Innovation and diffusion of medical treatment

We develop and estimate a dynamic structural model of demand in a setting where product characteristics endogenously evolve in response to aggregate consumer choices. The direction and speed of innovation are inefficient because individuals do not account for their influence on innovation, creating an externality. Our application focuses on drugs invented to combat human immunodeficiency virus; they differ in their efficacy and propensity to cause side effects. We find that the externality is quantitatively important; temporarily subsidizing the experimental treatment would have increased average social welfare by improving average health and would have reduced inequality in lifetime utility across health groups.