On Tuesday night, I went to a pub quiz and spent the last few minutes before it began googling the 2014 Nobel prizewinner for Economics – in case it came up as a question.
It didn’t.
There were, however, some questions about recent soccer scores. And a brief triumphant moment where I correctly guessed that the unit of currency in use today that was once a unit of weight in Ancient Mesopotamia was the (Israeli) shekel*.
*Confession: it did help that the quizmaster was Jewish.
Jean Tirole, who won the 2014 Sverige Riksbank’s Prize in Economic Sciences in memory of Alfred Nobel, is French. And he won it for his work in New Industrial Organisation (or “new IO” – or “calculated silliness” as Paul Krugman so affectionately refers to it).
“Calculated Silliness”
In a time before Jean Tirole (and his colleague Jean-Jacques Laffont – who suffers from the unfortunate personal crisis of being dead, thereby disqualifying him from sharing the prize), economists saw the world of business in two ways:
- A world in which a single business has all the power – moo ha ha! (Monopoly); or
- A world in which no business has any power whatsoever – boo. (Perfect Competition).
Of course, economists knew that the real world was somewhere in between – but then economists tend to live by “Yes, it works in practice – but does it work in theory, my good chap?”
You see – the problem is that the real world is econometrically-awkward. There are feedback loops, conundrums and irrational inconsistencies that make the whole business of modelling it with calculus – well – more than a life’s work. And that’s not good for winning Nobel prizes – because then you die and a protégé picks up where you left off and wins the 8 million kroner and all you’re left with is a passing reference in articles where the old guard are pretty sure that you would have won it if only you’d not been so unfortunately mortal. Humbug.
Anyway – because economists were so fixated on the extremes of perfect competition and monopoly, it meant that their solutions to market failures were somewhat prescriptive. As in “That market is a bit monopolistic – put a price cap on it!” or “Collusion is basically a monopoly, with is basically the root of all evil – destroy it with fines!”
There are some real problems with that kind of prescriptive approach. And just bear that “price cap” in mind for a moment – I’ll get to it shortly.
Jean Tirole was one of the many economists that noticed the problems associated with the simplistic measures being put in place. And instead of dealing with things mathematically, Jean Tirole went at the problem with a series of thought experiments, adding in dashes of game theory*.
*I’m simplifying – but that’s what I do.
So take the price cap as an example.
Thought experiment:
- If the government proposes a price cap, what might a rational firm do?
- It could set out to influence the setting of the price cap.
- It might present high cost schedules to justify the higher price cap – including lavish executive compensation packages, etc.
- It might also try to capture the regulatory bodies attempting to regulate it.
- And once the price cap is set, it might attempt to suppress any development or innovation that would result in lower prices due to lower costs – because why risk it?
- Cue: market failure.
- Which is not in the public interest – despite the original intention.
In particular, Jean Tirole’s work tended to focus on the large corporations that are so problematic to regulate – mainly because their size allows them to react to regulation in a way that can get a bit macro…
A quote from the New Yorker:
From Amazon’s battle with book publishers to Cablevision’s attempted takeover of Time Warner Cable and the European Commission’s investigation of Google, the issue of how to deal with companies that operate in markets where competition is restricted or absent has become front-page news around the world. Tirole and his colleagues, particularly the late Jean-Jacques Laffont, didn’t establish a set of hard-and-fast rules for governments to follow in individual cases. But they did create a unifying intellectual framework that regulators, aggrieved parties, and the companies themselves can draw on in thinking through the relevant issues.
The key point:
[Regulation is] an ongoing game between two players with different goals and secrets that they can hide from each other. In the language of game theory, in which Tirole is expert, it is a “principal-agent” problem, where the government is the principal and the firm is the agent. The general question then becomes this: Can you design a regulatory system that offers incentives to both sides—the regulators and the firms—to do things that are in the public interest?
And because I like flexible results, I’m a fan of this:
The Tirole approach doesn’t always point toward tougher oversight. In some cases, it may make sense for regulators to back off, lest they discourage firms from investing and innovating. As in many other areas of economics, a tradeoff is involved, in this case between stimulating technical progress and preventing firms from gouging consumers. On the other hand, Tirole points out, there’s also a danger that government officials will get “captured” by the industries they are supposed to be regulating, and go too easy on them.
Which sounds far more realistic than general economic theory would normally allow.
The Vitriol
When I was reading up on Jean Tirole, I came across this Austrian response: Nota Bene: Jean Tirole wins Nobel for a pseudo-problem.
In it, Mr Tirole is called “a garden-variety neoclassical economist”, alongside much belittling use of adjective (my personal favourite: “teeny-weeny”).
Basically, the crux seems to be “How dare you say that firms get caught up in games with each other – they’re just trying to find the right price to charge the market!”
Did I hear someone say ad hominem? And straw-man? And jealous much?
Delicious.
Rolling Alpha posts opinions on finance, economics, and the corporate life in general. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha.
