The telecommunications business, the newspaper business, and the banking business may all seem to be hugely different sectors of the economy – to a layman, that is. Yet in the world of academic economics, there is often a trend toward an overarching theory of “how everything works” that can be applied across business sectors and international borders.
On Monday, the Royal Swedish Academy of Sciences announced that this year’s winner of the Nobel Prize in Economic Sciences is French economist Jean Tirole. The 61-year-old economist’s study of the regulation of monopolies and near-monopolies has made it clear that if you try to regulate a newspaper company the way you regulate a telecommunications provider – or try to shoehorn any other major business into a regulatory scheme built for a different industry – the result will be failure.
Tirole’s research at its most basic focuses on firms with “market power.” These companies are so dominant in their fields they don’t risk losing customers when they raise prices above the marginal cost of their products.
Economic theorists, particularly of the free market variety, tend to assume that market failures – generally, situations where a provider of goods or services is not faced with competitors who force prices down – are few and far between. In reality, consumers deal with market failures every day.
In many cities, there are only one or at most two significant daily newspapers. Many Americans have only one choice for their cable television service, their utility provider, and in some parts of the country, their grocery stores.
Tirole noted that traditional economic theory, when it recognized market failures, tended to identify only the extremes: perfect competition and the existence of a monopoly.
“There are two main difficulties,” the Nobel Committee wrote in a summary of Tirole’s work. “First, many markets are dominated by a few firms that all influence prices, volumes and quality. Traditional economic theory does not deal with this case, known as an oligopoly, instead it presupposes a single monopoly or what is known as perfect competition. The second difficulty is that the regulatory authority lacks information about the firms’ costs and the quality of the goods and services they deliver. This lack of knowledge often provides regulated firms with a natural advantage.”
Tirole helped solve the problem of how to regulate large firms that contract with governments in a way that allows them to earn a profit while assuring they don’t gouge customers on pricing.
In his research, Tirole developed a theory of how governments can effectively craft individualized regulatory regimes for large, monopoly-like companies. These companies compensate for the government’s lack of full knowledge of the business by creating incentives for the companies to minimize the costs the government understands least.
For example, a company whose production costs are difficult to understand, and which might be the basis for artificially inflated prices, can be offered a contract that offers relatively high compensation for the services it delivers, but lower compensation for the costs it incurs. This creates an incentive for the company to lower its costs as much as possible.
Citing the “great practical significance” of Tirole’s work, the committee wrote, “He has penetrated deep into the most central issues of oligopolies and assymetric information, but he has also managed to bring together his own and other’s results into a coherent framework for teaching, practical application, and continued research.”
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