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Market power and regulation

Published:Wednesday | October 15, 2014 | 10:00 AM

The Sveriges Riksbank Prize in Economics and Science in Memory of Alfred Nobel for 2014 has been awarded to Jean Tirole of Tolouse Capitole University in France for his pioneering work on market power and regulation. According to the Royal Swedish Academy of Science: "Jean Tirole is one of the most influential economists of our time. He has made important theoretical research contributions in a number of areas, but most of all he has clarified how to understand and regulate industries with a few powerful firms", for example, cartels and monopolies.

What is the significance?

In a market or industry with few firms, including monopolies, (e.g. Jamaica Public Service), or oligopolies (e.g. Digicel and Lime) or cartels, (e.g. Organisation of Petroleum Exporting Countries), if left unregulated, these firms tend to produce output that is less than what is socially optimal and normally charge a higher price than any other market structure. Furthermore, there is no incentive to improve product quality in these market conditions since consumers are price takers and there is no competition. These firms, if unproductive, survive by established barriers to entry which restrict new firms from entering the market. Under such conditions, the market fails, and Jean Tirole has championed research on how to best solve or regulate such market failures. The Royal Swedish Academy of Science claims that:

"From the mid 1980s onwards, Jean Tirole has breathed new life into research on such market failures. His analysis of firms with market power provides a unified theory with a strong bearing on central policy questions, like how should the government deal with mergers and cartels? And should it regulate monopolies?"

Why was he awarded the prize?

Under normal circumstances, a government would take a one-size-fits-all approach towards regulating a monopoly or cartel-type of market structure. By so doing, they would try to regulate price, for example, by implementing a price ceiling or cap where firms cannot charge over a determined price, in an attempt to protect consumers. Along with price regulation, government normally forbids firm from colluding if they have the same type of business while permitting firms who rely on each other in a form of vertical diversification to cooperate. Tirole's theoretical research displayed that such actions by government might work in some situations but not all. He demonstrated that government regulatory strategy for a monopoly or an oligopoly type of market structure is industry specific which denounces the one-size-fits-all approach.

How so?

The results of his work indicate that a price ceiling, for example, can influence dominant firms to engage in cost reduction strategies if they wish to maximize profit, which is a good thing for society. On the flip side, a price ceiling may still promote pursuit of exaggerated profits which is a burden to society. He also showed that cooperation between firms on the setting of prices in this type of market structure may be dangerous for consumers. However, cooperation regarding patents may be advantageous to society. The merger of firms at different levels of production can facilitate new, innovative business processes, but can be bad for completion.

What solutions did he propose?

After receiving his doctorate in 1981 from the Massachusetts Institute of Technology, he continued working there for eight years before moving back to his native France. In a number of books and journal publications, Tirole used game theory and mathematics to illustrate that it is best for society as a whole if regulatory or completion policy is tailored to fit each industry's exact conditions. He examined the issue in real time in a variety of industries, including but not limited to banking and telecommunications, using a variety of regulatory and completion policy framework to arrive at the best possible solutions. According to the Swedish Royal Academy:

"His work has helped government shape the right policy instruments to help dominant firms become more productive and at the same time prevent them from harming competitors and consumers."