Richard Holden

THE founder of modern economics, Adam Smith, pointed out that the “invisible hand” of competitive markets leads to an efficient allocation of resources. When markets are competitive government should just “get out of the way”.

Yet most markets are not perfectly competitive – the extreme case being where there is a single monopolist.

This opens the door to government interventions making markets work better. But which interventions are best? What tools should be used? Which markets should be targeted?

This year’s Nobel Prize in Economic Sciences was awarded to Jean Tirole for “his analysis of market power and regulation”. Tirole’s work provides answers to these vexing questions – it has deepened our understanding of how markets actually work, and provided policymakers with a playbook for how to make them work better.

As one example, imagine you are a government regulator of a monopolist, such as a power company. The large fixed costs involved might mean that having multiple competing firms is not sensible, but one large monopolist will charge high prices and hurt consumers. What do you do?

One answer is to control the prices they charge. But to do this effectively means knowing what their true costs are – something that is typically very difficult for a regulator. Worse still, you would like the firm to work hard at lowering their costs, but this won’t happen if they don’t capture some of the benefit of those lower costs.

In path-breaking work in 1986, Tirole and co-author Jean-Jacques Laffont (who might have shared the Nobel award had he not sadly died, too young, in 2004) showed how a regulator can best balance providing incentives to reduce costs with the use of public funds – perhaps raised through inefficient taxes, since incentives cost money.

Remarkably, Laffont and Tirole showed that offering the monopolist a menu of possible regulatory schemes does the trick. You, the power company, can have a cost-plus contract or a fixed-price contract, or something in between. You choose.

And just like a good magician’s carefully designed scheme, you will always choose the card he expects. This cunning trick makes it in the interest of the monopolist to implicitly reveal its costs through its choice of regulatory scheme.

Part of what makes Tirole’s work so remarkable is that he has been able to analyse complex markets such as credit cards, telecommunications and banking, yet use a general analytic approach from which broad lessons can be learned. It is social science at its absolute best: using mathematical rigour to illuminate real-world problems and provide effective policy prescriptions.

And it’s not just academics and students who might benefit.

As Australia embarks on its second great competition policy review, with Ian Harper due to report in March next year, Tirole’s Nobel provides a timely reminder of the importance and power of good competition policy. In many ways there are parallels between the evolution of the economics of regulation, and the competition policy reform process in Australia.

The year Tirole defended his doctoral dissertation at MIT was 1982, the same year that University of Chicago professor George Stigler won the Nobel prize.

Stigler – a towering figure both intellectually and physically – was a pioneer of the study of how firms interact, and how competition policy can achieve efficiencies by driving down prices. In many ways Tirole was his natural extension and intellectual heir – incorporating strategic decision-making and hidden information into the picture.

So, too, might it be with Harper and Fred Hilmer. The 1993 Hilmer report, and the reforms it heralded, was a watershed in Australia. It took a hard line against monopolies and anti-competitive practices, and the results have been hugely beneficial to Australian consumers.

Harper’s Tirole to Hilmer’s Stigler would be to bring Australian competition policy into the 21st century. To deal with complex markets with complex problems – such as firms that know a lot more than regulators do, markets that are hard to define, and markets involving complicated networks of players such as credit cards.

Tirole’s work provides a road map for Harper. But he could do well to use Tirole’s work as a touchstone, much the same way that Stigler influenced Hilmer.

Tirole is a scholar’s scholar – thoughtful, careful, creative and genuinely the smartest guy in the room. He has inspired a generation of young economists around the world. But his work has had impact far beyond the classroom, seminar room and academic journals. He has described how real, complicated markets work, and helped policymakers to make them work better.

Tirole is a kind of engineer for the social sciences. And in highlighting that, the Nobel committee has displayed impeccable taste.

Richard Holden is professor of economics at UNSW Business School. A version of this post appeared in The Australian.