Hoover Daily Report

The Economic Nuances of the Latest Nobel Laureate

via Wall Street Journal
Monday, October 13, 2014
Image credit: 
Sergey Nivens, Shutterstock

On Monday, Jean Tirole, a professor at France’s Toulouse University, was awarded the Nobel Prize in Economic Sciences “for his analysis of market power and regulation.” Someone at the news conference in Stockholm asked if this was a “political prize.” Tore Ellingsen, chairman of the prize committee, said it wasn’t: “Like an engineer, he offers a tool kit for problem solving that is applicable no matter what your political preference.”

That’s true. Mr. Tirole has done first-rate work, using game theory to analyze markets in which there are only one or a few dominant sellers. Most economists would probably agree that he deserved the prize.

Still, the question about politics was natural because the prize announcement emphasized the applicability of Mr. Tirole’s work to reining in large firms. A careful reading of articles he has written, however, shows an economist carefully considering not just the uses of regulation but also its downsides.

From the late 1960s to the early 1980s, the field of industrial organization was dominated by the Chicago School, where four of the major players were the late George Stigler (who was awarded the Nobel in 1982), his colleagues Sam Peltzman and the late Yale Brozen, and UCLA economist Harold Demsetz. They argued that even though most industries do not fit the economists’ model of “perfect competition” in which no firm has the power to set a price, the real world was plenty competitive. Firms compete by cutting costs, by cutting price and by innovating. These economists’ understanding of the ubiquity of competition led them to be skeptical about much of antitrust law and most government regulation.

In the 1980s, Mr. Tirole applied game theory to the field of industrial organization. The key idea here is that firms with market power take into account how their rivals are likely to react when they change prices or product offerings. The Chicago School economists recognized this but did not rigorously use game theory to spell out some of the implications. Mr. Tirole did.

One issue that he and his late colleague Jean-Jacques Laffont focused on was “asymmetric information.” A regulator has less information than the firms it regulates. So, if the regulator guesses wrong about a regulated firm’s costs, which is highly likely, it could set prices too low or too high. Messrs. Tirole and Laffont showed in 1986 that a clever regulator could offset this asymmetry by constructing contracts and letting the firm choose which contract to accept.

Suppose that some firms can lower their costs and other firms cannot, but the regulator can’t distinguish between them. A regulator might offer the firms either a cost-plus contract or a fixed-price contract. The cost-plus contract will appeal to firms with high costs while the fixed-price contract will appeal to those firms that can lower their costs. In this way the regulator maintains incentives to lower costs.

These insights are most directly applicable not to regulation but to government entities like the Defense Department when it negotiates with firms providing highly specialized products like ships, tanks and airplanes. George Mason economist Tyler Cowen ’s first reaction to Monday’s prize announcement, posted on his Marginal Revolution blog, was that Mr. Tirole’s work is really about principal-agent theory, not about reining in big business. In the Defense Department example here, the Pentagon is the principal and the contractor is the agent.

Mr. Tirole also has examined so-called two-sided markets. Consider Google : It can price its services to users (one side) and its services to advertisers (the other side). The higher the price to users, the fewer users and, therefore, the less money Google would make from advertising. Google’s choice is to set a zero price to users and to charge for advertising. In 2006 Mr. Tirole and his Toulouse co-author Jean-Charles Rochet demonstrated that the decision about profit-maximizing pricing is complicated, and they do some heavy math to compute such prices under various theoretical conditions.

But they do not commit the mistake of thinking that regulators are necessarily better than firms in setting prices. Consider the recent issue of interchange fees (IF) in payment-card associations like Visa and MasterCard . Many regulators have advocated government regulation of such fees. But in 2003, Messrs. Rochet and Tirole wrote that “given the [economics] profession’s current state of knowledge, there is no reason to believe that the IFs chosen by an association are systematically too high or too low, as compared with socially optimal levels.” In other words: Back off. Interestingly, the article from which I’m quoting was not among the 159 articles referenced by the Nobel Committee.

If George Stigler were alive today, he would probably recognize, in Jean Tirole, a kindred spirit. In 1950 Stigler advocated breaking up U.S. Steel . In his 1988 memoirs he confessed, “I now marvel at my confidence at that time in discussing the proper way to run a steel company.” Mr. Tirole seems to share Stigler’s humility.

Mr. Henderson is an economics professor at the Naval Postgraduate School and a research fellow at Stanford’s Hoover Institution.