Jean Tirole: Market Power and Regulation

Jean Tirole is one of the most influential economists of our time. He has made important theoretical research contributions in a number of areas, but most of all he has clarified how to understand and regulate industries with a few powerful firms. Tirole was awarded the 2014 Nobel Prize for his analysis of market power and regulation.

Below a Scientific Background on JEAN TIROLE: MARKET POWER AND REGULATION compiled by the Economic Sciences Prize Committee of the Royal Swedish Academy of Sciences.

To what extent should the government intervene in the marketplace? Economists often consider fiercely competitive markets to be in the public interest. When producers in such markets strive to earn a profit, they are led — as if by an invisible hand — to deliver high quality at low cost. But many industries are not very competitive, and this lack of competition widens the scope for beneficial public intervention. Theories of regulation and competition policy aim to provide useful scientific guidance for such intervention. Clearly, any recommendations must rest on a sound understanding of how imperfectly competitive markets work. When a firm has market power, how will it behave? How does its behavior affect the firm’s suppliers, customers, and competitors? Questions like these are studied within the field of Industrial Organization (IO). George Stigler was awarded the 1982 Prize in Economic Sciences “for his seminal studies of industrial structures, functioning of markets and causes and effects of public regulation”. Since then, however, the IO field has undergone rapid development, indeed a revolution. This revolution has greatly enhanced our understanding of imperfectly competitive markets, which in turn has laid a foundation for better informed competition policy. Comparable progress has been made in the theory of optimal regulation of firms with market power.

The progress in these areas largely reflects two methodological breakthroughs: game theory and the theory of mechanism design. By the end of the 1970s, the time was ripe for applying these tools to the major issues of imperfect competition, regulation, and competition policy. Over the next decade, many economists were drawn into these fertile fields. The analytical revolution was to a large extent a collective effort but, among many contributors, Jean Tirole stands out. No other scholar has done more to enhance our understanding of IO in general, and of optimal policy interventions in particular. The theoretical advancements coincided with a period of great public-policy interest in the same issues. During the 1980s and 1990s, many countries pursued regulatory reforms and pro-competitive liberalization — sometimes in conjunction with privatizations. The European Union created the single market. Many new issues arose that could not be fruitfully studied with the help of existing theory — their analysis required a combination of oligopoly theory and contract (principal-agent) theory and an integration of industrial economics with public economics. Tirole’s expertise spans all these fields, and he was thus ideally positioned to make a lasting contribution.

Before discussing the specifics, let us emphasize that Tirole’s overall scientific contribution is greater than the sum of his individual contributions. He has created a unified framework for IO theory and regulation, founded on a rigorous analysis of strategic behavior and information economics. It is hard to do justice to his immense body of work in a few introductory paragraphs, but a few features of his research do loom large.

First, Tirole has established a new standard of rigor in the fields of IO and regulation. He has consistently derived his results from fundamental assumptions about preferences, technologies (including contracting technologies) and information asymmetries, eschewing the convenient but ad hoc assumptions that had previously seemed necessary in order to make analytical headway. From the outset, Tirole’s approach has required unusual technical expertise, especially in the rapidly evolving fields of game theory and contract theory. While this year’s prize emphasizes Tirole’s creative application of these analytical tools to regulation and IO theory, it is noteworthy that Tirole also made significant contributions to the toolbox itself.

Second, Tirole’s rigor has facilitated realism. Division of labor in the scientific community frequently encourages theorists to specialize in understanding the inner logic of new models, leaving the challenging job of confronting the models with reality to more applied scientists. As a result, theoretical work sometimes seems detached from “the real world” and “relevant practice”. By contrast, Tirole has carefully designed his models to capture essential features of specific economic environments, and to highlight important mechanisms that previous applied research had either ignored or failed to articulate with sufficient precision.

Third, Tirole has brought order to an unwieldy literature. By deploying a consistent conceptual framework over a wide range of issues, he became a leader in the creation of the first encompassing and coherent theory of IO. After more than 25 years, his groundbreaking 1988 textbook remains the best road-map to the field. If the book is becoming outdated in a few areas, this is largely due to Tirole’s own subsequent work and the work he has inspired. Tirole’s 1993 book, co-authored with Jean-Jacques Laffont, presented a unified framework which has deeply influenced how economists think about regulation.

Fourth, Tirole’s models have sharpened policy analysis. Focusing on the fundamental features that generate a divergence between private and public interests, Tirole has managed to characterize the optimal regulation of specific industries. Often, his rigorous thinking has overturned previous conventional wisdom. For example, he successfully challenged the once prevalent view that monopoly power in one market cannot be profitably leveraged into another market by vertical integration. As a result, competition authorities have become more alert to the potential dangers posed by vertical integration and restraints. More generally, Tirole has shown how the justifications for public intervention frequently boil down to problems of information asymmetries and credible commitments. These general lessons — together with a catalogue of specific applications — form a robust foundation for policy analysis.

In this document, we briefly summarize Tirole’s most important contributions to the theory of IO and the regulation of dominant firms.

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