In 2014, French economist Jean Tirole was awarded the Nobel Prize in Economic Sciences “for his analysis of market power and regulation.” His main research, in which he uses game theory, is in an area of economics called industrial organization. Economists studying industrial organization apply economic analysis to understanding the way firms behave and why certain industries are organized as they are.
From the late 1960s to the early 1980s, economists George Stigler, Harold Demsetz, Sam Peltzman, and Yale Brozen, among others, played a dominant role in the study of industrial organization. Their view was that even though most industries don’t fit the economists’ “perfect competition” model—a model in which no firm has the power to set a price—the real world was full of competition. Firms compete by cutting their prices, by innovating, by advertising, by cutting costs, and by providing service, just to name a few. Their understanding of competition led them to skepticism about much of antitrust law and most government regulation.
In the 1980s, Jean Tirole introduced game theory into the study of industrial organization, also known as IO. The key idea of game theory is that, unlike for price takers, firms with market power take account of how their rivals are likely to react when they change prices or product offerings. Although the earlier-mentioned economists recognized this, they did not rigorously use game theory to spell out some of the implications of this interdependence. Tirole did.
One issue on which Tirole and his co-author Jean-Jacques Laffont focused was “asymmetric information.” A regulator has less information than the firms it regulates. So, if the regulator guesses incorrectly about a regulated firm’s costs, which is highly likely, it could set prices too low or too high. Tirole and Laffont showed that a clever regulator could offset this asymmetry by constructing contracts and letting firms choose which contract to accept. If, for example, some firms can take measures to lower their costs and other firms cannot, the regulator cannot necessarily distinguish between the two types. The regulator, recognizing this fact, may offer the firms either a cost-plus contract or a fixed-price contract. The cost-plus contract will appeal to firms with high costs, while the fixed-price contract will appeal to firms that can lower their costs. In this way, the regulator maintains incentives to keep costs down.
Their insights are most directly applicable to government entities, such as the Department of Defense, in their negotiations with firms that provide highly specialized military equipment. Indeed, economist Tyler Cowen has argued that Tirole’s work is about principal-agent theory rather than about reining in big business per se. In the Department of Defense example, the Department is the principal and the defense contractor is the agent.
One of Tirole’s main contributions has been in the area of “two-sided markets.” Consider Google. It can offer its services at one price to users (one side) and offer its services at a different price to advertisers (the other side). The higher the price to users, the fewer users there will be and, therefore, the less money Google will make from advertising. Google has decided to set a zero price to users and charge for advertising. Tirole and co-author Jean-Charles Rochet showed that the decision about profit-maximizing pricing is complicated, and they use substantial math to compute such prices under various theoretical conditions. Although Tirole believes in antitrust laws to limit both monopoly power and the exercise of monopoly power, he argues that regulators must be cautious in bringing the law to bear against firms in two-sided markets. An example of a two-sided market is a manufacturer of videogame consoles. The two sides are game developers and game players. He notes that it is very common for companies in such markets to set low prices on one side of the market and high prices on the other. But, he writes, “A regulator who does not bear in mind the unusual nature of a two-sided market may incorrectly condemn low pricing as predatory or high pricing as excessive, even though these pricing structures are adopted even by the smallest platforms entering the market.”
Tirole has brought the same kind of skepticism to some other related regulatory issues. Many regulators, for example, have advocated government regulation of interchange fees (IFs) in payment card associations such as Visa and MasterCard. But in 2003, Rochet and Tirole wrote that “given the [economics] profession’s current state of knowledge, there is no reason to believe that the IFs chosen by an association are systematically too high or too low, as compared with socially optimal levels.”
After winning the Nobel Prize, Tirole wrote a book for a popular audience, Economics for the Common Good. In it, he applied economics to a wide range of policy issues, laying out, among other things, the advantages of free trade for most residents of a given country and why much legislation and regulation causes negative unintended consequences.
Like most economists, Tirole favors free trade. In Economics for the Common Good, he noted that French consumers gain from freer trade in two ways. First, free trade exposes French monopolies and oligopolies to competition. He argued that two major French auto companies, Renault and Peugeot-Citroen, “sharply increased their efficiency” in response to car imports from Japan. Second, free trade gives consumers access to cheaper goods from low-wage countries.
In that same book, Tirole considered the unintended consequences of a hypothetical, but realistic, case in which a non-governmental organization, wanting to discourage killing elephants for their tusks, “confiscates ivory from traffickers.” In this hypothetical example, the organization can destroy the ivory or sell it. Destroying the ivory, he reasoned, would drive up the price. The higher price could cause poachers to kill more elephants. Another example he gave is of the perverse effects of price ceilings. Not only do they cause shortages, but also, as a result of these shortages, people line up and waste time in queues. Their time spent in queues wipes out the financial gain to consumers from the lower price, while also hurting the suppliers. No one wins and wealth is destroyed.
Also in that book, Tirole criticized the French government’s labor policies, which make it difficult for employers to fire people. He noted that this difficulty makes employers less likely to hire people in the first place. As a result, the unemployment rate in France was above 7 percent for over 30 years. The effect on young people has been particularly pernicious. When he wrote this book, the unemployment rate for French residents between 15 and 24 years old was 24 percent, and only 28.6 percent of percent of those in that age group had jobs. This was much lower than the OECD average of 39.6 percent, Germany’s 46.8 percent, and the Netherlands’ 62.3 percent.
One unintended, but predictable, consequence of government regulations of firms, which Tirole pointed out in Economics for the Common Good, is to make firms artificially small. When a French firm with 49 employees hires one more employee, he noted, it is subject to 34 additional legal obligations. Not surprisingly, therefore, in a figure that shows the number of enterprises with various numbers of employees, a spike occurs at 47 to 49 employees.
In Economics for the Common Good, Tirole ranged widely over policy issues in France. In addressing the French university system, he criticized the system’s rejection of selective admission to university. He argued that such a system causes the least prepared students to drop out and concluded that “[O]n the whole, the French educational system is a vast insider-trading crime.”
Tirole is chairman of the Toulouse School of Economics and of the Institute for Advanced Study in Toulouse. A French citizen, he was born in Troyes, France and earned his Ph.D. in economics in 1981 from the Massachusetts Institute of Technology.
About the Author
David R. Henderson is the editor of The Concise Encyclopedia of Economics. He is also an emeritus professor of economics with the Naval Postgraduate School and a research fellow with the Hoover Institution at Stanford University. He earned his Ph.D. in economics at UCLA.