Reminder: Nothing is perfect in this world
We have established in our previous articles* that, in the vast majority of cases, market failures do apply. When these imperfections (market power, information asymmetries, monopoly) reduce social welfare, public policies must strive to correct them without rendering market mechanisms ineffective.
An understanding of the origins of these imperfections and knowledge of the market structure are essential to be able to propose suitable regulations. We must avoid exacerbating any imbalances by drawing up rules that are too rigid or inappropriate to the specific conditions of the industry and therefore unenforceable.
The regulator should aim to increase social welfare, while ensuring that companies do not forego production and trade. The main difficulty for the regulator (or the payer in a public market) is that they do not have all the information. In particular, they do not know a priori what the producer's cost function is.
Asymmetry of information in a public market
In an April 2013 note on price formation and price changes in public procurement, the French Ministry of Economy and Finance wrote that ”no one has yet managed to develop the formula that would surely give the right price for a good piece of work.” This claim reflects a reality that public authorities encounter with every decision.
By way of illustration, let us imagine a municipality which, in response to a request by its inhabitants, has taken the decision to have a swimming pool. There is no perfect competition because there is only one agent and one product. The city has an idea of the cost, high enough for its budget for this type of infrastructure. By contrast, the firm lacks crucial information: the municipality sees the realised production costs, but not how much eﬀort the ﬁrm has put into cost reduction. This may result in higher transfer prices.
There are generally two types of contracts: A fixed-price commitment for the entire duration of the public market or an adjustable price that includes unanticipated costs (‘cost-plus’) ultimately borne by the client. In practice, a fixed price will be chosen only if completion is not exposed to imponderables.
- In the face of a fixed-price bid, a firm that knows it will have difficulty controlling its costs will overestimate the proposed price. An efficient company that is able to control its costs will, too, offer a higher price to benefit from an informational rent. For the town hall, the cost is higher and it will have to monitor the work to prevent an increase in the costs borne by the company from resulting in a drop in quality.
- In the case of a cost-plus offer, there is no longer an incentive to keep costs under control. The final cost may be higher for the municipality, which, we should remember, does not know whether its interlocutor is efficient or inefficient.
These two price discovery mechanisms exemplify the two main problems of asymmetry of information. On the one hand, the Principal (the municipality) does not know the qualities of the Agent (the company), which characterises adverse selection. On the other hand, the municipality cannot observe, after the contract has been signed, the actions taken by the company to manage its costs, which corresponds to a moral hazard. These asymmetries result in higher costs for the Principal.
A solution: Incentive contracts and revelation mechanism
To overcome this problem, Jean Jacques Laffont and Jean Tirole proposed a model in 1986 that shows that it is possible to come up with a contract that will both help to understand the nature of the firm (efficient/inefficient) and encourage it to control costs.
The model relies on a pricing mechanism that simultaneously incorporates the fixed price and the adjustable price, with the overrun burden being shared between the Principal and the Agent at a ratio chosen by the Agent (a cost-sharing term). If the company is efficient, its proposal will be closer to the fixed price because it knows that it can act to control costs. In contrast, a company that is less efficient and less willing to cut costs will offer a large variable portion.
By making a proposal, the company ‘reveals’ thus its cost function and its commitment to make efforts, which in part corrects the asymmetry of information before the contract is signed. It is also an ‘incentive,’ as the least efficient company handles part of the increase in costs, affecting the end-result. The model demonstrates that this price mechanism optimises social welfare compared to the two extreme situations (fixed price, cost-plus), while satisfying the participation constraint.
Jean Tirole stressed certain precautions relating to the use of this mechanism. First, if the Efficient Agent, by making a significant effort, reduces costs more significantly, it would be inappropriate for the regulator to confiscate some of his efforts. Secondly, efforts on cutting costs must not be at the expense of quality, which requires constant monitoring of the implementation of the work.
Implementation of the model
As it stands, the mechanism described by the model has rarely been used in real life. However, the few cases where it was applied have confirmed its results. In particular, it has been observed that the most efficient companies opt for fixed-price contracts. Along with other research by Jean Tirole carried out in the 1980s, this model has, however, made a profound mark on the study of information asymmetries and the work on regulation.
This model structure (Principal-Agent, asymmetry of information, mechanism design) has been extended to other complex areas, allowing a rigorous approach on the basis of industrial organisation theory. On the other hand, because its set-up makes it relatively easy to adapt it, it has been possible to extend the model to other market situations: multi-product firms, dynamic markets (commitment problems, renegotiation of contracts), competitive tendering by several suppliers, etc.
Food for thought
Regulation is one of the cornerstones of European integration, which has sometimes been caricatured precisely for this reason. The difficulty for the legislator is to propose identical rules that apply to economies and businesses that can be very different and constantly evolving.
By correcting market imperfections, regulations aim to increase social welfare, but must not discourage businesses from participating in the economy. As was said in one of our previous articles*, the concept of perfect competition is not operational in the markets for goods and services. We must also remember that we have presented you with economic and not moral, concepts.
In the 1960s and 1970s, economists who had direct access to government were macroeconomists who intended to promote tools compiling large economic aggregates as part of a demand-driven economy.
The development of the industrial organisation, which deals with market imperfections, corresponds, perhaps by chance, to the liberalisation of markets from the 1980s onwards and the development of a supply side economy. It then became necessary to propose more narrowly focused approaches and to define the rules of the game to increase social welfare.
 Laffont and Tirole , “Using Cost Observation to Regulate Firms”, Journal of Political Economy”
*Also read: Jean Tirole – Introduction to the works of the prize-winning economist (Part 1) / Markets that are perfect are like fish that can fly (Part 2) / Does a rise in market power explain the ills of developed economies? / Superstar firms and the concentration of corporate power – getting out of hand?
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