Economics of COVID-19

Externalities: why do we need coordinated public action in the pandemic?

With infectious diseases like Covid-19, how one person behaves necessarily affects other people's wellbeing - there are what economists call 'externalities'. To achieve good overall outcomes for society, it is not enough to rely on individuals' incentives to protect themselves.

Externalities and infection

In the context of infectious diseases, the most well-known externality is what's called theinfection externality. For communicable diseases such as Covid-19, an infected person can spread the disease to others, who can in turn spread it further and so on.

This means that what an individual does to protect him or herself from becoming infected can have widespread effects on others, effects that the person may be tempted to ignore. Thus, an infected person may have a strong negative infection externality on society but at the same time a modest private incentive to choose the right protective measure.

A classic example of this is the positive externalities of vaccination, articulated as early as 1997 by Joseph Stiglitz. As immunised individuals cannot infect others, people who vaccinate themselves indirectly benefit others (this is known asherd immunity- seeToxvaerd and Rowthorn, 2020).

For that reason, many vaccines are routinely given to children and to at-risk individuals free of charge in order to encourage vaccine uptake. Notably in Australia, vaccination isa pre-requisite for attending state school education, showing that there are alternative ways to encourage socially beneficial decisions by individuals.

As a last resort, one can consider imposing fines on those who do not wear face masks in public or who do not respect social distancing restrictions. Such fines have recently been introduced in the UK.

Externalities that change behaviour

Up till now, we have mainly considered externalities that change other people's wellbeing. But in fact, one can distinguish between two different types of externalities, which may both be present in any given situation:

First,spilloversare present when the decisions of others directly increase or decrease the wellbeing of a person.

Second, there may bestrategic interaction. Strategic interactions are present when the decisions of others influence a person's incentives to make certain decisions him or herself. Pollution and open source software are examples of spillovers. To consider examples of strategic externalities, we will distinguish between two cases.

Decisions arestrategic substituteswhen higher activity by others makes lower activity more desirable for someone. Vaccines and social distancing are good examples of strategic substitutes. Decisions arestrategic complementswhen higher activity by others makes higher activity more desirable for someone. Think of social media platforms like Facebook: because ofnetwork effects, having a profile on Facebook is more valuable when many others adopt Facebook. That's why some platforms such as Facebook become very large, while others like MySpace wither and disappear.

As an example of strategic complements, consider treating your child for lice. The treatment is costly and cumbersome, and the day after, the child will be back in school where he or she will interact with other kids. Suppose that lice are widespread in the school and that other parents do not treat their children. In that case, it is likely that your child will be re-infected the very next day.

Thus, the incentive to treat your child may be modest. In contrast, if there is a concerted effort by all parents to treat their children and eradicate the lice, then you will find it privately optimal also to treat your child. In any case, the incentive to do the treatment is higher when others also do the treatment.

In terms of policy and behaviour, when decisions are strategic complements, it is easier to ensure good outcomes than under strategic substitutes. The reason is that under strategic complements, people actually have aligned incentives and everyone would be happy to go along with the best common course of action. In such cases, policy may be effective even at minimal effort. The government can simply take on a coordinating role and need not spend significant resources to change behaviour.

In contrast, when there are strategic substitutes, then policy may be more difficult to carry out and may entail using resources. This is because a policy measure can now have what's called acrowding-out effect. Suppose, for example, that the government offers a subsidy to some people to take a vaccine. If these people take up the offer, others may be tempted tofree-rideon this and thus be less willing to get vaccinated themselves. In a sense, the more the government does to achieve a good outcome, the less effort will people make to achieve these outcomes.

Reference:

Flavio Toxvaerd, "Externalities: why do we need coordinated public action in the pandemic?", Economic Observatory, 21^st Oct 2020, https://www.coronavirusandtheeconomy.com/question/externalities-why-do-we-need-coordinated-public-action-pandemic

Assessment Tasks:

Study the Economics of COVID-19 case above and complete the following 4 tasks:

Task 1

Explain the economic concept of externality. Explain, using the example of the COVID-19 vaccine, why the free market fails to produce the (allocative) efficient result.

(10 Marks)

Task 2

Use a demand and supply model to illustrate the difference between free-market equilibrium and social efficient equilibrium and explain the causes leading to the inefficiency.

(10 Marks)