A positive externality is when an economic actor A works to add value, but the benefits of this work are mostly captured by other economic actors B. The following tidbit from Marginal Revolution caught my eye:

It’s not surprising that when Moderna reports good vaccine results, Moderna does well. It’s more surprising that Boeing and GE not only do well they increase in value far more than Moderna. On May 18, for example, when Moderna announced very preliminary positive results on its vaccine it’s market capitalization rose by $5b. But GE’s market capitalization rose by $6.82 billion and Boeing increased in value by $8.73 billion.

A cure for COVID-19 would be worth trillions to the world but only billions to the creator. The stock market is illustrating the massive externalities created by innovation. Nordhaus estimated that only 2.2% of the value of innovation was captured by innovators. For vaccine manufacturers it’s probably closer to .2%.

Who can internalize the externalities? Moderna clearly can’t because if they could then on May 18 Moderna would have increased in value by $20.52b ($4.97b+$6.82b+$8.73b) and GE and Boeing wouldn’t have gone up at all. Massive externalities.

A clever institutional investor like Blackrock or Vanguard could internalize some of the externalities by encouraging Moderna to work even faster and invest even more, even to the extent of lowering Moderna’s profits. Blackrock would more than make up for the losses on Moderna by bigger gains on other firms in its portfolio. Blackrock does indeed understand the incentives, although its unclear how much beyond jawboning they can actually do, legally.

I’d like to see more innovation in mechanisms to internalize externalities–perhaps in a pandemic vaccine firms should be given stock options on the S&P 500. Until we develop those innovations, however, the government is the best bet at internalizing the externality by paying vaccine manufacturers to increase capacity and move more quickly than their own incentives would dictate. Billions in costs, trillions in benefits.

This tidbit is a great example of the phenomenon that I’ve written about before: the economic participants who add the most value are not the ones who get the greatest profits, just as in the example above. A common example is nurses and teachers, and a common refrain in this discussion is ‘but we have no idea how much value a teacher or a nurse adds because we have no way to measure it’. In fact the inability to measure value has slowly translated to implying that profits earned is a measure of value added – which is certainly not true. Why is it useful to think about better alignment of value added and profit earned? Because aligning the two better creates the right incentives, which I think will lead to more value creation - and as a society, it is value creation that we really should be caring about, not total profit generation, even though the latter is what we measure when we measure revenues, earnings and GDP. The purpose of this blog post is to make the connection between this situation and the economic concept of externalities, as highlighted in the above tidbit about Moderna.

In the Moderna example, the value added to society by Moderna, by creating a Covid vaccine is mostly not captured by it, rather it is captured by other economic participants who would benefit from a vaccine, such as airlines, who would see increased travel. In this specific example, I wondered why Moderna, in principle, couldn’t just buy airline stocks, or indeed just the S&P500 index, as a way to capture more of the value it generates. This is a specific example, but maybe it hints at possible mechanisms to better align value generation and value capture. In the more general case, the goal of aligning value generation and value capture is the same as the goal of internalizing externalities. So the questin boils down to identifying what the externalities are in any given situation, and how to do remove these externalities. I think the first steps is to have a way to identifying the externalities systematically, or discovering them in an automated or crowd-sourced way – as in a large dataset of many many such situations. And then identify common patterns of externalities, and then think about how to break those externalities down. I suspect, that as the above tidbit suggests, that goverment legislation will have a role to play.