It is not particularly difficult for an economist to pay tribute to Jean Tirole. His academic achievements, scholarship and ideas have deeply influenced almost all distinct fields of economics. His productivity resembles that of a human machine with numerous academic publications in the top journals and over 8 advanced scientific books. All of Tirole’s work is inspired from real and interesting socio-economic situations. In my opinion, the award of the 2014 Nobel Prize in economic sciences is not surprising at all.
One of Tirole’s principal contributions was the study of industries in which firms have significant market power or how it’s usually called Industrial Organization. Therefore, this award is interesting in that it underscores an ongoing debate about market regulation and bonus culture that has gained prominence since the onset of the financial crisis.
Can we regulate monopolies without distorting their incentives for cost reduction?
In most countries, goods like electricity and gas are provided by a single firm – in other words, they are natural monopolists. Governments allow these monopolies to exist because, arguably, the costs of establishing the networks required to provide these kinds of goods and services are larger than the potential benefit from competition. While attempting to reap the social benefits, governments attempt to keep these kinds of monopolies in check through regulation.
Regulation of monopolies is particularly difficult for two reasons. First, governments do not necessarily know a lot about the firm they are trying to regulate: they usually have little information about the costs of production or innovation. Auditing may be very costly for various reasons and therefore the government needs to give the right incentives to the monopolist to truthfully disclose his information. Second, while governments want monopolists to charge the lowest possible price, they also want them to invest in innovation so as to reduce the costs of production. This in conjunction with point one above makes the task of governments extremely complicated.
Even worse, in many countries, governments delegate regulation to an external authority. Naturally, a problem of collusion arises. How can we be sure that the authority and the monopolist don’t secretly make agreements that will result in a loss for the government and its citizens? In fact, this is the same question we could ask ourselves in multiple situations: when a party with authority (a principal) hires an expert (a supervisor) to supervise a subordinate (an agent), how can he prevent collusion (an illicit agreement) between the last two.
These are some of the key problems that Jean Tirole has tried to resolve. He took on the topic in his famous 1986 article with Jean Jacques Laffont “Using Cost Observation to Regulate Firms” and alone “Hierarchies and Bureaucracies: On the Role of Collusion in Organizations”. Some 30 years later, we’re still grappling with the problem.
Keep vertical restraints in check
Imagine a particular software operating system produced by a single firm. Developing the software may be costly and therefore the firm needs to grant large profits by setting a considerably high price. Assume that the firm cannot sell the software directly to consumers but needs to first distribute it to retailers who act as intermediaries.
If the upstream software developer distributes the software to many retailers, then it needs to charge a low price, and the fierce competition between retailers will leave little room for profits. The only solution would be for the software developer to sign an exclusive contract with one of the retailers which may inefficiently be prohibited by competition law. Therefore, in some cases legal restrictions may give too little incentives for beneficial R&D investment.
In his research with co-authors Patrick Rey (1986) and Oliver Hart (1990), Tirole showed how these kinds of legal restrictions would give too little incentives for beneficial R&D investment.