Tirole’s Nobel Prize in Economics and Its Implications for Regulation

This year’s economics Nobel Prize (technically, it is not a Nobel Prize, but the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel) went to the French economist Jean Tirole. The price was awarded for his “analysis of market power and regulation”, according to the Royal Swedish Academy of Sciences.

Tirole has devoted much of his academic career to the question how to regulate markets with oligopolistic or monopolistic characteristics, such as companies in formerly public industries (railroads, post, telecommunications, highways, electricity and utilities). In other words, Tirole addresses markets which the economics profession traditionally does not believe to exist, as economists usually presuppose markets to be perfect, with fierce competition and in which companies are price takers as opposed to price setters. Left unregulated, such markets run danger of producing socially undesirable results: higher prices than justified by firms’ costs or the survival of inefficient companies by blocking entry of more productive ones. Regulating imperfect markets, however, is difficult. In this context, Tirole stresses the importance of asymmetric information – that is, firms are generally more knowledgeable than the government with regard to industry-specific details, such as production costs. The task of regulating these markets is further complicated by the fact that oligopolistic/monopolistic markets are different from case to case. Hence, there exist no standard solutions for regulation. For example, the committee points towards undercutting prices, which is generally prohibited under competition law, as setting prices below one’s production costs is an instrument for eliminating competition. Looking at the newspaper market, however, makes clear that prohibiting price cutting is not warranted in all cases. Newspapers, for example, often give away free copies in order to attract readers and thus increase advertisement income.

Tirole deserves special credit, however, for not being blind to the dangers accompanying industry-specific regulation. In this context, Tirole acknowledges that regulators may be captured by the ones they are supposed to be regulating in the public interest. Stigler (1971) is generally credited for conceptualising the economic theory of regulation (backed by empirical data) which posits that regulation often benefits producers rather than consumers. The reason for this lies in the fact that firms have a high stake in the outcome of regulatory decisions and will therefore devote considerable resources to gain favourable regulation. The public’s interest, on the other hand, is widely dispersed and any individual only has a small stake in the outcome. Thus, regulators may provide regulation in response to demand. Tirole, together with Laffont, complemented Stigler’s economic theory of regulation by providing a supply-side aspect. The authors allow for agency problems which manifest themselves in regulators providing favourable regulation for the regulated entities. According to Laffont & Tirole, decision-makers may be captured by the regulatees through monetary bribes, personal relationships, revolving doors between regulating agencies and the industry as well as party contributions.

Tirole’s seminal contribution to the way we see and try to regulate imperfect markets is deserving of the price in its own right. The Prize, however, is well-earned for at least two additional reasons: First, the trend towards successively less market discipline in favour of more regulation in the financial sector continues unabated after the crisis. As I and others have pointed out (see, for example, here and here) regulatory capture has played a crucial role in causing the financial crisis of 2007-2009. Second, the Prize comes at a time when the European Union has chosen to confer authority over bank supervision and regulation on the ECB as a non-democratically elected institution with no formal accountability. Clearly, the possibility of regulatory capture in combination with entrusting an institution devoid of any accountability with bank oversight raises red flags. Therefore, policymakers and regulators would be well-advised to read Tirole’s œuvre (along with other capture theory literature in general) and critically question the regulatory approach for the challenges ahead.

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