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Study of Incentives wins the 2014 Nobel Prize in Economics

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I was so excited to find out this morning that Jean Tirole won the 2014 Nobel Prize in Economics. When I think of Prof. Tirole, I usually think of him together with his long-time collaborator, Jean-Jacques Laffont, who unfortunately passed away in 2004. Together, Tirole and Laffont wrote some insightful economic analysis that has heavily influenced my thinking on economics and, judging from the tributes (e.g. here from Justin Wolfers), many other economists. So, my excitement was tinged with a bit of sadness that Prof. Laffont did not see this day when the hard work of him and Prof. Tirole was recognised as worthy of the Nobel Prize. There work, applied game theory, principal-agent theory, asymmetric information and contract theory to how markets in the real world work. They did this by understanding the incentives between buyers and sellers in these markets instead of assuming that all markets were perfectly competitive. And, importantly they also looked at if it was feasible if government could intervene in markets that were imperfect. Tirole and Laffont have definitely influenced many regulators and policy-makers, and I’m glad Prof. Tirole won the Nobel Prize now because I think some of his and Laffont’s insights bear repeating.

It seems to me that regulators and policy-makers need to relearn the power of incentives in designing regulation and policy to rectify market failure. The discussion on regulation seems to occupy two extremes. On one extreme, when regulation is proposed, it is usually in a knee-jerk reaction to ban some form of activity or product because of a serious accident. Or, on the other extreme, when deregulation is proposed, it is usually argued in terms of removing costs on businesses. Never mind that deregulation could lead to concentration of market power. But we hardly hear public commentary on the positive aspects of regulation in shaping market outcomes that are optimal. Yes, that’s right, regulation isn’t always a tedious, onerous and costly activity that justifies the employment of bureaucrats. Regulation can have a positive economic impact if designed and implemented properly as incentive-based regulation.

Profs. Tirole and Laffont showed us how to use the theoretical tools of game theory, principal-agent theory and asymmetric information to understand how market failure could arise and how incentive-based regulation can be designed to produce an outcome that is better for society as a whole. These lessons can be summarised as follow:

  • Moral Hazard. Reward productive activities, explicitly and implicitly. Where possible, link payment to the activity you want to encourage (explicit). Implicitly reward the activity by sharing some of the risk of the activity, such as by providing a fixed payment. Conversely, don’t reward unproductive activity explicitly through payment or implicitly through risk-sharing. The latter is often forgotten about so pay particular attention that you are not providing perverse incentives by taking on all the risk of the activity (e.g. providing guarantees for loans).
  • Adverse Selection. Don’t pay for lemons. How do you know when you can’t tell if you are buying a lemon or not? Use a ‘menu of contracts’ that are designed to appeal to different types. For example, don’t know how much to pay a contractor because you don’t know how hard working they are. Offer a contract that rewards high output through bonuses and another that has less emphasis on bonuses but a fixed component. A harder working contractor would go for the high bonus contract figuring they can make more that way. A less hard working contractor would choose the one with the fixed component because they would prefer the security. A menu of contracts can help you find out who the lemons are through their choice of contracts.
  • Asymmetric Information. Regulators don’t need to have perfect knowledge of industries to regulate them for the public good. As pointed out above, contracts can be designed to appeal to the incentives of large firms with market power, without the regulator knowing it’s full financial details.
  • Regulatory Capture. Regulators and bureaucrats aren’t mindless robots that blindly implement regulation and policy for the public good. There is always the risk that regulators and policy-makers may be captured by the vested interest to implement policy and regulations that benefit vested interests such as erecting barriers to entry (e.g. banning third-party access to infrastructure in the US). Policy instruments such as Regulatory Impact Statement make regulators and policy-makers accountable by clearly articulating the costs and benefits of new regulations, if implemented properly.

These are real problems that politicians, bureaucrats and regulators face. Tirole and Laffont contributions helped the practitioners of public policy to develop incentive-based regulation that can overcome these problems. Their solutions may be dismissed ‘second-best solutions’ or as ‘sub-optimal’. But in reality first-best policy can often be impossible to achieve because perfectly competitive markets and fully informed and rational consumers do not exist. Tirole and Laffont showed that economics, if it accommodated the realities of public policy could produce insights that can frame the problem around the incentive drivers and develop solutions that exploit these incentives. Something that is still relevant today for financial regulation, climate change policy, energy pricing, pharmaceutical markets and a host of other economic policy problems. I think there is still much for us to learn from Tirole and Laffont’s work.