Rallying innovation in the age of Covid-19

Will governments likely pay a princely sum for a vaccine for COVID-19?  Yes.

It is very unlikely that governments around the world are going to accept monopoly pricing for a vaccine developed for COVID-19 that potentially will benefit seven billion people. For life-saving drugs, it is not uncommon for those prices to be in the hundreds of thousands per person. Suffice it to say, for a vaccine intended to be given to a population such as the U.S., even $10,000 a dose would set the government back $3 trillion. That ain’t gonna happen.

Will governments likely pay a princely sum for a vaccine for COVID-19? Yes. Will they cover the costs and the risks associated with developing and trialing that vaccine? Hopefully. But given the uncertainty amid the crisis, there is a concern that pharmaceutical companies and their researchers do not need to add further uncertainty. Moreover, this isn’t just about the current crisis. Like SARS and H1N1, coronaviruses are probably with us for the foreseeable future and may require annual vaccine development.

There are other innovations that we might finally demand having felt the costs of a global pandemic in the modern era. All of those will be of a public nature with the idea of using them widely. That means that the price for these innovations will be set in negotiation with governments which, we can imagine, are unlikely to be less stingy with public funds going forward. Given this, how should we think about an innovation system for what are essentially ideas that will enhance the global public good?

Traditional Innovation Incentives Won’t Cut It

The usual way we try to encourage innovation in a market economy is to reward the innovator with intellectual property protection. If you have a new drug, you can secure a patent that gives you the exclusive right to sell it. In other words, your reward is to make whatever profits you can for a time unimpeded by close competition. That system works pretty well.

However, the main problem with regard to innovations that will help avoid or stem the effects of a global pandemic is a contradiction: In order for the innovator to receive profits, we have to allow the innovator to price in such a way that many will be unable to use the innovation. As our goal was widespread use, this contradiction is prohibitive.

The difficulty for a vaccine maker is that a low price on the vaccine reduces their profits but generates much more value for other firms as the economy recovers. There are clever ideas, however, to help the vaccine maker recover some of this value. Consider this, as told by columnist Matt Levine in a Bloomberg article in March 2020:

[I]f I ran one of the big index-fund companies, and a pharmaceutical company in my portfolio developed a patented fully effective cure for COVID-19 that it could manufacture cheaply and planned to sell to any-one who could pay $50,000 a dose, I would call that company right up and say “no, you give that pill away for free, because the value to me of COVID-19 going away quickly and the economy recovering — the value to me as an owner of airlines and hotels and chain restaurants and retailers and every other company — is vastly, vastly greater than the value to me of your profits on that pill.”

This is pretty ingenious. If you know you have a COVID-19 vaccine then you know that, when it is released, there will be an economic boom and so you can invest in the stock market on the basis of that information. That should generate a healthy return. Unfortunately, it also requires a very large amount of capital to make the return that would incentivize the innovator. Suffice it to say, relying on stock market processes to fund important innovative endeavours is risky at best.

Given the value on the table, the other option is to ignore the market altogether and have the government offer grants and subsidies to defray the costs of conducting research and development. This has certainly been a hallmark of the system of scientific research conducting in most countries following World War II.

The challenge is that it is very difficult to evaluate whether grants are being spent in an efficient manner. Consequently, grants tend to be favoured where no other sources of funding are available — for instance, for basic research that has no commercial payoff and a high degree of uncertainty — or where there is expertise to evaluate the efficacy of the research program and required expenditures. This task, however, is itself not amenable to a quick disbursement of funds. Thus, when there is any urgency, such as lives possibly being lost while research is being conducted, grants are unlikely to be an efficient means of generating innovations.

Advanced Market Commitments

This has caused economists to consider ways of encouraging innovations that combine the elements of grants with market signals. One approach contemplated was the use of prizes. For centuries, benefactors have announced prizes that would be paid in the event certain inventions were generated. The most famous was the prize for a clock that worked at sea so as to provide a dramatic improvement in navigation by measuring longitude at sea. Prizes have the advantage that they are clearly solutions to problems someone believes it would be valuable to solve. Thus, they have a market signal embedded in their makeup.

The difficulty is that the problems that are usually specified are to achieve some scientific milestone. These are not necessarily of the class that would require widespread adoption for the global public good. For pandemics and pandemic control we are talking about inventions whose adoption will impact on billions of people. Thus, quality and workability really matter. They cannot simply be scientific advances. The innovations need to be able to work for their intended functions. That is a tougher challenge that any one prize for a significant milestone is likely to bring. To solve these problems and enhance the market test associated with prize-like mechanisms, Michael Kremer proposed the use of advanced market commitments (AMCs).

Suppose you are trying to encourage the development and then manufacture of a vaccine. An AMC is a contract without a specific counterparty that a donor/sponsor offers to deliver the intended vaccine. The contract specifies that the provider (as yet unknown) will be guaranteed a certain payment per dose of the vaccine up to a specified quantity. This serves to set a floor on what the provider might earn because the contract specifies a subsidy for every dose actually purchased.

So a country, for instance, may pay a low price (such as $1) per dose but the provider would receive an additional subsidy (say $15) per dose. Thus, there is a guaranteed pay-off for providers but, in return, providers agree to cap the price they charge for the vaccine. Their overall earnings are greater, the more doses are actually sold. Obviously, if there are no candidates that pass certain quality standards, the contract is never paid out.

A key feature of AMCs is that they are not compulsory. Recall that why we need AMCs that ‘stick’ for innovations that potentially have high social value is that, in their absence, governments and other donors may claw back on promised returns. Thus, it is important that AMCs are a strong commitment. If AMCs are non-compulsory, this means that any innovator could choose to sell their product at whatever price they choose if they do not accept the AMC. This guarantees that AMCs will only enhance rather than reduce the returns to any R&D investments. The commitment increases the price above what the market would pay and, thus, the AMC contains a prize-like element, but only if the vaccine is used by lots of people.

How could AMCs be deployed for pandemic-related innovations? It depends on some features of the innovation — specifically, how close current efforts are to a viable product. For innovations that are more ‘technologically distant’ the goal is to encourage more R&D effort and resources. This might be the case for a vaccine that could handle most potential coronaviruses as opposed to the specific virus that is currently spreading. The challenge in designing the AMC is setting a price that will induce that R&D effort. This will be an easier task if that price encourages multiple simultaneous attempts to pursue the innovation.

At the same time, however, AMC designers will want to ensure that innovators’ payoffs are sensitive to how well their products work so they push to innovation towards products that are likely to be more effective. Thus, even though the price might be set ex ante, to encourage that effort and align incentives, AMCs for technologically distant innovations will likely remove the floor (in terms of sales guarantees) to give innovators more ‘skin in the game’.

Writing this, as I am, in the midst of a pandemic, it is reasonable to expect that much of the innovative effort will be focused on products that are much closer to market. An example of this might be vaccines to deal with the current strains of coronavirus or innovations to dramatically improve and reduce the costs associated with testing and treatment. In that situation, there are likely to be a number of candidate prospects in the pipeline and so the chief constraint is not more risky R&D but instead undertaking trials and then building capacity to bring these products to market.

When there is any urgency involved, grants are unlikely to be an efficient means of generating innovation.

An AMC designer faces a challenge as they would not have accurate information regarding the costs of those activities even if they know they are potentially substantial. The good news is that they have better information regarding precisely what the potential prospects can achieve. In setting the per unit price for the AMC for a technologically-close product, the designer has to refrain from setting a very low price — even though that may save on overall costs to those using the innovation — and err on the side of a higher price so that the necessary capacity investments actually are made.

As there is likely urgency in getting products to market quickly, you would not want to skimp on payments and risk insufficient capacity. Again, this highlights the importance of the AMC’s role as a commitment because, having built capacity, there will be pressures to reduce price. The AMC needs to guard against those pressures.

One thing that can take the pressure off prices in this situation is if the AMC can guarantee a certain level of sales for the product. After all, the innovator will be making investments depending on the overall return. Thus, they will be happy to tradeoff price with quantity so long as the total revenue (that is, price times quantity) does not change. This is a luxury AMC designers have when setting terms of a technologically close product as they have a much better sense of the overall level of demand for that product.

A relatively technologically close AMC has recently been undertaken to produce a pneumococcal conjugate vaccine specifically targeting developing countries where 700,000 children are estimated to die from the disease each year. Five countries and the Gates Foundation put up $1.5 billion for an AMC in 2007 and it was launched in 2009. Businesses would compete for a contract to supply the vaccine over a ten-year period with a price capped at $3.50 per dose (much lower than prices paid in developed countries).

In 2010, pharmaceutical companies GSK and Pfizer committed to each supplying 30 million doses annually. Note that it is important for a technologically close innovation, that the price actually be set rather than a per-dose subsidy. Michael Kremer, Jonathan Levin, and Christopher Snyder show that this latter case may actually cause too little capacity to be built as that will be sufficient for an innovator to appropriate what might be available to fund the product (the total need was 200 million).

Interestingly, while the AMC was successful in generating the required doses, the price was pushed down over the course of the decade. By 2018, half of the population that was targeted was covered. One reason for the delay was that India (a large potential recipient) did not adopt until 2017. This appears broadly successful although we can never be completely sure what would have happened in the AMC’s absence. Experience tells us that it would have likely been very little.

More Failure, Please!

Thus far, the discussion has focused on why business as usual, in terms of market and private rewards for innovation, is unlikely to be suitable for pandemic-related innovations. However, there is also a sense in which governments, in particular, need to abandon business as usual that often accompanies their own funding on research and development — an adversity to failure.

The innovation challenge is so potentially large that it is very important that we pursue as many different paths as possible. In a sense, there may be very important scientific and innovation directions out there which each have very unclear and hard to understand potential payoffs. Given that the payoffs can potentially be very high, this suggests that we should be more comfortable pursuing riskier and potentially unconventional scientific approaches.

In other words, there is a broad need for a portfolio approach to innovation — spreading our options widely — so as to better understand which paths might prove to be feasible. The takeaway here is that governments and donors should not be afraid of casting their net very widely and not just funding moon-shots but also loon-shots.

In the midst of World War II, Franklin D. Roosevelt authorized the creation of a highly funded project to build the first nuclear bomb. The Manhattan Project was a stunning success. It brought together a workforce of 129,000, including a large concentration of scientists (three of whom had won and three of whom would later win Nobel Prizes) at a cost of what today would be $23 billion to the New Mexico desert and, in three years, had built a working weapon.

To be sure, that weapon would create a decades-long existential crisis for the whole of humanity causing fear and sowing mistrust that continues to this very day, but right now we can marvel at the fact that the project met all of its KPIs and ended World War II in relatively short order. It is not a stretch to suggest that both managing the current COVID-19 pandemic (with tests, anti-virals and a vaccine) along with coming up with innovations to more effectively manage future pandemics, a project well in excess of the scale of the Manhattan Project is warranted.

Based on the potential future economic cost alone, there is an easy rate of return justification. What is more, unlike the Manhattan Project, this would not have to be conducted with secrecy and, indeed, there would be considerable merit to precisely the opposite in terms of openness.

This is not the place to scope out what that potentially massive endeavour would look like. However, I can list here some key features that should be considered as part of it:

• INTERNATIONAL COOPERATION: All of these efforts are in terms of contributing to a global public good. The challenge will be to find mechanisms that distribute the costs of achieving these goals in

a workable and sustained manner.

• REGULATORY AUDIT: Each country should pursue a major regulatory audit to ensure that there are no unnecessary impediments to being able to innovate and then to adopt new promising technologies. The COVID-19 crisis has already led to a relaxing of some regulatory rules specifically regarding approvals for public drug release.

• PATENT POOLS: There is merit to pooling together patents associated with COVID-19 and other future pandemic threats. A patent pool is an agreement between patent holders to licensing terms for patents between them. By agreeing to these, it is easier to combine innovations together to build products and services. An example of this emerged during the COVID-19 crisis when a patented HIV therapy, Kaletra, was potentially promising as a treatment for COVID-19. The patent holder, Abbie, announced it would not defend its patent rights. Suffice it to say, a more formalized agreement before the fact regarding licensing would remove frictions even further.

• EXPERT REVIEW BOARDS: The research involved will likely be pursued along many promising paths. This happened with the Manhattan Project where two different bomb designs were pursued in parallel. To organize these competing streams, expert review boards will likely need to be constituted on an ongoing basis. This could assist in the allocation of funds, the highlighting of impediments, the evaluation of project quality and the design of AMCs.

In closing

One thing a crisis of this magnitude should tell us is that there is room to do better. The funding for innovation for medical research is a fraction of that devoted to other threats — notably national security. Our experience in 2020 suggests that our attention has been misfocussed.

Joshua Gans is a Professor of Strategic Management and holds the Jeffrey S. Skoll Chair of Technical Innovation and Entrepreneurship at the Rotman School of Management (with a cross-appointment in the University of Toronto’s Department of Economics). He is also Chief Economist of the Creative Destruction Lab. His latest book, an ebook, is Economics in the Age of COVID-19 (MIT Press, 2020), from which this is an adapted excerpt. In November, an updated version of the ebook will be published in hard copy.

This article originally appeared in a recent issue of Rotman Management, the magazine of the University of Toronto's Rotman School of Management. www.rotman.utoronto.ca/connect/rotman-mag.