Market size, innovation, and the economic effects of an epidemic

We develop a framework for the analysis of the economic effects of an epidemic that incorporates firm-specific innovation and endogenous entry. Transition dynamics is characterized by two differential equations describing the evolution of the mass of susceptible in the population and the ratio of the population to the mass of firms. An epidemic propagates through the economy via changes in market size that disturb incentives to enter the market and to undertake innovative activity. We evaluate state-dependent interventions involving policy rules based on tracking susceptible or infected. Simple policy rules are announced at the time of the outbreak and anchors private sector’s expectations about the time path of the intervention, including the end date. Welfare gains or losses relative to the do-nothing scenario are computed accounting for transition dynamics.