Explaining the theory that got Jean Tirole his Nobel

David Weinberg and Tony Wagner Oct 13, 2014

French economist Jean Tirole won the Nobel Prize in Economic Sciences Monday, and it’s been reported that much of his work was in government regulation. But what did he actually figure out? 

“If Jean Tirole can be said to make one idea, it’s that the world is complicated,” says economist Alex Tabarrok. “And a lot of things can change depending upon small differences in who knows what information.”

Here’s an analogy: the world is like a classroom, full of kids of different skills and abilities and ethnic groups and genders. Very complicated, as any teacher can attest. Applying a single standard or teaching methodology across the board in the classroom isn’t fair to the kids. Nor is it efficient in terms of getting the best out of the class.

Tirole says the same goes for companies: you have to regulate each company differently. Just as one child might be motivated by detention, another by a reward of a bag of sweets and a third by praise, so individual companies, even those in the same sector, will be motivated by different things. The challenge for regulators is to determine what the best incentive is for each company and use that knowledge to regulate them.

It gets particularly tricky when there isn’t much competition. The government might tell an electric company it can only make 10 percent more than its capital investment, Tabarrok explains, but then that electric company might not have any incentive to keep costs down. Instead, Tirole proposes a more complex regulation that includes a price cap, letting the firm keep more profits below the cap.

The difficulty Tirole’s theories point out are in the interpretation of the message that regulators transmit to their target companies. Just as teachers have to be cognizant of how a statement to the class will land with each individual student. Put very simply, this all really boils down to communication within the financial sector.

Tirole found that by offering a menu of more complex, precise options, Tabarrok says, regulators can learn more about the real incentives at play in the industry they’re policing. That notion can be applied elsewhere, from defense contracts to CEO compensation, but it has limits.

“Precisely because different rules are optimal in different circumstances, the regulator — even a sophisticated regulator — might not be able to pull off the trick which Tirole recommends that they try,” Tabarrok says.

Just like teachers, who can find it tough to pull off the trick of keeping an entire class engaged, challenged and disciplined all the the same time.

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