by Matthew Short
Jean Tirole rocked the world of professional economists when he received the 2014 Nobel Prize in Economic Sciences. He was awarded for his work in the fields of industrial regulation, competition and strategic behavior in non-competitive industries, such as banking and telecommunications. The French native and Massachusetts Institute of Technology graduate whose work is often described by his colleagues with, “It’s complicated,” was honored for his groundbreaking insights that have become enshrined in government policy and revamped economic thought. Compared with the work of previous Nobel laureates who were focused on developing new econometric theories, Tirole’s work is refreshingly applicable in everyday life.
The French economist, together with a group of his colleagues, helped shape government thinking about monopoly regulation. Tirole put forward the idea of the Edgeworth price cycle, claiming that firms engage in price wars (cutting the prices below those of their competitors) to increase their market share. A return to the equilibrium price would occur only when the weaker firm has exhausted its financial resources by selling too cheap. Therefore, whenever a firm perceives a financial advantage over its rival, it has an incentive to engage in a price war. Despite the lower prices during the battle, the benefit to consumers is inconsistent to say the least. Once the dust settles, consumers are left at the mercy of the winner who then sets a price just under the loser’s marginal cost, and the whole process starts over. This theory only addresses duopolies specifically, but his work is also relevant to small oligopolies. Moreover, other economists have collected empirical evidence confirming this phenomenon in retail gasoline markets.
Perhaps Tirole’s most notable contribution to economics has been his influence on industrial regulation. While the U.S. has remained stagnant in implementation of his theories on industry regulation, Tirole has played a major role in Europe by way of his ideas on telecommunications. The American cable industries are thus still dominated by monopolies or small oligopolies whereas the Europeans diversified their market by forcing cable company owners to offer licensing agreements for existing infrastructure (such as sharing tower stations or frequency sharing) to new entrants. This way, the entrant and the incumbent reduce their technology investment costs, while the initial investment does not act as a barrier to the market entry. “What we’ve been trying to do is to get regulation which is light enough in order to let innovation happen and to promote investment by the incumbents,” Tirole explained.
Some Neo-Keynesian economists have displayed a stark affinity for competition laws due to a general distrust of firms and their suppliers collaborating “against” the consumer. Vertical economic integration (one firm owning its own supply chain) is, according to them, negative, because the firms and contractors can conspire in order to set the higher price. Tirole and his coauthors, on the other hand, stipulated that vertical integration does not necessarily have a negative effect to social welfare. Other researchers in this field claim that the overall social welfare is a trade-off between efficiency gains (creating your own network of suppliers) and consumer welfare (reaching the equilibrium price). Moreover, Tirole maintains that smart government regulation can compensate consumers elsewhere. Simultaneously, the incumbent company is prevented from maintaining monopolistic pricing and is encouraged to continue improving its services.
In the financial sector, many of Tirole’s ideas have been integrated into supranational and national law. Tirole foresaw that moral hazard problems would inevitably result in a financial crisis, whereby the state would distort the risk assessment of investors. The promise of the state coming to the rescue results in investment banks taking greater risks than they are able to handle, as seen during the latest economic crisis. Tirole argues that governments should buy out failing banks (those holding junk assets), but at heavily discounted rates. Other investment banks that hold intermediately priced assets should seek government financing on those same assets. These asset holders would therefore only pay a small regular interest payment in order to sell their assets once the market price was restored. Therefore, only investment banks with the healthiest assets are allowed back on the market. Unfortunately, many governments did not take this approach in the aftermath of the 2008 crisis – most banks were rescued at full rates irrespective of the quality of their assets.
Jean Tirole is the first Frenchman to win the award in economic sciences since 1988. Despite being described by the Nobel Committee as the “most influential economist of our time,” Tirole remains modest. When asked about his opinion on net neutrality, he answered, “… but I should pay attention to what I know and not talk more just because I won a Nobel Prize.” However, when he has something to say, one should take a seat. After all, in light of the inherent moral hazard in state-industry relationships, an application of Tirole’s work could prevent the next financial crisis.