Around this time of year the Nobel Prize in Economics is awarded, and while we don’t always cover it here on Adam Smith, Esq., this year’s is worth a note.
As everyone who cares about these things an iota knows by now, the winner was Jean Tirole of Toulouse University in France, for his work on the dynamics of firm behavior, and appropriate regulatory responses, in industries with a few powerful firms. This year’s Economics Nobel was noteworthy not just for the substance of the work that won the award, but because it was the first time in at least a dozen years the prize went to a single individual, and it was the first time a couple of decades no American was in the winner’s circle.
But seriously, I write about it because it shows the Nobel Committee beginning to pay more attention to modes of market failure than to unalloyed celebration of the Swiss-watch-functioning perfectly rational and efficient market. Those of us who care about handling economics with a bit of rigor and nuance have long been skeptics of the frictionless and all-knowing classical model, so consider it continuation of the trend exemplified by such milestones as Daniel Kahneman’s Thinking Fast and Slow that have brought behavioral considerations, game theory, and the law of unintended consequences more to the fore.
The New York Times captured the gist of Tirole’s work best in an interview with him published a few days ago:
Q.: I’ve asked a number of economists to summarize the Tirole approach to regulation, and they basically agree the best answer is, “It’s complicated.”
A. There’s no easy line in summarizing my contribution and the contribution of my colleagues. It is industry-specific. The way you regulate payment cards has nothing to do with the way that you regulate intellectual property or railroads. There are lots of idiosyncratic factors. That’s what makes it all so interesting. It’s very rich.
It requires some understanding of how an industry works. And then the reasoning is very much based on game theory. Usually we don’t have a perfectly competitive market, so we use game theory, which describes situations with a small number of actors. And information economics, those are the tools. But then you go into the industries and try to think about the possible rules. It’s not a one-line thing.
As the Nobel Prize committee said in its award:
Many industries are dominated by a small number of large firms or a single monopoly. Left unregulated, such markets often produce socially undesirable results – prices higher than those motivated by costs, or unproductive firms that survive by blocking the entry of new and more productive ones.
From the mid-1980s and onwards, Jean Tirole has breathed new life into research on such market failures. […]
Before Tirole, researchers and policymakers sought general principles for all industries. They advocated simple policy rules, such as capping prices for monopolists and prohibiting cooperation between competitors, …. Tirole showed theoretically that such rules may work well in certain conditions, but do more harm than good in others. [For example,] cooperation on price setting within a market is usually harmful, but cooperation regarding patent pools can benefit everyone. The merger of a firm and its supplier may encourage innovation, but may also distort competition.
The best regulation or competition policy should therefore be carefully adapted to every industry’s specific conditions.
And a bit of historic context helps. In the 1970’s and ’80s, the University of Chicago school of economists and the parallel “law and economics” movement tended to dominate regulatory thinking. And that school’s basic belief was that competition solves everything, even in industries with few players. Tirole moved beyond this by adding in a little game theory and asymmetric information—adverse selection, moral hazard, and their brethren—to show that sometimes regulation improved social outcomes, sometimes it aggravated bad outcomes, and mostly it all depend on exactly how the industry dynamics and the regulatory response were structured. As much as “it’s complicated,” this is pretty much captured by the alternative formulation, “it depends.”