Market shaping uses economic tools to solve market failures where commercial incentives for innovation trail behind societal needs. One example is advance market commitments (AMCs), which are “pull mechanisms” that tie payments to outputs. AMCs establish legally binding contracts to subsidize the purchase of a large quantity of a specific innovation if it is invented. Other examples include prizes, which are competitions that reward solutions for a specific problem, and milestone contracts, which are payments linked to achieving interim steps toward an innovation.

Commercial incentives for innovations to tackle climate change and prepare for pandemics, under existing market institutions, fall far short of the social value of such innovations. There are several possible reasons for this.

Externalities. Externalities are spillover effects (e.g. pollution) that may not be reflected in market prices. In some cases, innovations create benefits not just or even not primarily for the buyer of the good. A good example of this would be innovations that reduce greenhouse gas emissions, for example in cement production. Existing incentives to invest in these technologies are inadequate because many consumers are unwilling to fully pay for carbon benefits.

Low barriers to entry. There are many cases in which innovations are not patentable, are not easy to protect with first-mover advantages and it is very easy for subsequent competitors to enter the business as well. This reduces commercial returns to develop such innovations.

Idea spillovers are a related idea. Firms may not invest in innovation if they can easily spread to rivals (rivals may be able to reverse-engineer a product). Developing an innovation first and demonstrating it is possible may be costly and firms may only capture a small share of the returns.

Constraints on pricing. Social and political limits on pricing in the midst of pandemics can hold the commercial value of innovations far below their social value. This is not to say such limits are not warranted, but they create a gap between social and commercial value.

Large buyers with bargaining power. In some markets there are only a few buyers, perhaps only the government. In these markets, buyers have a large amount of bargaining power. Once the innovation is developed, these buyers can hold down prices. Firms can anticipate this and therefore underinvest in innovation to begin with.

Firms with (monopoly) pricing power. Some markets are not competitive – there may only be a small number of firms. Patents also provide innovators with temporary monopolies. As a result, these firms may be able to set higher prices. These high prices may exclude people who would benefit from the innovation and value it more than unit cost of production. From an economist’s perspective this involves static social inefficiency (“deadweight loss”).

Poor consumers in low and middle income countries may be unable to afford to pay the higher prices that would make investing in innovation attractive. This will result in underinvestment in innovations needed in those markets.

Behavioral biases. People may undervalue innovations that benefit them in the future or only benefit them with some probability. This may be the case with innovations to address future climate change or pandemic risks.  Therefore there will be insufficient demand for them which will reduce the return to innovation.

High fixed costs. Some innovations may have high fixed costs (e.g., research and development, manufacturing capacity) which may deter firms from developing them. Firms may not be able to set prices that enable them to cover their fixed costs. In addition, higher prices may exclude users who value the innovation above the unit cost, which is inefficient (see above on higher prices).

• Pull mechanisms enable you to direct innovation investment at specific problems we need to solve.
• Pull mechanisms can reduce demand uncertainty. They can signal to firms there will be demand for socially useful innovations. This can correct for existing markets providing insufficient commercial incentives for socially useful innovation. They can leverage future demand to incentivize innovation now.
• Pull mechanisms place the technological risk on the innovating firms – they know more about their probability of success.
• Pull mechanisms can be firm-agnostic: you do not need to choose which firm to support in advance.
• Pull mechanisms can be solution-agnostic. You can link payment to results which means they can be open to different ways of solving the problem.
• Payment is linked to delivering outputs and outcomes. If targets are not achieved, the sponsor does not have to pay.
• They can incentivize innovations that appeal to users. A pull mechanism can be structured to provide a matching bonus co-payment when a customer makes a purchase. This incentivizes firms to develop products customers will actually buy, not just those that work in the lab.
• Pull mechanisms can be designed to incentivize scale. Payment can be linked to producing and selling at large scale.

An Advance Market Commitment (AMC) is a type of pull mechanism. It involves making a binding promise, in advance,  to purchase or subsidize the purchase of a new product if it is invented. It may involve the firm committing to price at close to unit cost in return for the sponsor (government or philanthropist) subsidizing a large quantity of purchases.

The $1.5 billion Advance Market Commitment for the Pneumococcal Vaccine was launched in 2009 and led to the three vaccines tackling strains of pneumococcus prevalent in low and middle income countries.

Since then three vaccines for the strains of pneumococcus common in low- and middle-income countries have been developed, hundreds of millions of doses delivered, and an estimated 700,000 lives saved. The rate of vaccine coverage for the pneumococcal vaccine in GAVI countries converged to the global rate five years faster than for the rotavirus vaccine which GAVI supported without an AMC.

Think about the minimum incentive that might be required to incentivize a firm to invest in innovation in problems neglected by commercial investment.

The pull mechanism may need to cover the cost of research and development and production capacity.

It might be worth thinking about how this opportunity compares to other investment opportunities for firms in that sector.

For example, this report making the case for vaccine AMCs estimated “$3.1 billion is comparable to the value of lifetime sales of an average pharmaceutical product.”  This helped inform estimates of how large a vaccine AMC should be.

It may also be worth thinking about the size of the relevant market. Large global commodity markets may need larger incentives to incentivize firms.

Then think about the value of the benefits of the innovation to society as a whole. That should provide a ceiling on how large a pull incentive should be.