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On October 13, 2014, Jean Tirole won the Nobel Prize for his work on regulation. In the hopes of having companies compete fairly, governments try to regulate the firms. Unfortunately, as the governments do not know as much about the firms as the firms do about themselves, the regulation ends up being too heavy handed or too lax. The aim of the regulation is to promote competitive markets.
Jean Tirole, along with Jean-Jacques Laffont, Tirole’s partner until Laffont died in 2004, found a way of overcoming this problem.
Consider a natural monopoly. Because this firm has already spent a sizable amount of money to build a network, other firms would be dissuaded from investing in a second network and thus joining the market, because the subsequent price war if another firm were to join in would “make it hard to recoup the investment”.
This natural monopoly presents regulators with a problem, because they have the ability “gouge consumers and stifle innovation”. However, it is hard for regulators to discern to what extent this is happening.
The root of this problem has to do with a phenomenon called “asymmetric information”, wherein regulators have no idea how much a service provided by a monopoly should cost or how much the firm should be investing. In other words, they have insufficient information about the firm to determine the correct regulations to impose on the natural monopoly.
With this information, regulators have two options. The first option is to “cap prices at some markup to a firm’s costs”. The problem with this is that it does not provide any incentive for firms to be more efficient. The second option is to impose a hard price cap. The problem with this is that firms will pocket the extra gains in efficiency instead of passing the gains down to customers by reducing the prices.
Messrs Tirole and Laffont found that this conundrum is similar to another, more researched, economic problem, called the principal agent problem, where the owners of assets struggle to find incentives for those who manage them to do a good job. Messrs Tirole and Laffont then continued on to borrow ideas from other fields, such as game theory and auction design.
This is their finding: they state that instead of forcing one type of regulation on them (cost-plus contract vs set price), regulators should present firms with a choice between the two. As a result, firms with little opportunity to cut prices will opt for a cost-plus contract, while firms with the ability to innovate and cut prices would choose a set price. Either way, regulators gain valuable information about what type of firm that is, and thus allow the regulators to “negotiate the best deal for customers”.
Mr. Tirole, Mr. Laffont and Mr. Xavier Freixas, a professor at the Universitat Pompeu Fabra in Barcelona, also showed that the best solution is not always the one that results in the lowest prices. For example, a regulator whose primary interest is bringing low costs for consumers might keep reducing the set price, in hopes that the innovative firm might keep reducing the cost of its business. However, a rational firm might stop investing in cost-cutting measures entirely. In this case, the regulator’s best bet is to signal his or her intent to become more lenient with the regulation over time. Mr. Tirole shows how what might seem like regulatory failure to others might actually be a sensible response to this type of hard-to-manage market.
Mr. Tirole’s research does not stop with monopolies. He has also shown how overinvestment in technology could be a tool used by firms to limit competition, as it signals to competitors that it isn’t worth the trouble to compete. More recently, he has written an article with Jean-Charles Robert about how “the interconnectedness of modern financial systems would make it impossible for governments to allow big banks to fail, and that banks, anticipating bail-outs, would behave recklessly.” Regulation can be used to counter this problem by limiting leverage, for example.
Perhaps, his most relevant work is his analysis on “platform” markets, which serve more than one type of customer. An example of this would be a newspaper, whose market consists of both readers and advertisers. In these types of markets, anticompetitive actions may not actually be anticompetitive: a reduction of subscription price might be to attract more advertisers. So, regulation that demands higher subscription prices might actually wreck the two-sided market. Google and Amazon have faced a plethora of these cases.
Net neutrality follows similar arguments. Mr. Tirole suggests that “network owners should be allowed to charge higher access prices to heavy users… to cover the costs they impose on the infrastructure.” However, his research also shows that the network owner could easily abuse this by increasing his position in the consumer market. Mr. Tirole offers no formula for such a problem, but he does highlight the trade-offs in such scenarios.
1. Natural monopoly: According to Investopedia, this is "a type of monopoly that exists as a result of the high fixed or start-up costs of operating a business in a particular industry". For more about natural monopolies, click here.
2. Cost-plus contracts: If you have a certain cost for the product or service, you are allowed to charge a profit margin as a percentage of that cost. For firms that do not think they can reduce costs, they will opt for this type of regulation as they are guaranteed a certain percentage of profit.
3. Set price: where regulators allow firms to make a certain amount of revenue, and whatever profits they get when they pay off their costs, they can keep the profits. For firms who are innovative and believe that they can reduce their costs of productions, this is the best option, as they can reap higher and higher profits as they pay off their costs.
4. Anticompetitive: This is where a player behaves in a way that tries to eliminate other competition from the market.
1. The assumption behind this article, and behind Mr. Tirole’s work, is that all firms must be regulated in some way. Why is this?
a. To reduce the amount of asymmetrical information between buyers and sellers
b. To protect the environment
c. To encourage competition
d. To curb monopolies
e. For public safety, e.g. restrictions on the selling of drugs, restrictions on the selling of cigarettes and alcohol to minors, restrictions on the amount of radiation cell phones can have
f. Worker safety, e.g. minimum wage, maximum working days
2. What is the problem with asymmetric information? There are two main problems:
a. The firm will charge unfair prices to consumers for what may be necessary goods
b. As the firm has no competition, it will not strive to innovate and reduce its costs of production.
3. In the sixth paragraph, the author discusses the idea of agency, and how owners of assets struggle to find incentives for those who manage them to do a good job. This is called the principal agent problem. Take this example: You own a house in London and you have someone managing the house. Each week, he calls up with complaints about a broken tap or a broken air conditioner, and you must pay out of your own pocket to fix these problems. How can you be sure that the manager is not making this up and pocketing the extra money being sent? In other words, how can you incentivise such managers to do a good job managing this? This is the principal agent problem.
4. In the paragraph before the “competitive hedge” subtitle, the author mentions the idea of moral hazard, where the idea is that if banks believe they will be rescued, they will act recklessly. This is exactly what happened in the global financial crisis. It is important to not rescue all banks so that they do not become reckless, but it is important to rescue some so that the whole banking system does not fail. In March 2008, Bear Stearns, a bank in the USA, failed and was saved by JP Morgan. However, in September of the same year, the Lehman brothers failed, but were not bailed out. How do you strike a balance between bail-outs and not? It is a real challenge. Some people believe that the Federal Reserve had struck the wrong balance in 2008. There is no clear dividing line that dictates what the ratio of bail-outs to not should be. One reason for this might be that bail-out situations occur rarely and are never similar to each other.
5. In the same paragraph as the moral hazard one, the author mentions limiting leverage. This is where banks reduce the ratio of borrowing to shareholders’ capital. It all has to do with the capital adequacy ratio. More about this can be read here.