The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel aka “The Nobel Prize in Economics” has been awarded to Jean Tirole (Toulouse, France). Jean Tirole is a very safe choice, after a slightly controversial and almost ironic choice last year, where with Eugene Fama and Bob Schiller two economists shared the Prize (with Hansen), who stand for incompatible views on the efficiency of financial markets.
Jean Tirole has been honoured for his contribution to the analysis of market power and regulation. There are many other achievements that the committee could have cited. Jean Tirole’s contributions to contract theory, mechanism design and to modelling psychological phenomena using game theory are also outstanding and probably worth a Prize each. It was clear to almost any academic economist that Jean Tirole would win the Prize at some point. The only question was for which of his achievements.
The committee decided to give the Prize for Tirole’s work on how to tame the power of large firms. Up until the late 1970s the conventional wisdom on how to regulate natural monopolies or oligopolies was based on neoclassical monopoly and oligopoly theory. The theoretical underpinning for much of practical regulation of natural monopolies was Ramsey pricing (going back to the 1920s), which boils down to allowing a monopolist only to charge a price for its goods that guarantees break even. In a simple static monopoly model with perfect and complete information and without any contractual frictions this allows for the “least inefficient” departure from the optimal outcome that would prevail if competition were feasible. (Recall that in a natural monopoly competition is not feasible as the cost structure only allows for a single firm to serve the market, which then in turn if unregulated leads to very high prices and inefficiently low production resulting from monopoly power). Tirole’s work – much of it together with Jean-Jaques Laffont who passed away way too early in 2004 – emphasised that this old view can be misleading and harmful and worked out how to better regulate natural monopolies.
Let’s make this concrete with the help of an example and go back to telecommunication in 1970s. Before the advent of mobile communication telecommunication was clearly a natural monopoly. The setup cost of running a telecommunication network was enormously expensive (think of all those copper wires that have to be rolled out), while the extra cost of an additional phone call was comparatively small. Working competition drives prices towards the level of the cost of producing one additional unit. So competition in the telecommunication industry would drive the price of a call down towards the telco’s cost of handling one more phone call. Consequently, with such low prices the firms having to build the very expensive networks would make huge losses. Therefore, competition is not possible. Without competition only a single firm provides telecommunication services. This firm if unregulated can then use its market power to charge very high prices. This is highly inefficient as many citizens can then not afford making phone calls, they would be able to afford if prices properly reflected the cost.
Traditional regulation (in the spirit of Ramsay) would now regulate the price a monopolist can charge so that the monopolist does not make losses and gets a “reasonable” return on the capital it uses. This sounds very reasonable. Now Laffont and Tirole come into play. In 1993 their extremely influential book “A Theory of Incentives in Procurement and Regulation,” summarised and extended a large body of work published in many articles in the top economics journals in the years before. This hugely influential and extensive body of work demonstrated that this old way of regulating firms in imperfectly competitive markets can be quite counterproductive once other important aspects are taken into account. Using all the then newest modelling tools in game theory that allow for a meaningful analysis of strategic interaction in environments with informational frictions and without commitment devices, Tirole and Laffont described how to optimally regulate firms depending on the exact environment in a certain industry. One-size fits all regulation for industries with different characteristics was shown to be harmful.
Some of the problems with rate-of-return regulation in general shown by Laffont and Tirole are blatantly obvious with hindsight. Firms have private information about their cost (i.e. they have a better idea about their cost structure than the regulator) and therefore are prone to overstate the cost in order to be allowed to charge higher prices. Moreover, rate-of-return regulated firms have no incentive at all to reduce their cost by becoming more efficient. Those of you who are bit older might remember how inefficient slow and expensive telecommunication was in the 80s. Under certain circumstances firms might even have an incentive to become less efficient by inefficiently increasing the capital stock. Have a look at the huge headquarters of some smallish regulated natural monopolies such as SA Water (Adelaide, Victoria Square) or of the former SA vertically integrated electricity provider ETSA (Adelaide, 1 Anzac Highway) and compare it to the modest headquarters of a large international competitive firm Santos (Adelaide, 60 Flinders Street). If you know these building then you clearly know what I am talking about when mentioning over-capitalisation.
While Tirole’s work is highly theoretical and technical, it has a very practical side. Many of the theoretical findings translate into very real principles of regulation. Many of the now commonplace ways of regulating some non-competitive industries can to at least some part be followed back to the seminal theoretical work by Laffont and Tirole (with some other important contributors of course). Think of the separation of networks from retail. The formerly integrated monopolist ETSA is now called SA Power Networks and only provides the network, while where there can be competition there is. Think of all the energy providers that compete for the privilege to supply you with energy. In telecommunication Telstra still owns the majority of the copper network but is forced by the regulator to let others access and use it, which allows for competition that otherwise would not be possible. Some further separation of network and retail in conjunction with Telstra’s involvement in the NBN is still on the cards.
Another common practice of curbing monopoly power, keeping prices down and providing incentives for good product qualities going back to Laffont and Tirole (and others) are incentive mechanisms. While theoretically often very complicated, some rather simple ones are used in reality. Think, e.g. about rail companies bidding for being allowed to service a certain line for a certain amount of time. The bidding is done through a commitment to maximum fare prices and rules about penalties for poor service quality such as delays or cancellation. This provides an incentive to commit to low fares in order to get the franchise. The threat of losing the franchise at the end of a term is an additional incentive to provide good services to the penalties for bad services that are already included in the tender. A similar tender system saw Connex losing its franchise of operating the suburban passenger rail services in Melbourne to another company (i.e. Metro Trains Melbourne in 2009.)
The examples given above only outline a minuscule part of the impact Jean Tirole has had and clearly still has on the economic profession but also on the way modern competition policy is conducted. It is amazing that in an extremely quickly moving profession Tirole’s seminal textbook on Industrial Organization from 1988 is still relevant. I also once in a while still use Jean Tirole’s game theory text (1991, together with Drew Fudenberg) and the 1993 book on procurement and regulation with Jean-Jaques Laffont, which I mentioned before. Tirole did not stop there. In the nineties Tirole contributed extensively to contract theory and still does. Lately, Tirole together with Roland Bernabou has written extensively on how psychological phenomena can be modelled using game theory. This work is shaping up to become another seminal contribution that will still be relevant in another quarter of a century. Congratulations to Jean Tirole on being awarded the Prize. Well deserved!!!