A Nobel for incentives

The importance for India of Jean Tirole

It is a common complaint about modern economics, particularly theoretical economics, that it is too far removed from the real problems of economics. In the West, this takes the form of the accusation that most economists failed to predict or warn about the possibility of the 2008 financial crisis. In India, there is concern that economic theory developed in the West fails to provide the tools required to analyse the pressing public policy problems in India. In many ways these are unjust criticisms. By awarding the 2014 Nobel Memorial Prize in Economics to Jean Tirole, an economic theorist based out of the University of Toulouse in France, the Royal Swedish Academy of Sciences has in fact demonstrated just how unjust they are.

Prof Tirole is one of the most quietly influential of economists. He may not be a public intellectual like Paul Krugman, with a wide-ranging audience for his newspaper columns; unlike Larry Summers, he may not have taken up a major public position; and he has not positioned himself, like Joseph Stiglitz, as a prominent critic of globalisation. Yet his work has been as influential as that of any of the others. As the Nobel committee points out, it spans several different sub-disciplines of economics; but in each case it focuses on rigour and the careful analysis of strategies and incentives. Modern "industrial organisation" - the theory of the firm, of pricing strategies, of regulation and of monopolies - has developed more thanks to Prof Tirole's work since the early 1980s than anything else. By organising a deeply disorderly field, and by ensuring that properly rigorous models are used, he has taken the study of the firm out of the fuzziness common to "management studies" and into the greater clarity of the economics profession. The consequences have been considerable. One the Nobel committee mentions is the demonstration, through mathematical modelling, that monopolies in one field can be extended into another through vertical integration. A question that Prof Tirole famously asked is: "What is worse than a monopoly?" And he answered it thus: "A chain of monopolies." This insight has changed the way that regulators behave - the various antitrust actions against Microsoft earlier this century were not unrelated to this development.

Rigour such as Prof Tirole brings to basic questions of incentives is clearly missing in the debate on Indian corporate bodies, as well as on public policy. One of the few theoretical papers of quality to focus on the incentives behind public-private partnerships or PPPs, for example, was authored by Prof Tirole together with a frequent collaborator, Eric Maskin. One of the things that they discover: "PPP contracts [between a bureaucrat and a company] need to be carefully reviewed by independent authorities that can expose hidden rent backloading... PPPs can be expected to entail higher transaction costs." It is worth noting that this paper has been available since June 2007. This insight is something that Indian policymakers are only now accepting after considerable pain - though a clear independent authority is still not even on the anvil. More than most Nobel prizes in economics in the recent past, Prof Tirole's work is relevant to Indian public policy. It is to be hoped it leads to a revolution in rigour and formal modelling in Indian economic circles.