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.”
In 2014, the most immediate and relevant application of part of Tirole’s thinking surrounds the workings of “platform markets.” Platform markets have actually been with us for a very long time, but only recently have they penetrated common awareness and assumed outsize importance in the economy. Here a definition and a bit of discussion from the always helpful Marginal Revolution (emphasis mine):
Platform markets, also called two-sided markets, are markets where a firm brings together two or more sides both of whom benefit by the existence of the platform and both of whom may (or may not) be charged. … An example is the Xbox, a platform for game players and game developers, credit cards a platform for buyers and firms that accept that card, newspapers a platform for readers and advertisers, and malls a platform for customers and stores to meet. An important example for the internet age is that Google is a platform of search users and advertisers [Airbnb and Uber are also platform markets—Bruce].
A key difficulty in these markets is that the price charged to one side of the market influences the demand on the other side of the market. The price a newspaper charges to readers, for example, influences the number of readers but that in turn influences the price that the advertisers, the other side of the market, are willing to pay to advertise in the newspaper. It further often happens that one side of the market is harder to “get” than the other and so the profit-maximizing prices on the two sides of the market are very different. One side of the market may even be “subsidized.” The price that newspapers charge readers, for example, is often much less than the cost of the newspaper. Or, to give another example, Microsoft makes money by selling its Xbox at close to cost or even below cost and charging game developers a fee for the right to write games for the Xbox and a royalty rate on their sales. Google finds it optimal to give its services away for free and just charge one side, the advertisers, for being on the platform.
Antitrust and regulation of two-sided markets is challenging because the two sets of prices may look discriminatory or unfair even when they are welfare enhancing.
This really brings me to why I thought this year’s award worthy of a note here on Adam Smith, Esq.
The more intimately familiar I become with Law Land, the more convinced to my core am I that context matters.
That, to coin a phrase, “it’s complicated” and “it depends.” That the microeconomics of the situation almost always trump the macroeconomics. I can’t say those insights are worthy of a Nobel, or even of a ride on the NYC subway (“that and a Metrocard…,” as the famous dismissive phrase goes), but they do matter.
One-size-fits-all models, matrices, and stratagems invariably disappoint.
But is it ever fascinating.
I can’t resist leaving this meditation on the Nobel without sharing with you a true story concerning a different Nobel Prize that qualifies squarely for the “You can’t make this stuff up” category. It comes courtesy of Lowering the Bar, and describes the experience Brian Schmidt, a winner of the 2011 Nobel in physics (for discovering the expansion rate of the universe is accelerating) had when he traveled recently to Fargo:
One of the things you get when you win a Nobel Prize is, well, a Nobel Prize. It’s about that big, that thick, weighs half a pound, and it’s made of gold.
When I won this, my grandma, who lives in Fargo, North Dakota, wanted to see it…. You would think that carrying around a Nobel Prize would be uneventful, and it was uneventful, until I tried to leave Fargo with it, and went through the X-ray machine. I could see they were puzzled. It was in my laptop bag. It’s made of gold, so it absorbs all the X-rays—it’s completely black. And they had never seen anything completely black.
They’re like, ‘Sir, there’s something in your bag.’
I said, ‘Yes, I think it’s this box.’
They said, ‘What’s in the box?’
I said, ‘a large gold medal,’ as one does….
So they opened it up and they said, ‘What’s it made out of?’
I said, ‘gold.’
And they’re like, ‘Uhhhh. Who gave this to you?’
‘The King of Sweden.’
‘Why did he give this to you?’
‘Because I helped discover the expansion rate of the universe was accelerating.’
(He got home safely and the Nobel was not confiscated.)
