Real options approach to national corona responses
Why and when time matters?
Written with Thomas Taussi
Strategies against the COVID-19 pandemic might be better understood by relying on real options theory. Countries that implement lockdown, or just otherwise restrict some regular societal and economic activities, are paying an immediate price for a time-up, rather than maximally exposing the whole society to something multiplicative and uncertain. Ideally, nearly any strategy relies on a set of core assumptions, preferences, and variables that should be stated more or less formally and explicitly. As John Von Neumann once said, “There’s no sense in being precise when you don’t even know what you’re talking about.” In this context, exactness and accuracy are not necessarily top priorities. Instead, these exercises have the potential to make uncertainties “visible,” open for investigation, and that way position different anecdotes and construct in a broader sense.
In the case of nations responding to COVID-19, there are significant uncertainties that relate to several aspects of the disease model, transmission, individual and herd immunity, and its broader impact on overall health, for example. When the big picture is left wanting, many authorities are occasionally testing the boundaries of their field of expertise. Some economists and statisticians are screeching bold assumptions and base their thinking on some set of epidemiological beliefs. In turn, some epidemiologists and other public health experts have an almost godlike impact on national response strategies that should also include fundamental economic analysis that provides for trade-offs, constraints, and the effects of time.
In theory, it is relatively more straightforward to estimate the cost of control measures than the impact of something still unpredictable and uncertain. By implication, we mean more than just the narrow-minded analysis of mortality rate, spreading rate, reproductive ratio, etc. but the costs of being sick, second-order effects (e.g., destruction in production structure) and also other longer-standing health issues and productivity losses caused by the virus and its potential variations. These effects, if you understand the nature of systems thinking, are not linear or deterministic. There is asymmetric uncertainty hidden in plain sight.
If a country has managed to implement somewhat early measures to keep new infections to a minimum (i.e., R0 is below or near 1), it may still, in theory, be able to change to more laissez-faire mitigation or suppression strategy in light of new data and insights. Costs induced by control measures would become limited sunk costs, as a minimal number of infected people constitute no significant question marks for the future. In turn, a country with high infection rates could, in theory, try to shift its strategy away from herd immunity. Still, the infected population would remain as a liability, and a question mark, in light of newly emerging medical data and insights.
Real options are generally used to seek benefits from asymmetries, limiting downside without losing flexibility and the possibility to change the course of action. Instead of committing to an inflexible decision that could have a significant disadvantage, a minor upfront investment (i.e., by acquiring a real option) can grant access to the notable upside while screening and even minimizing the downside. Thus, the option is expected to improve decision-making at a later time. Here is where real options may often be underestimated: while extra time is necessary, time is still not the real driver of success. What makes the difference, in the end, is how you use that time that one manages to acquire via the option that has been acquired.
Time, as such, does not automatically produce better alternatives for decision-making. In some instances, better information and additional alternatives unfold over time regardless of one’s efforts. Depending on the underlying fundamentals, buying more time just fatalistically to wait in an inactive mode may turn out to be a desperate or an enlightened strategic move.
The other and least as a vital side of buying more time is about information and alternatives that depend on one’s preparedness and actions. Thinking of theoretical and precise decision-making models makes it easy to overlook the importance of meta-level success, that is, implementing the models in practice and forcing your assumptions to the ultimate litmus test — the reality. Any analysis, construction of shared understanding, and building a decision-making scheme requires time and directed judgment.
We want to emphasize three interlocked things that have emerged during this crisis, and these impressions are not mutually incompatible:
- The virus, SARS-CoV-2, and the severe disease it causes, COVID-19, are a grave and immediate public health threat due to the multiplicative nature of the viral epidemic. The exact nature of the illness is irrelevant as probabilities are what matters under uncertainty. What makes this disease a systemic risk is that it has multiple effects on various levels of complex human systems.
- Severe lockdown measures have caused, are causing, and will create tremendous human suffering and destruction in the short and long run. These losses are already taking place (and will have ripple effects throughout the globe on various levels), and they cannot be removed as such as one cannot “stop” the world and things from taking place. Lockdowns and other harsh measures, on the other hand, were necessary actions due to ignorance, failure of prudent planning, and pretense of knowledge. Lockdown was the last resort after no precautionary measures (hedging) took place at the systemic level before the situation got out of hand.
- A clear and goalpost-based road map to reopening is needed, but all actions towards normalcy need to be done in a prudent manner so that one doesn’t risk losing short-term victories under an uncertain situation. Every nation and individual needs to understand what has worked and what has not during these exceptional times. There is no need to reinvent the wheel.
The critical question remains: How do you use the additional time?
What is the purpose of additional time in a national response? This is the crucial aspect where national strategies can differ significantly. How do various programs take into consideration the effects of time during different stages of decision-making?
One can pose this question in a very general form: Is time a resource to generate action, or is it just for observation and waiting for whatever patterns to appear for being copied?
Written by Thomas Taussi & Thomas Brand.
The opinions expressed in this blog are strictly those of the authors. They should not be construed as the opinion(s) and position(s) of their current or former employers or the institutions with which the authors are affiliated.
