Jean Tirole, theorist of industrial organisation, incomplete contracts, and a lot else besides, has just won the Nobel Prizefor economics. Usually, his insights show how real-world incentives are complicated, and contracts can be difficult to write and enforce. Much of his work is very relevant to India; here are just four such insights gleaned from his 35-year career.
PPPs, renegotiation and “incomplete contracts”
The Nobel work: From the early 1980s onward, Tirole – with a succession of co-authors – demonstrated the danger of writing contracts that could be easily renegotiated. Standard economics assumes that any contract can easily predict all future states of the world, and that possible payoffs are clear to both contracting sides. This assumption is easily violated in practice. Under such circumstances, cost overruns, for example, should very rarely occur in procurement contracts, or in public-private partnerships. Tirole’s work shows that “systematic unforeseeen cost overruns” are a possibility.
The India application: In India, private-public partnerships have been plagued by cost and time overruns. Tirole’s papers provide a basis for estimating exactly how this happens over and over again. In many cases, it demonstrates quite clearly the dangers of renegotiation of a settled contract. This is not just unjust to the other firms that have bid, if the contract is handed out in an auction setting. If in general renegotiation is a possible, Tirole’s work shows, then a climate in which renegotiation is inevitable will emerge – and so will cost overruns.
In later work, Tirole argues for an independent evaluation of all PPP contracts before they are signed, to prevent collusion between companies and bureaucrats. PPPs that are “unbundled” – in which development and operations are handled by separate contractors – are far less likely to lead to large-scale corruption. He also shows that firms use the threat of quitting a project to blackmail public parners into submission; if the government gives in, then a perverse incentive is created. Above all, Tirole shows that the simpler it is to write contracts and predict the future, and the more transparent the institutional structure, the fairer and more implementable contracts will be.
“Efficient access pricing”
The Nobel work: One of the central problems of a modern economy is how to open up networks – such as telecom or power networks – to competition and new companies. Tirole showed that new entrant companies who were given access to the expensive networks built up by incumbents would indulge in “cream-skimming” – work to wean away only the incumbents’ most lucrative customers. As the Nobel committee says: “Giving the incumbent the responsibility for covering the fixed cost of the network all by itself, and letting entrants free-ride by paying very low marginal-cost access prices, would inefficiently distort consumer choices towards the entrant.”
The India application: In India, problematic power supply is often cited as a major constraint for industrialisation. “Open access” to electricity has been promised for over a decade. This means that factories, for example, should be able to make contracts to have power supplied to them by companies other than their local state-controlled electricity utilities – but over the networks set up by the state electricity boards. There have been many complaints that “wheeling” or transmission charges have been charged by local electricity boards. Tirole’s work explains why such fees are charged – but it also provides guides and models to determine whether such charges are excessive.
Accountability and “multiple objectives”
The Nobel work: To what degree can government bureaucrats – or company managers – be trusted? What sorts of tasks will allow for greater accountability? Tirole and his co-authors have written a series of papers that have made major insights into these and related questions. In particular, when agencies or bureaucrats or executives have multiple missions, then they show mathematically that they are likely to be given less autonomy. When they have “fuzzy” missions – in other words, their job is too complex to be easily understood – then they are even less trusted.
The India application: Agencies like, say, the Reserve Bank of India, will find their independence easier to preserve if they commit to a single, monitorable target such as the consumer price index. Managers, too, will find themselves more free if just judged on the profits they make. However, consider Tirole’s own insight: “Incentives that are related to an easily measured objective (for example, the cost per student for a university, which can be easily reduced by teaching large numbers of students in large lecture halls) can cause one to ignore equally important objectives that one has neglected to measure (such as the quality of teaching or research).” Approaches such as India’s to financing and regulating education have typically ignored this insight.
Corruption and regulation
The Nobel work: Much of Tirole’s work has focused on how regulators and bureaucrats can be led into corruption. In one early paper, he showed that interest groups were actually more politically powerful when they benefited from inefficient regulation. If two groups were equally willing to bribe officials, but one bribed them towards efficiency and the other towards inefficiency, the latter would wind up with more influence. In another paper, he examined how companies could suffer long-term effects from a single failure in quality – a logic he extended to the effects on bureaucracies of a short period in which corruption happened to increase. A bureaucracy only had to give into corruption once – after that, corruption would become entrenched, and lack of trust endemic.
The India application: Tirole found that anti-corruption campaigns simply don’t work – they just encourage bureaucrats to postpone corruption till attention is elsewhere. Counter-intuitively, an amnesty for past corruption might actually help clean up bureaucracies. To reduce the threat of regulatory capture by business, the best thing for governments is to “reduce the stakes that interest groups have in regulation” – in other words, to ensure that the payoffs to even good firms from favourable regulatory decisions are small. More market, less regulation – counter to the popular conclusion that Tirole’s work argues for more regulation of big business.
PPPs, renegotiation and “incomplete contracts”
The Nobel work: From the early 1980s onward, Tirole – with a succession of co-authors – demonstrated the danger of writing contracts that could be easily renegotiated. Standard economics assumes that any contract can easily predict all future states of the world, and that possible payoffs are clear to both contracting sides. This assumption is easily violated in practice. Under such circumstances, cost overruns, for example, should very rarely occur in procurement contracts, or in public-private partnerships. Tirole’s work shows that “systematic unforeseeen cost overruns” are a possibility.
The India application: In India, private-public partnerships have been plagued by cost and time overruns. Tirole’s papers provide a basis for estimating exactly how this happens over and over again. In many cases, it demonstrates quite clearly the dangers of renegotiation of a settled contract. This is not just unjust to the other firms that have bid, if the contract is handed out in an auction setting. If in general renegotiation is a possible, Tirole’s work shows, then a climate in which renegotiation is inevitable will emerge – and so will cost overruns.
In later work, Tirole argues for an independent evaluation of all PPP contracts before they are signed, to prevent collusion between companies and bureaucrats. PPPs that are “unbundled” – in which development and operations are handled by separate contractors – are far less likely to lead to large-scale corruption. He also shows that firms use the threat of quitting a project to blackmail public parners into submission; if the government gives in, then a perverse incentive is created. Above all, Tirole shows that the simpler it is to write contracts and predict the future, and the more transparent the institutional structure, the fairer and more implementable contracts will be.
“Efficient access pricing”
The Nobel work: One of the central problems of a modern economy is how to open up networks – such as telecom or power networks – to competition and new companies. Tirole showed that new entrant companies who were given access to the expensive networks built up by incumbents would indulge in “cream-skimming” – work to wean away only the incumbents’ most lucrative customers. As the Nobel committee says: “Giving the incumbent the responsibility for covering the fixed cost of the network all by itself, and letting entrants free-ride by paying very low marginal-cost access prices, would inefficiently distort consumer choices towards the entrant.”
The India application: In India, problematic power supply is often cited as a major constraint for industrialisation. “Open access” to electricity has been promised for over a decade. This means that factories, for example, should be able to make contracts to have power supplied to them by companies other than their local state-controlled electricity utilities – but over the networks set up by the state electricity boards. There have been many complaints that “wheeling” or transmission charges have been charged by local electricity boards. Tirole’s work explains why such fees are charged – but it also provides guides and models to determine whether such charges are excessive.
Accountability and “multiple objectives”
The Nobel work: To what degree can government bureaucrats – or company managers – be trusted? What sorts of tasks will allow for greater accountability? Tirole and his co-authors have written a series of papers that have made major insights into these and related questions. In particular, when agencies or bureaucrats or executives have multiple missions, then they show mathematically that they are likely to be given less autonomy. When they have “fuzzy” missions – in other words, their job is too complex to be easily understood – then they are even less trusted.
The India application: Agencies like, say, the Reserve Bank of India, will find their independence easier to preserve if they commit to a single, monitorable target such as the consumer price index. Managers, too, will find themselves more free if just judged on the profits they make. However, consider Tirole’s own insight: “Incentives that are related to an easily measured objective (for example, the cost per student for a university, which can be easily reduced by teaching large numbers of students in large lecture halls) can cause one to ignore equally important objectives that one has neglected to measure (such as the quality of teaching or research).” Approaches such as India’s to financing and regulating education have typically ignored this insight.
Corruption and regulation
The Nobel work: Much of Tirole’s work has focused on how regulators and bureaucrats can be led into corruption. In one early paper, he showed that interest groups were actually more politically powerful when they benefited from inefficient regulation. If two groups were equally willing to bribe officials, but one bribed them towards efficiency and the other towards inefficiency, the latter would wind up with more influence. In another paper, he examined how companies could suffer long-term effects from a single failure in quality – a logic he extended to the effects on bureaucracies of a short period in which corruption happened to increase. A bureaucracy only had to give into corruption once – after that, corruption would become entrenched, and lack of trust endemic.
The India application: Tirole found that anti-corruption campaigns simply don’t work – they just encourage bureaucrats to postpone corruption till attention is elsewhere. Counter-intuitively, an amnesty for past corruption might actually help clean up bureaucracies. To reduce the threat of regulatory capture by business, the best thing for governments is to “reduce the stakes that interest groups have in regulation” – in other words, to ensure that the payoffs to even good firms from favourable regulatory decisions are small. More market, less regulation – counter to the popular conclusion that Tirole’s work argues for more regulation of big business.
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