Wednesday, October 15, 2014

2014 Nobel Prize in Economics: Jean Tirole

The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2014 was awarded to Jean Tirole «for his analysis of market power and regulation. What is Jean Tirole’s contribution?

Imagine company that owns infrastructure and production capacity for energy generation in a certain region of a country. This company is a monopolist: it faces no competition and can exploit its unique position in the market to raise prices above a competitive price in order to increase its profit. High, non-competitive prices mean economic losses due to exclusion of consumers who cannot afford to pay the high price. A standard solution to this economic inefficiency is for the government to impose regulation on the company. In practice, the regulation can take multiple forms such as price cap regulation that mandates that the price must be below a certain amount e.g., 100$ per unit of service, rate of return regulation that requires that the company’s return cannot exceed a certain fixed amount, e.g. 10%, or taxation such as license fees, sales tax, etc.

A law  introduced by the Prime Minister this summer about taxing several industries is an example of such regulation. At the time, the public perceived the law as a success for the government in its fight with the oligarchs whose companies abuse their monopoly position in the market to obtain abnormal profits. The rationale for the law was to redistribute some of the proceeds from the companies back to the state. An article in VoxUkraine offered an alternative perspective. It argued that the law is counter-productive because taxes the very industries that have been the engine of the economic growth in Ukraine in the recent years and thus harms the ability of the country to resist the looming economic crisis.

It is unclear which of these two positions is correct: the taxes are economically counterproductive because they stifle incentives to innovate and invest in the industry or that the taxes are economically justified because the firms already earn enormous profits. The truth is known by the owners of the companies who have access to the true accounting data, including expenses off the books and profits hidden in offshore accounts, but not by the government or the public who can only inspect official accounts.

Jean Tirole, jointly with Jean-Jacques Laffont, applied the mathematical tools of the theory of optimal design of mechanisms and contracts to the question of optimal regulation of a monopoly firm in an environment in which the firm has superior private information about their profits and costs, including the investment in infrastructure and modernization. Their work have created a field of economics that studies industrial organization and regulation.

The space constraints prevent us from describing even one percent of the enormous amount of work that has been done by Jean Tirole, and so we will limit ourselves to describing the main insight from Jean’s early basic model of regulation, developed jointly with Jean-Jacques Laffont.

In their model, Jean and Jean-Jeaques have focused on the question of optimal regulation that provides incentives for a monopoly company to invest into improving its, possibly outdated, production technology (this is certainly a critical problem for many companies in Ukraine). They further assume that the company has private information about its efficiency. Tirole and Laffont show that it is optimal for the government to offer the company a menu of several different alternative regulation schemes and allow the company to lobby for the regulation scheme it prefers. The most efficient firm will lobby for and will be paid a subsidy for innovation, independently of their amount of production, realized profits, or costs reported on the books. The less efficient firms will be paid a smaller subsidy for innovation, but will also be reimbursed a part of their variable cost that depends on the amount of production. That is, it will be optimal that some firms will be provided fixed funds for investment, while other firms will be paid subsidy per unit (ton, kW, etc.) of production. Furthermore, it is optimal to let the firms decide by themselves which of the policies applies to them.

The big picture is that the optimal regulation is not simple and might require different approaches to different firms. The regulation has to take into account incentives for the firms to innovate and invest in developing new technologies, something urgently needed in Ukraine, as well as the assymetry of information and lack of understanding by the government and the regulator of the specifics of the market, which is another important problem in Ukraine. Regulation is not about requiring the companies to produce at low prices or taxing the profits of successful companies. Instead, the goal of regulation is to improve economic efficiency and overcome other problems generated by lack of competition. Of course, the best solution to the lack of competition is encouraging competition whenever possible, the solution Ukraine can apply in many industries.

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