As I was anxiously waiting
for the announcement of this year’s Nobel under Economics discipline to hear a
name more pleasing to my ears (…sure you can easily guess my stupidity—the name
I was looking forward to), on October 13th the Academy awarded this
year’s Sveriges Riksbank Prize in Economics to Jean Marcel Tirole, the French
professor from the Toulouse School of
Economics, in recognition of his important theoretical contributions that
clarify as to “how to understand and
regulate industries with a few powerful firms.”
The significance of his
contributions to the field of economics can well be gauged from the mere fact
of the academy choosing a non-American after more than a decade for the award. Jean Tirole, who obtained his first degree in
engineering from the most prestigious Grand Ecoles in France and later PhD in
economics from MIT under the supervision of Eric Maskin who himself is a Nobel
Laureate, is the third French economist to win the Nobel in economics.
Traditionally, economists
engaged in regulatory economics had based much of their work on two benchmark
cases: either a monopoly firm or the frictionless, hypothetical world of
perfect competition where all firms are identical and enjoy no market power.
Accordingly, they designed simple policies that governments could adopt for
regulating all industries.
Moving away from this
traditional approach, Tirole argued that the regulatory mechanism that works well in one industry may not work
well for another industry/situation, for, according to him, in the real world,
markets are not dominated by one firm but by a small number of big firms with
power in the markets. What he meant is: they are oligopolies. He built simple
and elegant mathematical models based on the very fundamental features of
various industries and their specialties. As these models reflect the strategic
behavior and information economics, they
afford a better understanding of the interaction between firms, paving the way
for the governments to design optimal regulatory policies.
Thus, Tirole, making use
of the modern micro-economic techniques such as game theory, asymmetric
information and contract theory provided a new standard of rigor in theory to
‘regulation’ that captured specific economic environments, while, of
course, giving an orderly shape to an
otherwise unwieldy literature. Making use of game theory framework, Tirole
explained how the consequences of regulation depended not only on what action
the regulator took, but also on how the few big firms interacted with each
other. He stressed on the fact that ‘information
asymmetry’ keeps the regulators unaware of the actual costs of production of
firms because of which the regulations launched by governments can at times result
in unintended consequences.
For instance, the
government fearing that, say, pharmaceutical firms are likely to exploit
consumers by charging high prices on drugs, may impose price caps. But such
caps on price tend to induce firms to reduce their costs to the extent where a few
firms alone would remain in the market, which might unwittingly allow them to
make excess profits. And it is certainly not in the long term interest of consumers,
argues Tirole.
Therefore, his
prescription is: offer a portfolio of cleverly designed regulatory contracts to
firms so that they will automatically select the one that best suits their
business model. Now the question is: What makes a contract look like cleverly
designed in different situations? It is these aspects that Tirole studied along
with his co-authors, Laffont and others and, borrowing ideas from auction
design and game theory, suggested that in such situations, regulators should
offer cost-plus contracts and set price contracts. This shall make a firm that
has scope for cutting costs opt for cost-plus contracts, while an innovative
firm would opt for a set price contract.
This choice of the firms automatically makes the regulator know as to
what sort of a firm they are dealing with, which in turn enables them to
bargain a best deal for the consumers.
Stretching himself beyond
the regulation of monopolies, Tirole also studied the impact of ‘over
investment’ in new technology on competition and observed such investment can
at times eliminate competition in the market, for rival companies see no
business sense in competing in such an environment. Interestingly, in one of
his recent publications with Jean-Charles Rochet, he observed that the
interconnectedness of modern financial systems is such that it would make the
failure of big banks impossible, and the obvious fallout of such a situation
would be: reckless behavior of banks, for they are sure of being bailed out by
the exchequer. His suggestion to check such moral hazard is to cap their
leverage.
It is in the light of
these challenges that the regulators face in managing competition that Tirole’s
work becomes indispensible to regulators, and as the Academy observed, his work
certainly enabled “governments” understand the peculiarities of each firm and be
able to “encourage powerful firms to become more productive and, at the same
time, prevent them from harming competitors and customers.”
Besides his theoretical
contributions to the discipline of economics, Tirole also wrote two text books, The
Theory of Industrial Organization and Game
Theory with his classmate Drew Fudenberg, which have indeed become iconic
in their own right. The former book is a distillation of all the research that
took place in the field of industrial organization and importantly presented in
one unified framework facilitating easy comprehension for the graduate students.
His book on game theory introduces the principles of non-cooperative game
theory covering strategic form games, Nash equilibria, sub-game perfection,
repeated games and games of incomplete information in an easily understandable
style, duly accompanied by many applications, examples and exercises.
