The choice of Economics Nobel laureates is often a subject of contention. The award of the 2014 Nobel Prize in Economics to Jean Tirole is not such a choice. He started appearing as a shoo-in for the prize in informal polls of economists and annual pre-Nobel announcement lotteries almost two decades back.
His research for more than three decades in the domain of Industrial Organisation (IO) provides a normative theoretical basis for evaluating the structure and performance of individual markets and for economically reasoned intervention in them. The positive aspects of IO theory, i.e., explanations of why a particular market structure can be expected to deliver certain outcomes, are of venerable vintage. Over the last few decades, these explanations have been sharpened with the use of game theoretical models.
While it was well understood that certain markets had to be imperfect, e.g., natural monopolies, and that this called for government intervention in the service of social welfare, the normative theory required for prescribing the nature and extent of such regulation was scanty and did not add up to a systematic framework. As a result, regulatory practice was based on jurisprudence largely innocent of economic logic, historical precedent and bureaucratic norms, with only an obligatory bow towards economic principles.
The reason for the unsatisfactory nature of normative IO theory was the absence of the theoretical tools required for modeling asymmetric information?a key regulatory challenge. While the effects of regulating a monopoly will depend on the regulated firm?s cost structure, this data is typically private information for the firm and not ascertainable by the regulator.
A solution to this problem awaited two key developments further up the theoretical food-chain. The first was the development of a theory of incomplete information games, i.e., games in which players have asymmetrical information. This happened in the 1970s in the work of John Harsanyi (Nobel laureate, 1994). The second was the fashioning of a framework for systematically comparing the properties of alternative institutional arrangements, such as different regulatory structures. This area of economics, called mechanism design, has roots in the 1960s, but it found its true calling after it was harnessed together with Harsanyi?s concept of a Bayesian Nash equilibrium. This work started in the mid-1970s and gathered steam in the 1980s in the work of (among others) Roger Myerson and Eric Maskin (Nobel laureates, 2007).
Jean Tirole was the right person (trained in engineering and decision theory at the elite Ecole Polytechnique and the Ecole Nationale des Ponts et Chausse?es), at the right time (late 1970s), in the right place (MIT doctorate and later professor) to put this marriage to work in the area of normative IO theory, in particular the problem of optimal regulation. The rest, as they say, is history?copious research output of prodigious quality.
The theory of optimal regulation provides a coherent economic framework for the regulation of industries characterised by naturally imperfect markets, such as network industries (e.g., telecommunications, electricity, oil and gas). In this framework, the regulator considers contracts with the firm that (a) provide incentives to the firm to willingly ?participate? in the regulatory arrangement, and (b) induce the firm?s ?good behavior?, subject to (c) the constraint that the firm has private information not available to the regulator. Among the contracts that perform all three tasks, the optimal contract is the one whose outcomes are considered best by the regulator?where competition concerns are addressed while maintaining investment incentives. Depending on the context, the regulatory contracts translate into tariff orders, standards of performance contracts, access rules, etc.
Another application of Tirole?s work is the regulatory system of access prices and access rules for network industries in which competition is deemed infeasible because of natural monopoly features, e.g., the infrastructure required for the transmission and distribution of electricity and last mile networks in telecommunications. A system of regulated access allows potentially competitive segments of network industries, e.g., power generation in electricity, gas production in the natural gas industry and long-distance services in telecommunications, to become more competitive than they would be otherwise.
More recently, his work on multi-sided markets, i.e.,markets where groups of agents interact via intermediaries or platforms (e.g.,operating system software, web portals, video game consoles, payment systems and search engines) is guiding antitrust policy.
The institutional context for Tirole?s work is also important. While Tirole and numerous collaborators have built a sophisticated theory to guide regulators and thereby accorded regulators an important institutional space in market economies, subsequent work recognises the institutional and political-economy constraints on regulators.
It was pointed out, especially by Laffont, that it is important to recognise that effective regulation is hampered by the weak institutional environment of developing countries, which results in the regulatory contract between governments and firms being incomplete. It is vital that the political system provides a clear objective and mandate to a regulator. The regulator should have the legal basis and the incentives to pursue her mandate. However, the creation and sustenance of independent regulatory institutions requires a substantial degree of political will and judicial maturity. Here in lies the rub.
Sudhir A Shah & Payal Malik
Shah is Professor of Economics, Delhi School of Economics and Malik is Advisor (Economics) Competition Commission of India