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Monday, October 20, 2014

Nobel to Jean Tirole, the French Economist ….

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. 
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