The importance of being Jean Tirole

On Monday, the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel (aka the Nobel Prize for Economics) for 2014 was awarded to Jean Marcel Tirole. The French professor from the Toulouse School of Economics has been recognised for his important theoretical contributions, especially in providing a unified framework for our understanding of market power and regulation of firms.

This is not esoteric theory, rather it is theory grounded firmly in the real economic world with a very strong policy flavour. Tirole is known for building simple and elegant mathematical models from fundamental premises drawing on his detailed knowledge of various industries and their specific features. These models incorporate strategic behaviour and information economics to understand the interaction between firms and how governments can design optimal regulatory policies.

Tirole’s work represents a break in the sense that specialists in regulatory economics in the past sought to design simple policies that governments could adopt for all industries. Tirole’s argument was that what works well in one industry may not work well in other situations.

Regulatory economics basically asks what activities should be conducted by the public sector and what should be left to private players, and also how the latter should be regulated when necessary. Much of the earlier work was done based on two benchmark cases of either a monopoly firm or the frictionless, hypothetical world of perfect competition where all firms are identical and enjoy no market power.

Tirole, however, provided a new standard of rigour in theory that captured specific economic environments and yet provided order to a rather unwieldy literature. His work rests strongly on the building blocks of modern microeconomics — game theory, asymmetric information and contract theory.

The starting point of his work is that in the real world markets are not dominated by one firm but by a small number of big firms with power in the markets. In technical terms, thus, they are oligopolies.

Game theory looks at how the final outcome of any situation depends on the actions of multiple actors. Using this framework, Tirole showed that the consequences of regulation depended not only on what action the regulator took, but also on how the few big firms interacted with each other.

Information economics is important because often regulators aren’t fully aware of the actual production costs of firms, creating asymmetric information that can have untended consequences from any regulatory actions. Contract theory, likewise, emphasises that the government can only write short-term contracts with firms and this has consequences for the future behaviour of firms.

At the risk of oversimplification, Tirole’s work may be summed up by the prescription that policymakers should refrain from a one-size-fits-all approach to regulation.

If the government feels firms in a market are going to exploit consumers by charging high prices — think drugs — they can impose price caps. But price caps can also create strong incentives for firms to cut down costs to the extent where only a few of them remain in the market allowing them to make excess profits. This will not be in the consumer’s long-term interest and hence not the best policy in all situations.

Instead, a better approach could be to offer firms a menu of cleverly designed regulatory contracts so that firms will automatically select the one that best suits them. Tirole along with his co-authors studied what these cleverly designed contracts could look like in different situations. This can probably better address situations where firms know more about their actual production costs than the regulator.

But it is not just his theoretical contributions that are immense. No less important are his pedagogical contributions. Ask any graduate student in economics and they will tell you about two textbooks by Tirole: The Theory of Industrial Organisation and Game Theory (the latter is co-authored with his classmate Drew Fudenberg).

In teaching theoretical industrial organisation, too, one can think in terms of two epochs — before Tirole’s textbook and after Tirole’s textbook. The latter distils and presents all important papers written in the field of Industrial Organisation using one unified framework. Before this book came out, you had to read individual papers, each with their own notation and framework. Tirole’s genius was to put it all into one framework, with common notation and set of practice problems thrown in just to make sure.

Similarly his book on game theory can still be found on the shelves of every graduate student pursuing theoretical economics since it is still a major reference after 23 years.

Jean Tirole is the third person of French origin (the other two being Maurice Allais for the Allais paradox about consistency of choice over probabilistic outcomes and Gerard Debreu for his work on General Equilibrium theory) to win the Nobel Prize in Economics. Tirole obtained his PhD in Economics in 1981 from MIT under the supervision of Eric Maskin who himself got the Nobel Prize in 2007.

Tirole’s first degree was, interestingly, in engineering from the Ecole Polytechnique, which is the most prestigious of the Grand Ecoles. In France, the education system splits into two after high school: the best students after intensive preparatory schools go to Grand Ecoles (much like our IITs) while others go to the university (considered the easier option), and the majority of the French educated elite, regardless of their eventual area of work, are usually from Grand Ecoles.

Mathematicians often talk about their Erdos number that is, how many degrees of co-authorship separate you from the legendary graph theorist Paul Erdos. You have an Erdos number of 1 if you have written a paper with Erdos himself and an Erdos number of 2 if you have written with a co-author of Erdos and so on. I just checked — my Tirole number is 3.

The writer teaches microeconomics and game theory at Louisiana State University

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