Regulation and Market Power

A full house of students and faculty took advantage of the opportunity to hear 2014 Nobel Laureate Jean Tirole discuss his groundbreaking work on market power, market failures, and effective approaches to regulation.

“Economists have extolled the virtue of markets, and not just Chicago economists,” Tirole said. Well-functioning markets force producers to deliver products and services at cost and protect the consumer from anti-competitive pricing.

Thus regulation is essentially a balancing act between restraining market power (anti-trust) and preserving economic efficiency. Regulators face a tradeoff between lowering prices for users, which means a wider diffusion of the product or service, and guaranteeing a rate of return for the firm or firms that supply the product or service.

Market dominance arises when a small number of firms hold a commanding advantage over infrastructure (railroad lines), utilities (power or water), or intellectual property (a patent to key technology). Likewise, this is where much regulation is focused.

“If one firm holds all the power, that is not necessarily a bad thing,” Tirole said. For example, in some technology sectors, a single firm dominates because it puts forth an innovation that customers value. The same reasoning holds true for utilities: market domination is fine when one company dominates because it has made a significant investment, such as building a power grid. But when a utility dominates simply because of luck of circumstance, that skews competition unfairly.

“Of course, these things seem completely obvious, but in practice it is difficult to know,” he explained.  Regulators and those outside the sector naturally have less information than the firms involved. Regulators must recognize this information asymmetry, or their attempts to control a sector will fail to deliver cost-effective regulation.

As an example of regulation with significant information asymmetry, Tirole cited laws in France requiring the judiciary to oversee firms’ ability to eliminate jobs. “You have to go to a judge who decides if a layoff is justified or not, which is kind in spirit, but if you talk to the judges they actually have no clue about whether the removal of a job is justified or not…It’s pretty inefficient,” Tirole commented. “If you are a regulator, you have to take into account that there are pieces of information you don’t have.”

He outlined two broad principles for reducing informational asymmetries to fine-tune regulation. The first is that regulators must collect data. They can look for subtler ways to get that information, by benchmarking—comparing themselves to similar firms in similar market conditions—or by auctions that reveal which firms will pay to compete in the marketplace.

The second principle is that one type of regulation is not going to work for everyone; therefore regulators should offer a menu of options to firms. For example, a regulator could offer two different types of contracts—cost-plus and fixed-price—and allow the firms to choose which they wish to use. Fixed-price contracts give firms a powerful incentive to lower costs, but that may also lead them to cut quality, giving regulators more to monitor, Tirole noted.

A newer challenge for regulators is the growing importance of two-sided markets, where the provider of a platform product or technology makes deals with sellers and buyers of a service. A current example is Uber, which provides a matching platform for drivers and riders. Other examples are debit and credit card companies selling their product to both merchants and cardholders or computer operating systems sold to developers and users.

The platform’s cost for facilitating these transactions is offset by the willingness of clients on the selling side to access buyers. Regulatory issues arise when there is only a single platform available or when merchants enforce the use of a specific platform. The fees paid to the platform provider add costs that a customer might otherwise avoid.

As technology proliferates and new industries are established, new regulation will be needed and expansive knowledge of all corners of these industries will not be available. “Economists have to recognize that industries are different from each other and we have to help regulators understand market power and the costs of intervening in those businesses,” Tirole concluded. “But even more needs to be done. We economists are supposed to make the world a better place.”

Tirole said the right way for regulators to balance market power is a case-by-case, “rule of reason” approach, but that imposes daunting informational requirements on the regulator. Economists must help with that, he said.

“Economists have a duty to develop a rigorous analysis of how markets work and to account for the specificity of industries. We have to account for what regulators know and what they do not know.

“We need to have information-light rules that do not require regulators to have too much information and that don’t use information the regulator is unlikely to possess,” Tirole explained. “And we have to participate in policy debate, we can’t hold ourselves remote.”

— Robin Mordfin and Toni Shears