Externalities and Incentives: The Economics of COVID

How can understanding externalities and incentives help us better respond to COVID-19?

The benefits of vaccines extend beyond those receiving the shot (e.g. a "positive externality") and that means that vaccines are under-incentivized. There are a variety of institutions to try to correct this; during a pandemic, these institutions don’t work so well.

Every day without a COVID-19 vaccine means thousands of lives and billions of dollars lost. That means the positive externalities to the rapid development of a safe, effective vaccine are huge!

Alex Tabarrok dives into the positive externalities associated with vaccines and explains his research with Nobel Prize winner Michael Kremer, Susan Athey, and Chris Snyder on how to incentivize development of a vaccine for COVID-19.

***INSTRUCTOR RESOURCES***
This video’s classroom assignment: https://mru.io/mo0
Related COVID theme assignment on the incentives of ideas: https://mru.io/bqt
More high school teacher resources: https://mru.io/bf2
More professor resources: https://mru.io/77k
EconInbox: https://mru.io/evt
Try out our practice questions: https://mru.io/ckd

***MORE LEARNING***
More on externalities: https://mru.io/mu5
More on incentives: https://mru.io/zgl
Read more about Alex’s COVID proposal: https://www.nytimes.com/2020/05/04/opinion/coronavirus-vaccine.html

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- [Alex] Hi, everyone.

Today, I want to talk
about applying

some of the principles
of economics,

namely externalities
and incentives,

to understand COVID
and vaccine policy.

Let's begin with a simple flu shot.

A flu shot is a great example of
a good with a positive externality.

When I get a shot,
I benefit myself,

but I also benefit other people

because I'm less likely
to transmit the virus.

In fact, the economist
Corey White has estimated

that every two flu vaccinations
saves someone else

from getting sick
and having to miss a day of work,

and every 4,000 vaccinations
saves a life --

that's an incredibly
cost-effective way of saving a life.

The problem is that even though
the social benefits are very high,

people are unlikely to weigh
the social benefits

as high as the benefits
to themselves.

So individuals are
under-incentivized to get a flu shot.

Now we deal with
the external benefits

of vaccinations
in a variety of ways.

In some cases, such as polio,

we require school children
to be vaccinated by law.

In other cases,
we offer incentives.

We subsidize vaccines
to keep the price low.

It's not just government policy,
by the way.

Some firms will offer
their workers free flu shots --

that's an interesting case
where the employer internalizes

some of the positive externalities
from vaccination.

COVID is especially fascinating

because we can actually see
the externalities in market prices.

Whenever one
of the vaccine companies

has even a little bit of good news,
say, from a clinical trial,

the entire stock market jumps up.

Airline stocks, for example --

they jump up with every bit
of good vaccine news.

The airlines, in other words,
are capturing some of the benefits

produced by vaccine manufacturers.

And since the vaccine manufacturers
aren't capturing all of the gains

from producing vaccines,

the vaccine companies
are under-incentivized.

Now this is a case
where economics leads you

to a completely different conclusion
than the man in the street.

The man in the street is worried
that the vaccine manufacturers

will profit too much
from a vaccine --

that they will price gouge.

The economist is worried
that the vaccine manufacturers

aren't profiting enough.

By the way, innovations, in general,
are under-incentivized.

The Nobel Prize-winning economist
William Nordhaus has estimated

that innovators -- they only receive
about 2 to 2.5% of the value

of their innovations.

Now we do have some institutions
to try to alleviate this problem.

We subsidize basic research
in universities,

and we offer firms patents,
for example.

But neither of these solutions
is going to work well for COVID.

It's too late to subsidize
the basic research.

And a patent is exactly
the wrong idea.

A patent raises the price
above the competitive price,

but we know the competitive price
is already too high.

For a good with a positive externality
like a vaccination,

we want the price to be
below the competitive price.

So a patent creates
a severe misallocation of resources.

So what do we do?

If we can't increase the profits
of the vaccine companies,

say, because of politics,
we can cut their costs.

That's one reason why
Nobel Prize winner Michael Kremer,

Susan Athey,
Chris Snyder, and myself,

working with a team of economists

at accelerating
health technologies --

why we have proposed
paying vaccine manufacturers

part of their costs.

Now, unfortunately,
most vaccines fail,

so, typically,
a vaccine manufacturer --

they won't take the risk

of getting a vaccine factory
up and running

until after a vaccine has been
proven safe and effective.

But if we follow the typical route,

we might end up
with an approved vaccine

and not enough capacity

to get millions of shots
in arms for months.

So what we want to do

is pay firms to build
at risk capacity now.

It's expensive to build
a factory for a vaccine

that may never be approved.

But it's even more expensive
not to have a vaccine available

the moment that one
is proven safe and effective.

In the U.S. alone, every month
without a vaccine is costing

thousands of lives
and billions of dollars of GDP.

So speeding a safe
and effective vaccine

is extremely valuable
and worth investing in.

Okay, so there you have it:

externalities, incentives,
innovation policy,

using market design to improve
social outcomes --

these are key principles
of economics,

and they can help us
to improve policy in a pandemic.

- [Narrator] If you're a teacher,
you should check out

our classroom activity
that incorporates this video.

If you're a learner, make sure
this video sticks

by taking a few quick
practice questions.

To learn more about
externalities, click here.

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