Month: October 2014

Graduate students in economics will instantly know Jean Tirole from his textbook, The Theory of Industrial Organization. In this textbook, Tirole brought game theory to the study of industrial organization–the study of firm behavior in different market structures (competition, duopoly, oligopoly, monopoly). First published in 1988 this textbook has been the dominant one in the field since that time. (Tirole has also written excellent advanced textbooks in game theory and finance which together have made him one of the most influential teachers of graduate students everywhere). The new game theory provided new answers and new questions. We can see in this prize the continued working out of the game theory revolution in different areas in economics. First the prizes went to the founders (Nash, Selten, Aumann, Schelling) and then to applications of the new theory in different areas (Hurwicz, Maskin and Myerson for mechanism design, Vickrey for auctions). This is probably the last one in this line as behavioral approaches take over and game theory runs out of steam.

A theory prize!  A rigor prize!  I would say it is about principal-agent theory and the increasing mathematization of formal propositions as a way of understanding economics.  He has been a leading figure in formalizing propositions in many distinct areas of microeconomics, most of all industrial organization but also finance and financial regulation and behavioral economics and even some public choice too.  He is a broader economist than many of his fans realize.

Tirole is a Frenchman, he teaches at Toulouse, and his key papers start in the 1980s.  In industrial organization, you can think of him as extending the earlier work of Ronald Coase and Oliver Williamson with regard to opportunism and recontracting, but applying more sophisticated and more mathematical forms of game theory.  Tirole also has been a central figure in procurement theory and optimal contracts when there is asymmetric information about costs.  The idea of mechanism design runs throughout his papers in many different guises.  Many of his papers show “it’s complicated,” rather than presenting easily summarizable, intuitive solutions which make for good blog posts.  That is one reason why his ideas do not show up so often in blogs and the popular press, but they nonetheless have been extremely influential in the economics profession.  He has shown a remarkable breadth and depth over the course of the last thirty or so years.

His possible pick had been heralded for some numbers of years now, this award should not be considered a surprise at all.  You will note that the Swedes mention Jean-Jacques Laffont, who died a decade ago, and who co-authored many of the key papers in this area with Tirole.  Such a mention is considered a nod in the direction of implying that Laffont, had he lived, would have shared in the prize.

Here is Tirole’s home page.  Here is Tirole on Wikipedia.  Here is a short biography.  Here is Tirole on scholar.google.com.  Here is the press release.  Here is background from the Swedes.  Here is the 54-page document on why he won, one of the best places to start.  Here is the Twitter commentary.

One idea of Tirole’s I use frequently has to do with renegotiability.  Let’s say a regulator and a monopolist agree to a scheme of regulation and provision, creating some surplus for both parties.  As time passes, will each side of that bargain stick with the original agreement?  A simple example here is the defense contractor.  After a procurement contract is written, sometimes the supplier has the incentive to conduct a hold-up, to report that costs are higher than expected, and to ask for more money in return for timely fulfillment of the contract.  Of course this is a contract breach, but if no other supplier can step in and do the job, it may be optimal for the government to give in to these demands to some degree.  The question then is: how should the contract best be designed in advance, so as to prevent this problem from popping up later on?  Or should the renegotiation simply be allowed?  Anyone wishing to tackle these questions likely would start with the papers of Tirole on this topic.  For one thing, these papers help explain why a second-best optimal contract may offer some rents to agents and appear to give the agent “too good a deal.”

Some of his key papers focus on asymmetric information about costs.  Say a firm knows its costs and the regulator can only guess.  Ideally the regulator would likely to make the firm price at marginal cost, but the firm will pretend marginal cost is higher than it really is.  The regulator and the firm thus play a game.  Tirole figured out with rigor which principles govern how this game works and what a second-best regulatory solution might look like.  With Laffont, here is his key paper in that area.  David Baron made contributions to this area as well.  Again, there is a potential argument for an “agent rent,” to limit the incentive of the agent to lie too much about costs, for fear of losing that rent if the cooperative relationship breaks down.

Tirole, writing sometimes with Rey, wrote some important papers on vertical agreements and how they can be used to extend market power, for instance when can buying up parts of a supply chain help extend monopoly power?  His paper with Oliver Hart figures out some of the conditions under which vertical acquisitions can help foreclose a market.  With Rey, Tirole surveys the literature on vertical relations and foreclosure.

This early 1984 paper, with Drew Fudenberg, laid out the conditions when firms should overinvest in capacity to deter competitive entry, or when firms should instead look “lean and mean” for entry deterrence.  The underlying analysis has shaped many a business school discussion.

I am a fan of this 1996 paper on how we can think of firms as credible ways of carrying reputations in a collective sense.  For instance the existence of a firm called “Google” transmits real information about the qualities of the people you deal with when you are transacting with members of the Google firm.  This was an important addition to the usual Coasean vision of thinking of a firm in terms of economizing transaction costs.

He has written some key papers on financial intermediation, collateral, and the agency problems associated with lending, here is one well-cited paper by him and Holmstrom. Here is a non-gated version (pdf).  A key argument is that a decline in the value of the collateral in a lending relationship can lower efficiency and also output, and this can help explain some features of business cycles.  This 1997 paper was well ahead of its time and it remains one of Tirole’s most widely cited works.  Arguably it is relevant for recent financial crises.

He has a 1994 book with Mathias Dewatripont on the prudential regulation of banks and how to apply the proper incentives to make sure banks do not take too much risk at public expense.  Obviously this also has since become a much more important topic.  How many of you know his 1996 paper with Rochet on “Interbank Lending and Systemic Risk“?  They show the contradictions which can plague a “too big to fail” policy and the attempts of central banks to maintain a “creative ambiguity” about what kinds of bailouts will occur, using rigorous game theory of course.

With Rochet, he has a well-known paper on platform competition, laying out the basics of how these “two-sided” markets work.  Think of internet or payment portals which must get both sides of the market on board.  What are the efficiency properties of such markets and what are the game-theoretic issues?  In this setting, how do for-profits compare to non-profits?  Competition to monopoly?  Rochet and Tirole laid out some of the basics here, here is their survey piece on the field as a whole.  Alex’s post above has much more on these points, and Joshua Gans covers this area too, here is Vox.

In public choice economics, he and Laffont have an important paper on when regulatory capture is actually likely to occur.  I have yet to see the insights of this paper incorporated into the rest of the literature adequately.  His paper on the internal organization of government considers the relative appropriateness of high- vs. low-powered incentives as applied to government employees, among other matters.  His 1999 paper with Mathias Dewatripont, “Advocates,” shows in game-theoretic terms why something like the Anglo-American system of competing lawyers might make sense as the best way of discovering information and adjudicating the truth.  This paper shows how career concerns affect bureaucratic incentives and what is the optimal degree of specialization within a government bureaucracy.

He has thought very deeply about the nature of liquidity and what is the optimal degree of liquidity in a securities market.  There can be some side benefits to illiquidity, namely that it forces parties to stay committed to an economic relationship.  This must be weighed against the more obvious benefits of liquidity, which include having better benchmarks for measuring managerial performance, namely stock price (see this paper with Holmstrom).  This kind of analysis can be applied to the question of whether the shares of a firm should stay privately traded or be put on a public exchange.  This 1998 paper, with Holmstrom, is a key forerunner of the current view that the global economy does not have enough in the way of safe assets.

Here is his paper on vertical structure and collusion in bureaucracies (pdf).  Here is his very useful survey article, with Holmstrom, on the theory of the firm.

His textbook on Industrial Organization is a model of clarity and remains a landmark in the field, even though it came out almost thirty years ago.

He has written a book on telecommunications regulation (with Laffont) although I have never read that material.

In finance he wrote this key 1985 paper, deriving the conditions under which you can have an asset bubble in a market with rational expectations.  The problem of course is that the price of the asset tends to keep rising, relative to the size of the economy as a whole, and eventually it becomes impossible to keep on buying the asset.  This has to mean an eventual crash, unless the growth rate of the economy exceeds the general rate of return on assets.  This paper helped us think through some issues which recently have resurfaced with the work of Thomas Piketty.  His earlier 1982 paper on speculation is also relevant to this topic.  Most economists think of Tirole as game theory, finance, and industrial organization, but his contributions to finance are significant as well.

Just to show his breadth, here is his paper with Roland Benabou on incentives and when they undermine the intrinsic desire to do a good job.  For instance if you pay kids to get good grades, will that backfire and kill off their own reasons for wanting to do well?  Alex covers that paper in more detail.  This other paper with Benabou, “Self-Confidence and Personal Motivation,” is a great deal of fun.  It analyzes the benefits of overconfidence, namely greater motivation, and shows how to weigh those benefits against the possible costs, namely making more mistakes.  It shows Tirole dipping a foot into the waters of behavioral economics and again reflects his versatility in terms of fields.  I like this sentence from the abstract: “On the supply side, we develop a model of self-deception through endogenous memory that reconciles the motivated and rational features of human cognition.”  Again with Benabou, here is his paper on willpower and personal rules, very much in the vein of Thomas Schelling.

Here is Tirole on intellectual property and health in developing countries, with plenty on policy.

It’s an excellent and well-deserved pick.  One point is that some other economists, such as Oliver Hart and Bengt Holmstrom, may be disappointed they were not joint picks, this would have been the time to give them the prize too, so it seems their chances have gone down.

Overall I think of Tirole as in the tradition of French theorists starting with Cournot in 1838 (!) and Jules Dupuit in the 1840s, economics coming from a perspective with lots of math and maybe even some engineering.  I don’t know anything specific about his politics, but to my eye he reads very much like a French technocrat in terms of approach and orientation.

Jean Tirole is renowned as an excellent teacher and a very nice person.