Nobel rewards economist who told us how to tame the big firms which run our lives

Pre-Nobel. Tirole at the IMF. International Monetary Fund

Jean Tirole has won a deserved Nobel prize. The French economist from Toulouse 1 Capitole University has made some significant contributions to almost all fields in economics, but it is his work in the field of industrial organisation that particularly stands out, and which drew admiring words from the the Nobel Committee:

Jean Tirole is one of the most influential economists of our time. He has made important theoretical research contributions in a number of areas, but most of all he has clarified how to understand and regulate industries with a few powerful firms.

This field of research answers questions about how market power distorts market outcomes and hurts consumers. It also attempts to describe what governments can do about it. Tirole’s work has helped enormously to understand how to design regulations in a world where corporations have market power and they know more about their own production process than the government does.

His works with various collaborators highlighted not only how good regulation should be designed, but also how badly designed regulations can impose more costs on society than it ideally would like to bear.

Power games

We can all see the new Nobel laureate’s relevance in the modern world by looking in some detail at just one of his innovations. The privatisation of utility companies in the 1980s and 1990s in many countries, both in Europe and elsewhere, was designed to bring entrepreneurship and private investment into this industry. However, it was clear from the outset that this market would be dominated by a few large firms and that competition would not serve to limit the prices these firms charge to customers. It was clear that government intervention is needed to do this – and an obvious regulatory policy measure was at the time to cap the prices of these firms.

Playing it smart with the power firms Ian Britton, CC BY

However, the early work of Tirole with Jean-Jacques Laffont pointed out that this early regulatory measure is counter productive. Low prices ultimately require low costs, hence the regulator also wants to ensure that the utility companies reduce their costs. Unfortunately, price caps induce utility companies which have less scope for cost reduction to reduce the quality of their service in order to lower their costs. Since the regulator does not know which firm has more scope for cost reduction and which has less, it cannot cap prices differently across firms.

Tirole and Laffont’s work implied that if the regulator offered two types of contract for utility companies – one with the usual price cap, and another one where the government shares the costs with the utility company, the former will be chosen by firms who can reduce costs more easily and the latter by firms who find it more difficult. Both then will have an incentive to reduce costs. This is less costly for society than the simple price-cap.

This early work opened up new avenues of research which recognised that a good regulatory regime should take into account how firms respond to a particular regulation – it is where game theory meets public policy and has influenced actual regulatory policy design over the past three decades.

Getting to the heart of the crisis

Our understanding of the global financial crisis has been shaped by his work. One of the most important questions for policy makers to answer has been how to make financial institutions more robust so that the huge social and economic costs may be avoided in the future. Several contributions from Tirole over the years offer important insights into the problems which have surfaced in financial systems since 2007.

During the crisis, financial regulators were criticised for too-cosy relationships with banks. The work of Tirole and Laffont provided one of the first analyses of such “regulatory capture” in 1991. They showed how to design a regulatory framework that minimises the risk. The crisis has also seen rating agencies fall under scrutiny for their role and, in his book with Matthias Dewatripont, Tirole warned against the exclusive use of private rating agencies back in 1994. And when we look at the breakdown of financial marketplaces, particularly the interbank market and its severe impact during the crisis, we can turn to Tirole’s work with Jean Charles Rochet published in 1996. That examined why systemic crisis is more likely to occur in a market where participants such as banks are strongly interconnected and made recommendations for what the regulator could do to minimise such a risk.

Rereading some of his research today helps to understand what happened during the financial crisis of 2007. If more regulators and policy makers had reread it before 2007, then things may have been quite different. This award goes some way to acknowledging that.