Externalities and Incentives: The Economics of COVID

Course Outline

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.

Teacher Resources


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


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