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Nobel economics prize winner an economist and a gentleman

Kindness, humility - and a new approach to regulating monopolies: Nobel Prize for Economic Science, Jean Tirole. AAP/EPA/Studio Tchiz/

The winner of this year’s Nobel Memorial Prize in Economic Sciences, Jean Tirole, is one of the most prolific, respected and admired economic theorists of the last 30 years and has had significant influence on the way regulators think, particularly around monopolies.

A French economist working at the Toulouse School of Economics, Tirole combines the rare gift for an economist of not only being a brilliant theorist but also being able to apply his insights in the world of business and public policy where his work has had substantial and lasting effects.

The theoretical framework Tirole brought to the study of market structures and regulation relies heavily on advances in game theory and mechanism design. Tirole treats the problem of regulation as a principal–agent relationship in which the regulator is the principal and the regulated firm is an agent pursuing its own objectives and having private information the principal does not have.

A particularly vexing problem for a regulator is how to deal with natural monopolies, such as military equipment providers or public utilities. In these industries, competition is often not a practical option as cost-advantages make a single large provider more efficient. However, if left unchecked a natural monopolist will charge a price much higher than its cost, thereby earning large profits while hurting customers or tax payers who would benefit from a lower price.

If the regulator imposes a rigid price cap, the firm has an incentive to operate efficiently and minimise costs; but since the regulator does not know the firm’s overall costs, the firm may either be very profitable or at the brink of bankruptcy depending on where the price cap was set. To avoid this problem regulators moved to regulating the rate-of-return the firm is allowed to earn based on what is deemed a “reasonable” rate of return on the firm’s investments.

But as a result the firm no longer has an incentive to operate efficiently—indeed, additional capital investments raise the cost-base on which the rate of return is calculated and thus increase the firm’s total profits. In the context of the Australian electricity grid this phenomenon is known as “gold-plating”. Thus each of these two forms of regulation addresses one problem while exacerbating the other.

Tirole’s work (primarily with the late Jean-Jacques Laffont) proposes designing optimal incentives to solve this and other regulatory problems. In the above example, instead of using either price-cap or rate-of-return regulation, the regulator could offer the firm the option of choosing between price-cap and a rate-of-return regulation.

A firm with low costs would then choose the price cap as this allows the firm to benefit from low costs and from further productivity enhancements, while a higher-cost firm would choose rate-of-return regulation as this guarantees its return despite the higher cost.

Now, since the firm’s choice reveals whether it has low or high cost, the price cap offered can be lower and the rate-of-return more specifically tailored to the firm than when this information is private. The regulator thus benefits from being able to design to the type of firm it faces, thus improving the overall outcome.

The research has led to a deep understanding of regulatory mechanisms to minimise the welfare loss resulting from the firm’s private information and unobserved behaviour.

Tirole’s work also analyses competition when there are just a small number of large firms, such as the grocery industry, banking, telecommunications. Prior to his work, there were few tools to analyse the competitive behaviour of firms, and the standard tools were largely based on the number and sizes of firms in a market. Using the new tools of game theory, Tirole and his co-authors redefined the way economists think about competitive behaviour in oligopolistic markets.

They showed that key drivers of competitive behaviour are (1) whether some firms in the industry have an informational advantage; (2) beliefs about the actions of other firms in the industry; (3) the nature of competition in our industry, which depends on the technology and products provided. For example, competition in the airline industry is shaped partly by the seats available on a route, and partly by differences in quality perceived by customers.

Prior to Tirole’s work, many economists argued that antitrust agencies such as the ACCC should not oppose vertical mergers (a large firm buying its supplier) or vertical restraints (a large firm refusing to deal with more than one customer firm, or pressuring their supplier to cut off other customers). Even if the firm is a monopolist, they argued, the source of its power is monopoly in that one market which it can’t leverage into related markets.

But Tirole and his co-authors showed that a monopoly can increase its power by using vertical mergers or restraints. For example, if a firm who buys from the monopoly cannot observe how much is sold to their competitors, the monopoly is tempted to offer additional discounted sales to some customers, which reduces their competitors’ profits.

In the long run, this undermines the monopolist’s ability to sustain high prices. By acquiring one of the downstream firms, or by giving exclusivity to one firm, the monopolist can restore his pricing power because that downstream firm will be protected from secret discounts. As a result of these insights, competition authorities are now much more cautious when evaluating vertical mergers and vertical restraints.

Tirole did not dwell in the abstract; he has studied the credit card industry, banking, telecommunications, patent races, and other industries. He was instrumental in creating the area of “applied theory” in economics in which detailed characteristics of a market infuse the construction of an appropriate model.

The unified theoretical framework he developed has made it possible for a large body of empirical work to develop, dedicated to identifying which of the theoretical models best describes the conduct of firms. This empirical field assists firms and regulators in predicting the effect of mergers, policy changes, and the design of better regulation.

Tirole is also admired as a teacher and mentor. His work and several influential text books have shaped a generation of economists. In 1991 he left MIT to found the Institut d’Economie Industrielle at the University of Toulouse with Jean-Jacques Laffont.

They built the Institute into one of the leading centres of economic research in Europe, and it has had a huge impact on the training of young European economists. He constantly makes himself available to students and less influential colleagues. Kindness and humility are not traits commonly found in renowned economists, but they certainly characterise Jean Tirole.

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