up such contests quickly to the billions of people with Internet access.
This is not the first time Netflix has run such a prize. The Netflix Prize offered a million dollars to anyone who could improve Netflix's movie recommendation algorithm, Cinematch, by 10%, as well as progress prizes for the best improvement each year. Quality movie recommendations increase customer satisfaction and thus reduce churn and increase lifetime customer value.