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Jean Tirole – Introduction to the works of the prize-winning economist (1/3)

In this article, Investors’ Corner presents the works and thinking of Nobel laureate Professor Jean Tirole, who is a keynote speaker at the BNP Paribas Asset Management 2019 Investment Forum on the theme of disruptive change in a superstar economy. This is part 1 of our three-part series.*

The Nobel Prize awarded for a vast body of work

In 2014, Professor Tirole received the Nobel Prize in Economics for ‘his analysis of market power and regulation’. Sweden’s central bank, the Sveriges Riksbank, which awards this prize, gave this summary of the work that led it to distinguish Professor Tirole.

“Many industries are dominated by a small number of large firms or a single monopoly. Left unregulated, such markets often produce socially undesirable results – prices higher than those motivated by costs, or unproductive firms that survive by blocking the entry of new and more productive ones. From the mid-1980s and 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: how should the government deal with mergers or cartels, and how should it regulate monopolies?"

Professor Tirole's work is substantial and, fortunately for economic science, still has much to offer. For the sake of simplification, descriptions of it are often reduced to its fundamentals – industrial economics and market regulation. However, the work also focuses heavily on financial markets, asset bubbles, behavioural economics and game theory.

To introduce readers to Jean Tirole's thinking, it is useful to start by looking at how he sees the market. A second article will focus on market power, followed by a third on regulating market power.

The article A Tribute to Jean Tirole published by the Economic Research Department of BNP Paribas, a long-term partner of the Toulouse School of Economics, founded by Jean Jacques Laffont and chaired by Jean Tirole, presents a more comprehensive overview of his work. More specifically, the Nobel laureate’s lecture explains how public policy can correct market failures, which also requires a specialist in industrial economics to focus on how companies move towards a market equilibrium.

Defining ‘the market’

In his book The Theory of Industrial Organization, Jean Tirole highlights the empirical difficulty of defining a market. He writes that ‘the concept of the market is far from simple... [ while] the definition of a market cannot be too narrow, [neither] should [it] be too broad. The ‘right’ definition depends on what use will be made of it. There is no easy recipe for defining a market’. Beyond this amusing reflection, the idea is to describe a standard (which one might present as an ideal type in the sense of Max Weber) and then examine how and why reality deviates from this reference.

In the economic sense, a market is the place where supply and demand meet, where contracts (which may relate to quantities, quality or price) are agreed, and where trading is done.

In industrial economics, one also needs to define ‘the extent of a product,’ that is, its characteristics, which make the goods not perfectly substitutable, but similar[1]. In practice, it is a question here of looking at how production is organised, which will influence the nature of the market. Because of sector specificities, this also often means taking a case-by-case approach to examining the competition. Industrial organisation has a partial equilibrium approach, far different from the general equilibrium approach that rules in macroeconomics.

The ideal model of a market is the concept of ‘perfect competition’, and this standard breaks down quickly when the products on offer are not identical. It becomes inaccessible when the six assumptions that a perfect competitive situation must satisfy are stated:

  • Large numbers of sellers and buyers
  • Product homogeneity
  • Free entry and exit of firms
  • Transparency of information
  • Perfect mobility of the factors of production
  • Zero transaction costs.

In simpler terms, there are infinite number of producers and consumers who, freely and with no profits in the long run, trade a single product whose price and quality they know. Bearing in mind that economic theory assumes that each player will act in their own best interests, Arrow and Debreu have demonstrated (in 1954) that under certain economic assumptions there must be a set of prices such that aggregate supplies will equal aggregate demands given each individual's initial inputs and in a certain environment.

Ideal, optimal, certain environment... These conditions are indispensable to the construction of economic models and theories that make it possible to understand the reality, but do not aim to replicate it. Challenging the conclusions on the grounds that the assumptions are unrealistic is to misunderstand the essence of economists' work.

Market mechanisms

A market is made up of similar products, producers who offer them for sale, consumers who wish to buy them and a mechanism that enables the buyers and sellers to meet up. Facilitating their getting together is essential.

Either the market opens once a day, or continuously throughout the day. The first case was theorised by French economist Léon Walras in 1874. A market secretary announces, for example, a low price. As soon as a buyer accepts this price, the stated prices rise until a seller is found. This process (‘tâtonnement’ or ‘trial and error’) continues until a price is reached where the sum of the purchases is equal to the sum of the sales. Trading takes place at the final price.

There is a version in which calls are made on quantities. A purchase price and a sale price are offered in reaction and it is only at that point that the caller specifies whether he is a seller or buyer of the quantity. In this version, known as Marshall, the price is a function of the quantity announced. In Walras's version, the quantity is a function of the price announced.

Market participants

To conclude this introduction, we need to look at those involved in these markets, that is to say, businesses and consumers. Indeed, the industrial economy is interested in their interactions. On the one hand, these enable companies to develop their strategies. On the other hand, they allow the government to put in place regulatory policies to correct market imperfections.

The company

According to Jean Tirole, ‘a company must be able to produce (or sell) more efficiently than its constituent parts could by acting separately’. A company needs to be at its best at all times to maximise its profit (or minimise its losses), implement different combinations of business and adapt to its environment. This behaviour may lead it to seek market power to the point of monopoly, or to take advantage of interactions with other producers to be part of an oligopoly. As profit is defined as the difference between sales and costs incurred (fixed and variable), its maximisation involves minimising costs under the constraint of the production function (to sell, one must produce a product or a service). A company's cost function is the key input in industrial economics.

The consumer

Here, the demand function is crucial, with the consumer seeking to maximise his satisfaction, taking into account budget constraints by buying. This process will have an effect on the equilibrium price and therefore on the company's turnover. The demand function is determined by a 'reserve price' above which the consumer has decided that he or she will not buy. If this price is offered, the consumer “A” buys; if the price is lower, both consumer “A” and consumer “B” (who has a lower ‘reserve price’) buy; and consumer “A” achieves a higher level of satisfaction (or well-being). The lower the price, the more numerous and happy consumers there will be: the ‘consumer surplus’ rises.

Social well-being is defined as the sum of this consumer surplus and the producer surplus (profits). Jean Tirole concluded his Nobel Prize-winning speech with a fine statement: “Making this world a better world is the economist’s first mission.” We will see in our next articles how market imperfections that may limit social well-being are put in place and how they can be corrected. We will use the economic concepts presented in this note.

[1] For example, define whether a shirt and a tee-shirt are similar (in this case, it is one market) or if two distinct markets must be considered.

*Also read: Markets that are perfect are like fish that can fly (Part 2)Jean Tirole – Why and how to regulate? (Part 3)

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Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay.

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