Nobel for an economist who finds the market imperfect

14th of 11, 2014
By Tirthankar  Mukherjee

In their, perhaps natural, enthusiasm for the infallibility of the market, many Mongolian policy makers might have overlooked that for the second consecutive year the Sveriges Riksbank prize in economic sciences in memory of Alfred Nobel has gone to an economist whose work essentially assumes that markets are often inefficient, if not worse. The choice of Jean Tirole of Toulouse University in France has been greeted with serious respect, with none of the amusement last year when the committee honoured Eugene Fama (whose work showed markets are efficient) and Robert Shiller (who proved that they’re not).

One tribute from a fellow economist says, “Jean Tirole, along with others, established a good theoretical foundation for the non-Chicago view of things that markets fail in various ways. It’s important to think hard about the reasons that they fail and it’s important to think hard about the consequences.”

The award committee has said it chose Tirole for his microeconomic research investigating how large firms should be regulated in order to prevent consumers being damaged by their monopolistic behaviour, thus recognising that competition does not always fulfil the textbook promise that prices will be low and quality will be high. The recognition also critiques the conviction that economics can, with the application of enough mathematics, be converted from a messy social science into a hard science along the lines of physics and chemistry. (Incidentally Tirole, who did his Ph.D. in economics at MIT, also has degrees in engineering and mathematics.)

Monopolies or a few companies dominate many markets. They hold the power to keep prices artificially high, and they often lack incentives to innovate or improve quality. Cable and electric companies are ready examples. Economists have long recognised that government regulation of such markets could produce better outcomes for society. For example, in The Wealth of Nations in 1776, Adam Smith railed against the abuses of monopolies and cartels, noting, “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.” Some 250 years later, the concern is undiminished as, first, many of the natural monopolies that were once state owned are now in private hands; second, some sectors have grown in size and power, posing great risks to the public, banking being a major example; and, finally, the enormous market power in the hands of some of the new technology giants, such as Google and Amazon.

Tirole’s work in “market power and regulation”, beginning in the 1980s, was in part a response to the need for new rules as governments in Europe divested state monopolies, seeking to encourage investment and innovation while preventing windfall profits. In a media conference after the announcement of the award, Tore Ellingsen, chair of the award committee, said Tirole’s work helps better the world because it enables governments to set regulations “so that large and mighty firms will act in society’s best interest”, adding, “We are affected by big firms all of the time. The quality of, for example, electrical, transportation, and telecommunication services and the price that we pay matters to all of us.”

So it does, but the smug and blinkered view in basic economic theory that assumes perfect competition in markets meant while oligopolies -- industries that are dominated by a few large firms and monopolies, often utilities or formerly publicly run industries, like railroads or electricity -- were everywhere, there had been little study on how they worked.  Oligopolies usually escaped nuanced regulation not just because they were so very large, but also because what Tirole called “asymmetric information”. Governments usually knew little about them, making regulation difficult. In Competition in Telecommunications, which Tirole co-authored with Jean-Jacques Laffont, he delves into what makes that industry unique and how different nations have regulated an industry that is often a monopoly or oligopoly.

The Tirole approach doesn’t always point toward tougher oversight. At times, it may make sense for regulators to back off, lest they discourage firms from investing and innovating. A tradeoff is involved between stimulating technical progress and preventing firms from gouging consumers. There’s always a risk, though, that government officials will get “captured” by the industries they are supposed to be regulating, and go too easy on them.

Tirole’s models are notable for their realism because of the way he links theoretical issues to questions of market structure. His work touches on a range of issues that come up in our daily lives, or at least our daily news. “I think that some of Jean Tirole’s proposals, in particular in the field of banking regulation, might help to reduce the probability that such a crisis will occur again in the financial sector,” said Ellingsen in the interview.

Even as he kept his focus on the linked areas of competition regulation and industrial organization, Tirole also studied a number of other areas of interest. His book on banking regulation, for example, focused on capital requirements as an integral part of stopping financial crises. His interests even extended to open-source software, with a line of research suggesting that contributions to open-source projects are an economically rational way for programmers to signal their skills.

I lack the competence to properly summarise in this small space Tirole’s overall ideas on regulation, mainly because he insisted that different industries need to be treated differently. The Nobel Committee referred to what he said about newspapers to illustrate this. Mongolian media work in a different way, but in most countries elsewhere, they often give information away at a discount to gain market share and increase advertising revenue. While a government might consider that “predatory pricing” illegal in some other context, such an approach doesn’t make sense in a press context.

Another field where Tirole has made a landmark contribution is that of industrial organisation, which studies how an industry is organised, given the companies involved in it, the basis of their competition with one another, and the degree to which government intervenes. His book on the subject brought the ideas of game theory (an approach to the formal study of decision-making) into the area of study and helped explain why different firms make different decisions, given different market structures. A firm will act differently in a monopoly than in a perfectly competitive market, for example.

Tirole has made important theoretical research contributions in a number of areas, but he has earned his place in the economics hall of fame primarily because of the way he explained how to understand and regulate industries with a few powerful firms. Many industries are dominated by a small number of large firms or a single monopoly. Left unregulated, such markets often produce socially undesirable results—prices higher than those motivated by costs, or unproductive firms that survive by blocking the entry of new and more productive ones. His analysis of firms with market power provides a unified theory with a strong bearing on central policy questions: how should the government deal with mergers or cartels, and how should it regulate monopolies?

Its practical application is what marks Tirole’s work and sets it apart. What he and Laffont theorised is the basis of current laws in Europe, New Zealand, Australia and other countries. Not in the USA, however -- one reason why consumers in those other countries generally enjoy lower prices and better service. Joshua Gans, an economist at the University of Toronto, has compared Tirole with Louis Pasteur as the rare example of a laureate whose work has both advanced theoretical understanding and directly affected daily life. I could not agree more.

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