Why Tirole

Jean Tirole’s Nobel prize has generated much excitement for those of us working alongside him at the Toulouse School of Economics (TSE). Tirole’s prize comes as recognition for over 30 years of work on a wide range of topics, from banking and finance to the regulation of network businesses. On a sombre note, it also comes at a time when we at the TSE are commemorating a decade since the passing of Tirole’s collaborator, Jean-Jacques Laffont, who, Tirole noted, “would have deserved to be with me” in receiving the prize.

The Nobel committee’s award specifically focuses on Tirole’s “analysis of market power and regulation”. There are two central questions. First, how will firms behave when there are only a few of them in the market? What prices will they set, what range of goods will they offer, and what will be the quality level of these goods? Second, if competition among firms is insufficient to constrain prices, what policies should regulators use for the benefit of consumers and society at large?

To answer these questions, Tirole has championed the approach offered by information economics, which centres on the role of information that individuals and firms hold privately. A classic example is the regulation of a firm’s pricing, say, a privately owned network that supplies electricity to homes and businesses. Such distribution networks are examples of “natural monopolies”: firms that face no competitors because replication of their infrastructure is infeasible or too costly. Other examples include railroads, ports and phone lines.

The question for a regulator of a natural monopoly is how to set the firm’s prices, given that it has better information about its technology. One possibility is to simply let the firm recover all of its costs. But this gives the firm’s managers little reason to reduce expenditures. Indeed, the management might engage in wasteful spending that benefits only themselves, knowing that the firm will be reimbursed. Alternatively, the regulator could fix a price that does not depend on the firm’s cost. The firm then keeps any reduction in expenditures for itself; that is, there are strong incentives to reduce spending. Unfortunately, this also means that very efficient firms make large profits to the detriment of consumers. The contribution of Tirole, together with Laffont, was to derive the optimal incentive scheme. They showed that the optimal scheme lies between the two extremes. Optimal regulation balances incentives for efficiency against reductions in firm profits.

Laffont and Tirole also studied dynamic models of regulation, noting that regulators do not set firm incentives once and for all but typically revise them overtime. They analysed the problem of a regulator that cannot commit to its future policies, showing how a firm will be led to reveal its true costs only gradually. Tirole has considered a host of other issues, specific to different markets. Together with Jean-Charles Rochet, he has been a leader in the study of platforms operating in “two-sided markets”. Here, a platform is a firm that provides services to users on each side. Credit cards provide services not only to cardholders but also to merchants who accept these cards. Newspapers not only attract readers, but also sell advertising space to companies that want to reach these readers. Tirole studied pricing and competition in these markets, influencing thinking on the regulation of credit-card interchange fees (the fees paid by a merchant’s bank to a customer’s bank). Another example is his study of “patent pools” (in collaboration with Josh Lerner), where companies come together to cross-license patents needed for a given technology. Such arrangements seem increasingly important in high-tech industries such as software development and biotechnology. However, because companies set prices for the pooled patents cooperatively, it is natural to worry that the practice could hurt consumers. Lerner and Tirole argued that it is difficult to assess whether this is the case, and that it depends on the market in question. But they were still able to provide robust policy advice. Tirole has also studied regulatory issues in banking and finance, of special interest in view of the recent financial crisis. He studied the implications of government bailouts in banking and considered how a government can restore a frozen asset market — the dilemma that was faced in the US market for mortgage-backed securities. As these examples attest, Tirole’s prize was not for a single contribution but for a wide-ranging body of work. He has been successful in identifying topics of importance for practitioners, such as regulatory policymakers. The running theme is careful modelling of the incentives faced by individual actors. He has devised models that are detailed enough to capture the relevant complexities, but simple enough to be accessible to a wide readership of economists.