1 3 OCTOBE R 2014

Scientific Background on the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2014

J E A N T I RO L E : M A R K E T P OW E R A N D R E G U L AT I O N
compiled by the Economic Sciences Prize Committee of the Royal Swedish Academy of Sciences

THE ROYAL SWEDISH ACADEMY OF SCIENCES has as its aim to promote the sciences and strengthen their influence in society.
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Jean Tirole: Market Power and Regulation
1

Introduction

To what extent should the government intervene in the marketplace? Economists often
consider fiercely competitive markets to be in the public interest. When producers insuch markets strive to earn a profit, they are led — as if by an invisible hand — to deliver
high quality at low cost.1 But many industries are not very competitive, and this lackof competition widens the scope for beneficial public intervention. Theories of regulationand competition policy aim to provide useful scientific guidance for such intervention.
Clearly, any recommendations must rest on a sound understanding of how imperfectlycompetitive markets work. When a firm has market power, how will it behave? How doesits behavior aﬀect the firm’s suppliers, customers, and competitors? Questions like theseare studied within the field of Industrial Organization (IO). George Stigler was awarded
the 1982 Prize in Economic Sciences “for his seminal studies of industrial structures,functioning of markets and causes and eﬀects of public regulation”. Since then, however,the IO field has undergone rapid development, indeed a revolution. This revolution has
greatly enhanced our understanding of imperfectly competitive markets, which in turnhas laid a foundation for better informed competition policy. Comparable progress has
been made in the theory of optimal regulation of firms with market power.
The progress in these areas largely reflects two methodological breakthroughs: gametheory and the theory of mechanism design.2 By the end of the 1970s, the time wasripe for applying these tools to the major issues of imperfect competition, regulation,and competition policy. Over the next decade, many economists were drawn into these
fertile fields. The analytical revolution was to a large extent a collective eﬀort but, among
many contributors, Jean Tirole stands out. No other scholar has done more to enhance
our understanding of IO in general, and of optimal policy interventions in particular.
The theoretical advancements coincided with a period of great public-policy interest in
the same issues. During the 1980s and 1990s, many countries pursued regulatory reforms
and pro-competitive liberalization — sometimes in conjunction with privatizations. The
European Union created the single market. Many new issues arose that could not be
fruitfully studied with the help of existing theory — their analysis required a combinationof oligopoly theory and contract (principal-agent) theory and an integration of industrial
economics with public economics. Tirole’s expertise spans all these fields, and he wasthus ideally positioned to make a lasting contribution.
1

Of course, there are exceptions to this rule. For example, if customers are poorly informed, or if thefirms’ activity entails negative externalities, competition might be detrimental. However, here we areconcerned with markets where those problems do not create major diﬃculties.
2
A Prize in Economic Sciences was awarded in 1994, to John Harsanyi, John Nash, and Reinhard
Selten for game theory, with a focus on non-cooperative solution concepts. Game theory was also central
to the 2005 Prize to Robert Aumann and Thomas Schelling, for their analysis of conflict and cooperation.
The 2007 Prize was awarded to Leonid Hurwicz, Eric Maskin, and Roger Myerson for mechanism design
theory. Related awards, for the investigation of more specific mechanisms, include the 1996 Prize to
James Mirrlees (taxation) and William Vickrey (auctions) and the 2012 Prize to Lloyd Shapley andAlvin Roth for their analysis of matching markets.

1

Before discussing the specifics, let us emphasize that Tirole’s overall scientific contribution is greater than the sum of his individual contributions. He has created a unified
framework for IO theory and regulation, founded on a rigorous analysis of strategic behavior and information economics. It is hard to do justice to his immense body of workin a few introductory paragraphs, but a few features of his research do loom large.
First, Tirole has established a new standard of rigor in the fields of IO and regulation.
He has consistently derived his results from fundamental assumptions about preferences,
technologies (including contracting technologies) and information asymmetries, eschewing
the convenient but ad hoc assumptions that had previously seemed necessary in orderto make analytical headway. From the outset, Tirole’s approach has required unusualtechnical expertise, especially in the rapidly evolving fields of game theory and contract
theory. While this year’s prize emphasizes Tirole’s creative application of these analytical
tools to regulation and IO theory, it is noteworthy that Tirole also made significant
contributions to the toolbox itself (see Section 6).
Second, Tirole’s rigor has facilitated realism. Division of labor in the scientific community frequently encourages theorists to specialize in understanding the inner logic of
new models, leaving the challenging job of confronting the models with reality to more
applied scientists. As a result, theoretical work sometimes seems detached from “the realworld” and “relevant practice”. By contrast, Tirole has carefully designed his models to
capture essential features of specific economic environments, and to highlight importantmechanisms that previous applied research had either ignored or failed to articulate with
suﬃcient precision.
Third, Tirole has brought order to an unwieldy literature. By deploying a consistentconceptual framework over a wide range of issues, he became a leader in the creation of
the first encompassing and coherent theory of IO. After more than 25 years, his groundbreaking 1988 textbook remains the best road-map to the field. If the book is becoming
outdated in a few areas, this is largely due to Tirole’s own subsequent work and the work
he has inspired. Tirole’s 1993 book, co-authored with Jean-Jacques Laﬀont, presented aunified framework which has deeply influenced how economists think about regulation.
Fourth, Tirole’s models have sharpened policy analysis. Focusing on the fundamental features that generate a divergence between private and public interests, Tirole has
managed to characterize the optimal regulation of specific industries. Often, his rigorous
thinking has overturned previous conventional wisdom. For example, he successfully challenged the once prevalent view that monopoly power in one market cannot be profitably
leveraged into another market by vertical integration. As a result, competition authorities have become more alert to the potential dangers posed by vertical integration andrestraints. More generally, Tirole has shown how the justifications for public intervention
frequently boil down to problems of information asymmetries and credible commitments.
These general lessons — together with a catalogue of specific applications — form a robust
foundation for policy analysis.
In this document, we briefly summarize Tirole’s most important contributions to
the theory of IO and the regulation of dominant firms. We start in Section 2 with his
seminal work on the public regulation of a natural monopoly, most of which reflects along-standing collaboration with Jean-Jacques Laﬀont.3 This work was mostly published3

Sadly, Jean-Jacques Laﬀont passed away much too young in May 2004.

2

in the period 1986 to 2001 and is summarized in Laﬀont and Tirole’s encyclopedic 1993
book. It builds a coherent foundation for regulation theory, replacing ad hoc assumptions
with explicit contracting frictions (such as asymmetric information and limited commitment). Many insights are quite general and apply to most regulatory settings, as well as
to the related topic of government procurement. Among the most significant advances
are the modelling of regulatory capture (collusion between regulatory agencies and regulated firms) and dynamic contracting. These advances were inspired by fundamental
contributions to contract theory: Tirole (1986a), Freixas, Guesnerie and Tirole (1985)
and Hart and Tirole (1988). The importance of these contributions extends far beyond
regulation and procurement.
Although general theories can be of great value, in the end all regulation must be
industry-specific. This point is illustrated by example in Laﬀont and Tirole (2000),
where they consider the regulation of the telecommunications industry, as well as inTirole’s studies of other industries, ranging from banking to electricity. The research on
the regulation of specific industries illustrates Tirole’s exceptional ability to grasp thecentral features of an economic environment, to formulate these features mathematically,
to analyze the resulting model, and to produce normative conclusions of great practicalsignificance.
Although the motivation for the prize focuses on normative theories of optimal regulation and competition policy, any normative theory must rest on a positive analysis of
how firms interact. For competition and regulation policy, it is especially important tounderstand interaction in imperfectly competitive markets. Therefore, oligopoly theoryis the most central topic in IO. Jean Tirole played a major role in the transformationof oligopoly theory during the 1980’s. Among his many contributions to this field, we
emphasize his work on strategic investments and R&D races (with Drew Fudenberg andothers), on dynamic oligopoly (with 2007 Economics Laureate Eric Maskin), and on
co-marketing (with Josh Lerner). These contributions are discussed in Section 3.
Section 4 discusses how theoretical advances have changed the way economists think
about competition policy. In particular, Tirole has convincingly analyzed public policies
regarding vertical contractual relationships. Vertical relationships only require regulation
if they impose costs on outsiders that are greater than the benefits to insiders. Thus, avital element of the analysis is a precise understanding of mutually beneficial contracts
between sellers and buyers in a vertical chain — a problem which closely resembles that of
optimal regulation of monopolies (discussed in Section 2). Another important element is
to understand the nature of strategic behavior towards competitors (discussed in Section
3). Tirole’s analysis of vertical contractual relationships quickly gained academic acceptance, and it has contributed to a significant revision of competition policy, especially in
the U.S.
As mentioned, Tirole has not only developed general theoretical frameworks of analysis, but also adapted them to the circumstances of specific and quite diﬀerent industries.
Section 5 discusses two such applications, namely to telecommunication and financial
intermediation.
Finally, Section 6 briefly describes some of Tirole’s many contributions to other topics:
general economic theory, financial markets, asset-market bubbles, organization economics,
corporate finance, and behavioral economics.

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2

The Regulation of Dominant Firms

In some industries, average costs are minimized when production is concentrated within
a single firm. When there is scope for rapid innovation, such a market will usually bedominated by the same firm only for a limited period of time, until a new firm makes asuperior innovation. While the dominant firm may earn temporary monopoly rents frompricing above marginal cost, those rents might be an acceptable price for society to pay
in order to encourage innovation (Schumpeter, 1943).4
In other cases, there is little scope for competitive challenges by new and innovative
entrants. For example, production may rely on a unique resource or an investment which
is prohibitively expensive to duplicate, and the usage of which cannot be completely
specified in a contract. Water mains, railroad tracks, and electricity-transmission lines
are a few examples. Firms that control such a resource — whether public or private — arecalled natural monopolies.5 How can natural monopolies be prevented from exploiting
their dominant power at the expense of consumers (and society at large) without making
them go out of business? If a monopoly is allowed to price freely, prices will typicallybe too high and output too low. If the firm is instead forced to price at marginal cost,
it may not break even and public funds must be used to cover its losses.6 The modern
theory of regulation characterizes optimal regulation under realistic assumptions about
information asymmetries, the distributional concerns of the government, and the social
cost of public funds.
After a brief historical background, we describe the basic Laﬀont-Tirole model ofregulation in subsection 2.2. Important extensions to this basic model are discussed insubsections 2.3, 2.4 and 2.5.

2.1

BackgroundIn 1945, Ronald Coase (the 1991 Economics Laureate) pointed out a problem in deciding
whether to use public funds for subsidies to a natural monopoly. To make the rightdecision, the government must know the social surplus (the diﬀerence between consumers’
valuation and production costs) generated by the firm. Since the social surplus will neverbe fully revealed by prices, and is particularly obscure under marginal-cost pricing, theinformational diﬃculties are considerable. Coase’s (1945) brief discussion highlighted
that information problems are crucial in regulation. Subsequent research has focused4

That said, there may be better ways to strike a balance between the production and utilization of
innovations than allowing unregulated monopoly behavior. This issue turns up in several guises in the
coming sections.
5Here we focus on the regulation of an existing monopolist. However, the focus of regulatory activity
has frequently been the introduction of competition (see Armstrong and Sappington, 2006). We will later
discuss Tirole’s work on competition in regulated network industries. Even if only one firm is allowed tooperate in the market, the government might be able to create competition by auctioning oﬀ the rightto operate (Demsetz, 1968). We refer to Laﬀont and Tirole (1987, 1988b), McAfee and McMillan (1986)
and Riordan and Sappington (1987) for studies of auctions in a regulatory/procurement context.
6
Under perfect competition, price equals marginal cost. However, if a firm has increasing returns toscale, perhaps because production involves large fixed costs, then it will operate at a loss if it prices atmarginal cost. Under such circumstances, an unregulated market either does not provide the product at
all, or involves imperfect competition with prices above marginal cost.

4

on an even more formidable information problem: the regulator cannot easily observe
whether the regulated firm is doing its best to keep production costs low, or how muchit would cost to raise output quality. Poorly designed regulation could thus easily entail
excessive cost overruns, or insuﬃcient productivity growth, in spite of large subsidies.
Historically, regulators have often relied on simple rules of thumb. With rate-of-return
regulation, the regulated firm is allowed to set prices above marginal cost, but its rateof return cannot exceed a given level. However, this form of regulation has a numberof shortcomings: it gives the firm no real motive to minimize its production costs, since
the government compensates the firm for cost increases (by allowing prices to go up),and it encourages the firm to over-invest in capital relative to other inputs (Averch
and Johnson, 1962). In fact, rate-of-return regulation lacks a normative justification.
For example, what criteria should be used to determine the permitted rate of return?
We need a normative framework to rigorously evaluate diﬀerent regulatory schemes andcharacterize optimal regulation.
Ramsey pricing As long ago as the 1920s, the polymath Frank Ramsey formallycharacterized the “least ineﬃcient” departures from marginal-cost pricing that would
allow a monopoly firm to break even (Ramsey, 1927). But the theory of Ramsey pricing
entailed no clear justification for the break-even constraint: why are subsidies to the firm
ruled out? Moreover, the informational requirements of Ramsey pricing are significant. In
theory, the regulator must know both cost functions and demand functions to computethe optimal prices. In reality, the firm’s management may have superior information
about both.
In the late 1970s, a number of researchers studied how the regulator might bypass
these problems by decentralizing pricing decisions to the regulated firm. Vogelsang and
Finsinger (1979) argued that a regulator with no knowledge of cost or demand functions
could use iterative rate-of-return regulation to implement long-run Ramsey pricing. The
average price a firm could charge in the current period would depend on the prices it
charged in the previous period and on its observed production cost. If the firm chooses
its prices myopically in each period — a very strong assumption — then this dynamic
process would converge to Ramsey pricing. Loeb and Magat (1979) argued that a regulator who knows the demand function but not the cost function might be able to implement the first-best marginal-cost pricing outcome. Assuming the regulator (i) can use
non-distortionary taxation to finance lump-sum subsidies, so that Ramsey-pricing is notnecessary, and (ii) assigns the same welfare weights to consumer surplus and firm profit,
so that distributional concerns are absent, the Loeb-Magat solution eﬀectively hands theentire social surplus to the firm. Indeed, the principal-agent literature teaches us that
allocative eﬃciency is obtained if a risk-neutral agent (here, the firm’s manager) is a residual claimant to the surplus. However, real-world governments usually have distributional
concerns that rule out such one-sided outcomes. Moreover, with distortionary taxation,or more generally in the presence of distortions elsewhere in the economy, the case for
Ramsey-pricing re-emerges (e.g., Hagen, 1979). Public funds have an opportunity cost,and handing surplus to the managers or owners of regulated firms hence also entails aloss of eﬃciency in the overall economy.

5

Towards a mechanism-design approach Under realistic assumptions about the government’s objectives and informational asymmetries, the regulator must thus balance theeﬃciency of the regulated firm against the social value of extracting the firm’s rents. In
1982, David Baron and 2007 Economics Laureate Roger Myerson studied this problem
without imposing any ad hoc restrictions on the regulatory scheme. This initiated themodern mechanism-design approach to regulation. However, Baron and Myerson (1982)
assumed that the regulated firm’s cost function is given and immutable. This assumption
rules out production ineﬃciencies and cost overruns, problems that are central in many
regulated industries. Sappington (1982) took an important step forward. He endogenized
the cost function by assuming the regulated firm can take unobserved actions to reduce
its production cost. However, by restricting the regulator to oﬀering linear contracts,
Sappington (1982) left an important question unanswered: what is the optimal shape ofthe regulatory contract?

2.2

The Basic Laﬀont-Tirole Model of Regulation

Laﬀont and Tirole (1986) applied the tools of mechanism design to a model with endogenous cost functions, similar to that previously studied by Sappington (1982). This
Laﬀont-Tirole model treats regulation as a principal-agent problem, with the governmentor “regulator” as the principal, and the regulated firm (or more precisely, its manager) as
the agent. The regulator observes realized production costs, but not how much eﬀort thefirm has put into cost-reduction (a post-contractual hidden eﬀort problem). Moreover, thefirm knows more about its cost-reducing technology than the regulator (a pre-contractual
hidden information problem). Importantly, Laﬀont and Tirole (1986) imposed no restrictions on the set of feasible regulatory mechanisms, except the restrictions that follow
from the information asymmetries and voluntary participation of the firm.
Assumptions We consider a simplified version of the basic model, where the government procures an indivisible public good from a privately owned firm. The good iscompletely financed by a transfer  from the government to the firm; individual consumers pay nothing.7 The regulator in charge of procurement observes the firm’s realized
production cost . Thus, the transfer  can depend on  allowing us to study optimal
cost-sharing between the government and the firm. The shadow cost of public funds is
1 + , where distortionary taxation implies   0. The regulator seeks to maximize totalsocial surplus  +  − (1 + ), where  is consumer surplus and  is the utility of thefirm’s manager. Specifically,  =  −  − Ψ(), where  ≥ 0 is the eﬀort exerted toreduce production cost, and Ψ() is the manager’s cost of eﬀort (an increasing, strictly
convex function). The production cost is  =  − , which depends on two factors: (i)it is increasing in eﬃciency parameter  the firm’s cost-type, drawn from an interval[ ] (the distribution is assumed to be continuous and to satisfy the so-called monotone
7

Procurement can be distinguished from regulation based on who receives the good: the government (procurement) or consumers (regulation). For our purposes, the distinction is immaterial, as theLaﬀont-Tirole model is applicable in both cases. The general model, where consumers can be charged a(regulated) price, is treated at length in Laﬀont and Tirole (1993).

6

hazard-rate property), and (ii) it is decreasing in the manager’s eﬀort .8 The manager
learns his firm’s true cost-type  and chooses . The regulator observes  but not  or
. Thus, the regulator encounters hidden information (unobserved ) as well as hidden
action (unobserved ). Low-cost types (low ) are inherently more eﬃcient than highcost types (high ). Whatever his type, the manager can reduce the production cost by
working hard. Since the marginal benefit of eﬀort is 1, and the marginal cost of eﬀort isΨ0 (), the first-best eﬀort level ∗ satisfies Ψ0 (∗ ) = 1.
Using the definition of  , social surplus is  −  − Ψ() − . All else being equal,
the regulator prefers as small transfers  as possible, as every dollar transferred implies
a net social loss of   0. However, the regulator must make sure that three constraints
are satisfied: (1) a participation constraint: each type of manager must participate voluntarily, which requires  ≥ 0;9 (2) a moral-hazard constraint: as the regulator does notobserve , the transfer scheme (mechanism) must motivate each manager to supply anappropriate eﬀort level; and (3) an incentive-compatibility (or self-selection) constraint:
as the regulator does not observe , the manager must voluntarily choose the appropriate
contract for his own cost-type.
Analysis Laﬀont and Tirole (1986) showed that the optimal transfers consist of a lumpsum payment plus a linear cost-sharing term. Specifically, the optimal mechanism canbe expressed as follows. After having observed , the manager announces his expected
production cost   . Then, production takes place and the actual production cost  isobserved by the regulator. The cost overrun is  −   (which, if negative, is actually acost saving). The transfer is given by the cost-reimbursement rule  = (   ), where(   ) ≡ (  ) + (  ) × ( −   ) Here (  ) is a lump-sum transfer, and (  ) is the share the regulator pays of any
cost overrun. Notice that (  ) and (  ) do not vary with the realized cost , but do
depend on the announced   . The mechanism can therefore be expressed as a menu ofcontracts. Self-selection requires the manager to truthfully announce his expected cost  so that he receives the contract which is appropriate for his type.10 Each contract ischaracterized by (  ) and (  ), and incentives are more high-powered if (  ) is small.
If (  ) = 1 then the contract is cost-plus: the regulator pays 100% of any cost overrun.
Cost-plus contracts are in general not optimal, because they provide no incentives forcost-reduction (the manager would set  = 0).
Laﬀont and Tirole proved that (  ) = 0 for the lowest cost-type ( = ), who
naturally announces the lowest   . Thus, the most eﬃcient firm gets a fixed-price contract
where the transfer (   ) = (  ) is purely lump-sum — i.e., independent of realized
cost . The incentives to reduce costs are then high-powered, and the manager supplies
the first-best eﬀort. Giving such high-powered incentives to all types would be sociallyvery costly, however. High-cost types would need a very large lump-sum transfer to induce
8

Since both the regulator and the manager are assumed risk-neutral, a random disturbance to the
production cost can be introduced in the basic model without changing any results.
9
The manager’s outside option is to exit the industry (and produce nothing).
10
Higher cost-types will expect to have higher production costs, so announcing   is equivalent toannouncing .

7them to participate in a fixed-price scheme. But managers of eﬃcient firms could always
pretend that cost conditions are unfavorable (by announcing a high   ), so incentive
compatibility would force the regulator to give them very large lump-sum transfers as well— even though their realized costs will in fact be low. Therefore, high-powered incentives
for high-cost types imply large (and socially costly) information rents for low-cost types.
Results: rent extraction vs. cost reduction Due to the social cost of publicfunds, the regulator must balance cost-reducing incentives for high-cost types against
rent extraction from low-cost types. The optimal mechanism gives all managers with   contracts with (  )  0. These incentive contracts specify that the government
reimburses the firm for a fraction (  )  0 of the realized cost. Since the firm only pays
a fraction 1−(  )  1 of cost overruns, the manager’s cost-reducing eﬀort is strictly lessthan the first best. However, as (  )  1 cost overruns are not fully reimbursed. All
types except the most ineﬃcient one earn information rents:   0 for all   . These
rents are socially costly, and the regulator could eliminate them by cost-plus contracts,
but does not do so because this would also eliminate the incentives to reduce costs.
For future reference, we refer to the optimal regulatory mechanism derived by Laﬀont
and Tirole (1986) as the optimal static mechanism, or o.s.m. As we have seen, theo.s.m. has the following three key properties: (S1) the manager self-selects by truthfully
announcing   , and thereby reveals his cost-type, (S2) each type    provides lessthan first-best eﬀort (i.e.,   ∗ ), and (S3) each type    receives an information rent
(i.e.,   0).
Impact Laﬀont and Tirole (1986) was published at a time when diﬀerent regulatory
schemes were hotly debated. Some policies were recognized to have poor incentive properties, leading to huge cost overruns. The trend was to abandon rate-of-return regulationin favor of price-cap regulation, where in eﬀect the firm becomes the residual claimant
for cost savings (as when (  ) = 0 above). While the poor incentive properties of rateof-return and cost-plus regulation had already been recognized, the Laﬀont-Tirole model
highlighted a subtle problem with price caps: high-powered incentives imply large rents
to eﬃcient firms, which is very costly if public funds are raised by distortionary taxation,or if the regulator has distributional objectives. To reduce these rents, optimal regulation
will generally not induce first-best levels of cost-reduction. Thus, observing unnecessarily high production costs does not necessarily reflect badly designed regulation. This
important fact plays a key role in dynamic regulation (see subsection 2.4 below).
More generally, by providing a normative framework of optimal regulation, the LaﬀontTirole model clarified the relative merits of diﬀerent policies. Since real-world policies
may not be well designed, it is quite possible that current practice diﬀers from the optimalmechanism.11 However, for the recommendations to be useful, the model assumptions
should approximate the situation facing real-world regulators. The basic framework of
the Laﬀont-Tirole model does seem consistent with empirical observations. For example,
the model explains why telephone companies operating under price-cap regulation (with11

Gagnepain and Ivaldi (2002) stucturally estimate a model of the French Public Transit System andconclude that existing regulatory policies are far from optimal. In particular, cost-plus contracts reducesocial welfare due to insuﬃcient cost-reduction.

8

high-powered incentives) on average oﬀer lower rates (Mathios and Rogers, 1989) andreport higher profits (Ai and Sappington, 2002) than companies under cost-of-service
regulation (with low-powered incentives).12
Discussion In the Laﬀont-Tirole model, the incentives for cost-reduction are maximized when prices are not distorted — i.e., when there is no reimbursement of cost overruns— so the natural monopoly bears the true social cost of its decisions. But with asymmetric information about the firm’s true eﬃciency, such high-powered incentives imply large
rents for eﬃcient (low-cost) firms. In the constrained optimum, prices are distorted inorder to reduce these rents. This trade-oﬀ is familiar from 1996 Laureate James Mirrlees’
pioneering work on optimal taxation. In his model, incentives to earn income are maximized when marginal tax rates are zero. But positive marginal tax rates for agents withlow earning ability make it possible to extract more revenue from high-ability agents,
because it relaxes their incentive-compatibility constraints. Thus, the government optimally allows distortions for low-ability agents in order to reduce the information rents
enjoyed by high-ability agents. A positive marginal tax rate for the highest ability agent
would not relax any incentive-compatibility constraints, however — in the Mirrlees model,
there should be “no distortion at the top”. In the Laﬀont-Tirole model, no distortion at
the top corresponds to a fixed-price contract for the most able ( = ) type. All othertypes face distorted prices, i.e., they bear only some fraction of the production costs they
incur.
A possible objection to the o.s.m. is that it is quite complex and requires hard-toobtain information about the distribution of types. It is a valuable theoretical benchmark,but would such a complex scheme be adopted by real-world regulators? There are several
responses to this kind of objection. First, one could use expert opinions to calibrate therange of uncertainty. Gasmi, Laﬀont and Sharkey (1997, 1999) show how engineeringmodels can be used for this purpose. Moreover, there are plausible scenarios in which alarge fraction of the social surplus generated by the o.s.m. can be attained by a simplified
version of it. Rogerson (2003) considers a simplification where the menu consists of only
two contracts: a cost-reimbursement contract (corresponding to (  ) = 1) and a fixedprice contract (corresponding to (  ) = 0). If the manager’s utility is quadratic andtypes uniformly distributed, the simplified mechanism can always capture at least threequarters of the social surplus generated by the o.s.m. Gagnepain and Ivaldi (2002) estimate a structural econometric model of the French public-transit systems, and conclude
that social welfare could be significantly raised if the operators were oﬀered to choose
between simple cost-reimbursement or fixed-price contracts.
Some U.S. regulators have begun oﬀering regulated firms precisely this kind of choice,that of a low-powered scheme (cost-reimbursement) or a high-powered scheme (pricecaps), and the theory provides a foundation for this (Laﬀont and Tirole, 2000, Chapter 2).
The theory shows that more eﬃcient firms should be given more high-powered incentives,
and this is an important qualitative insight. Thus, even if regulators do not formallyoﬀer a menu of contracts, they may consider several options when negotiating with the12Note that the theory advocates caution when interpreting this kind of empirical relationship. According to the o.s.m., more eﬃcient firms should choose more high-powered contracts, and the selection
bias can create diﬃculties for econometric studies (see Gagnepain and Ivaldi, 2002).

9

regulated firm. A firm which thinks that it can produce at a low cost will argue infavor of (perhaps lobby for) a high-powered contract. Qualitatively, the negotiation may
therefore lead to an outcome similar to that of a formal menu of contracts (as in theo.s.m.). The theory produces many other qualitative insights. For example, since it is
the regulator’s uncertainty about the firm’s eﬃciency that distorts the firm’s eﬀort levels,
any factor that reduces this uncertainty will reduce the distortions as well, i.e., incentives
should become more high-powered. Two such factors are competition in an auction forthe monopoly position, and benchmarking (where the firm’s performance is compared tothat of similar firms). Thus, all else being equal, auctions and benchmarking should leadto more high-powered incentive contracts (see Laﬀont and Tirole, 2000, Chapter 2).
Starting from their basic 1986 model, Laﬀont and Tirole came to enrich their theory and apply it to a series of public-policy issues. Their work, summarized in Laﬀont
and Tirole (1993), launched a revival of the theory of regulation. More generally, it also
inspired new theoretical work on public and private decisions under information asymmetries. Importantly, they imposed discipline on the research in this area. For example,
we have seen that in the basic Laﬀont-Tirole model, the regulator makes transfers to thefirm. Such transfers are a necessity in the case of procurement. But if the regulated firm
sells its output directly to consumers, real-world regulators rarely have the legal power totax or subsidize the firm. One response to this empirical observation could be to rule outtransfers by assumption. But a key aspect of Laﬀont and Tirole’s work was a reluctanceto include such ad hoc assumptions. Instead, they wanted to fully specify the regulator’s
objectives and constraints, and calculate the optimum policy using all available instruments. Of course, there might be good reasons why transfers are rare — perhaps there
is a danger of “regulatory capture”. But Laﬀont and Tirole wanted to formalize thesereasons, rather than simply assume that an instrument such as transfers is not used (seesubsection 2.5 for their model of regulatory capture). This general perspective, whichpermeates almost all of Tirole’s work, has raised the intellectual level on research in thisarea and added clarity as well as rigor to policy discussions.
So far, we have only considered the simplest possible case — a once-and-for-all procurement of an indivisible good by the government — to illustrate the basic model. We
now consider some generalizations of this case.

2.3

Multi-Product Firms, Quality Concerns, Access Pricing and
Network Interconnection

When the Laﬀont-Tirole model is applied to a multi-product firm, it sheds light on anumber of important issues, such as concerns about quality and access pricing.
To set the stage, consider first a multi-product firm that sells its output directly to
consumers, at regulated prices (following Laﬀont and Tirole, 1990a and 1993). Optimal
pricing reflects two considerations. The first is the eﬀect on consumer demand andthe regulated firm’s profits — this eﬀect can be summarized by familiar Ramsey pricing
formulas (except that the social cost of public funds  replaces the shadow price of thefirm’s break-even constraint, just as in the optimal commodity-taxation literature; see
Diamond and Mirrlees, 1971, Sandmo, 1974, and Hagen, 1979). The second considerationis the eﬀect on the firm’s incentives for cost reduction. However, as discussed in the10

previous subsection, if costs are observable then cost reimbursements can be designed toprovide this incentive. Accordingly, Laﬀont and Tirole (1990a and 1993) show that if acertain separability condition holds,13 then the incentive consideration does not influence
the optimal pricing of the firm’s output (price-incentive dichotomy). Goods should bepriced according to familiar Ramsey pricing formulas, even though the cost function
is endogenous and the government is able to subsidize financial shortfalls at the firmlevel, because distorting the price structure does not (under the separability condition)
provide incentives for cost-reduction. With this simplest benchmark case in mind, we
now consider some more complex cases of multi-product firms.
Quality concerns Formally, a firm with endogenous product quality is a special case ofa multi-product firm, as we may consider low-quality and high-quality goods as diﬀerent
products. Therefore, if quality is verifiable and can be specified in a contract, the analysis
is the same as for any multi-product firm, as discussed in the previous paragraph. The
more interesting case occurs when quality is not verifiable. In this case, the regulator
must create incentives for the regulated firm to provide the appropriate quality level— it cannot just be specified in a contract. Intuitively, high-powered schemes (such as
fixed-price contracts) give the regulated firm an incentive to reduce quality in order tolower its costs, while low-powered incentive schemes (such as cost-plus or cost-of-service)encourage high quality because the cost is passed on to consumers and/or the government(see Kahn, 1988). Therefore, it seems intuitive that a quality-conscious regulator shouldchoose a low-powered incentive scheme.
Laﬀont and Tirole (1993, Chapter 4) show that this intuition is correct for experience
goods, where consumers cannot observe quality before purchase. An impatient manager
who cares mainly about his current payoﬀ can reduce quality without any immediateeﬀect on the demand for the good. (The negative long-run eﬀect, once consumers discover
the low quality, is unimportant to the impatient manager). The regulator has only one
instrument — the cost-reimbursement rule — with which to achieve the twin goals of highquality and low production cost. Since these goals are inherently in conflict, a trade-oﬀ
arises: a high-powered incentive scheme results in low quality at low cost. Thus, forexperience goods the intuitive argument is correct: a high concern for quality makes lowpowered incentive schemes optimal. However, the intuitive argument is not correct forsearch goods, where consumers observe quality before purchase. In this case, the volume
of sales is a quality index (since high quality implies high demand). The incentive to
produce high quality can then be provided by rewarding the firm based on its volume ofsales, while the incentive for cost reduction is again provided by the cost-reimbursement
rule as discussed in subsection 2.2. For search goods, quality concerns should thus notnecessarily shape the power of the cost-reimbursement rule.14
13

An example of an aggregate cost function that satisfies the separability assumption is  = ( − 1  2    ), where  and  are defined as in subsection 2.2 and  denotes the output of good .
Using an engineering model, Gasmi, Laﬀont and Sharkey (1997) show that the separability condition is(approximately) satisfied for local telecommunications.
14
There may however be an indirect eﬀect. If a greater concern for quality causes the optimal quantity
to increase, then this increases the marginal social benefit of cost-reducing eﬀorts. To encourage morecost reduction, incentives should actually become more high-powered.

11

Access pricing and network interconnection Many regulated firms operate in acompetitive environment. In addition to the usual considerations involving the regulated
firm and its customers, the regulator must then also take into account how regulationaﬀects other (typically unregulated) firms. An important example is access pricing — theterms on which a regulated incumbent should be required to supply inputs to downstream
competitors. For instance, to compete for customers, rival firms might need access to a
local network controlled by a large incumbent telephone company. The liberalization ofindustries dominated by vertically-integrated incumbents — such as telecommunications
and electricity — made access pricing a hot topic in regulatory economics and policy.
Further work by Laﬀont and Tirole (1990c, 1993, 1994) clarified the optimal regulationof access prices.
Formally, access pricing is another case of a regulated multi-product firm, where someof its products are sold to other firms. Suppose the regulated firm produces  goods. Oneof these — say good 1 — is used as an input by a competitive fringe of small and pricetaking firms. The competitive fringe produces an output — say good +1 — that competes
with another product of the regulated firm — say good . Disregarding incentives, thekey insight is that goods 1 and  are substitutes. An increase in  (the price of theth good) increases the demand for the  + 1st good, supplied by the competitive fringe,
which in turn increases the demand for the input, good 1. This insight allows demand
elasticities to be computed, and the optimal access price 1 is given by a familiar-looking
Ramsey-pricing formula.
In general, incentives cannot be disregarded, however. To set a fair access price, theregulator may need the regulated firm to reveal information about its cost function. The
firm may be tempted to exaggerate the cost of supplying the input to its competitors inorder to raise the access price and, perhaps, “foreclose” the downstream market (eliminate
the competition). Laﬀont and Tirole (1993, Chapter 5) distinguish between two casesthat entail quite diﬀerent conclusions.
The first is a common network. In this case, the competitors use the same technology(the existing network) as the regulated firm to transform the input (good 1) into theconsumption good (goods  and  + 1). Therefore, if the manager of the regulated firm
claims that the cost of giving access to competitors is high, he is also saying that the costof producing good  is high. The regulator will then restrict the output of good , andthis mitigates the manager’s incentive to lie about its cost of giving access.
The second, more diﬃcult, case is network expansion. Here, the regulated firm can
supply good  to the final consumer using its existing network, but giving access tocompetitors requires new facilities or interconnections. The regulated firm can thenexaggerate the cost of giving access without also making a case against the productionof good . Now the regulator’s constrained optimum will likely involve higher accessprices, and less competition, than the first-best (full-information) outcome. Moreover,since a firm with high-powered incentives can gain more from increased access prices,low-powered incentives may be optimal.
As we shall see in Sections 4 and 5, concerns about anti-competitive foreclosure are
central to the legal treatment of vertical restraints and to the regulation of access prices
in network industries, and we thus discuss these concerns in those sections.

12

2.4

Contract Dynamics, Commitment Problems and Renegotiation

In practice, regulation is seldom once-and-for-all, but rather an activity that takes placeover an extended period. The regulator may then be unable to commit to a regulatory
policy over the relevant time span.15 This causes two kinds of problems. The first isthat the regulated firm may have insuﬃcient incentives to make long-run investments.
Suppose the firm can make a sunk-cost investment in a technology which will generate
future cost savings. If the firm invests and its costs fall, the regulator may be tempted to
expropriate the investment by reducing the transfer to the firm (or tighten its price cap).
If the firm anticipates this kind of hold-up problem then it may prefer not to invest. This
problem is the largest when long-run investments are essential, as in the electricity andtelecommunications industries.16 Tirole (1986b) provided a formal model of underinvestment in the context of government procurement under asymmetric information.
The second kind of commitment problem is studied by Laﬀont and Tirole (1988a,
1990b). It is more subtle than the hold-up problem, and depends on the existence ofasymmetric information. To understand this problem, suppose the one-period LaﬀontTirole model described in subsection 2.2 is repeated twice. Thus, in each of two periods
the government wants to procure the public good.17 The firm’s type (eﬃciency parameter) is the same in both periods, and is unobserved by the regulator. If the regulator could
credibly commit to a long-run (two-period) contract then it would be optimal to oﬀer theo.s.m. in both periods (see Laﬀont and Tirole, 1993, Chapter 1). Thus, the optimal twoperiod outcome would simply implement the static optimum twice. This is the perfectcommitment outcome.
But what if the regulator is unable to make credible long-run commitments? Laﬀont
and Tirole analyzed this problem under diﬀerent assumptions about the regulator’s commitment power.18 Laﬀont and Tirole (1988a) assumed the regulator cannot make any
commitments whatsoever, so long-run contracts are simply ruled out. Laﬀont and Tirole(1990b) introduced a limited form of commitment: the regulator can write a long-run
contract, and can commit not to unilaterally deviate from the contract, but he cannot
commit not to renegotiate the contract if the regulated firm agrees to do so (i.e., if a
15

In practice, regulatory policies are reviewed and revised periodically: in rate-of-return regulation
the permitted rate-of-return is subject to adjustment, in price-cap regulation the maximum price isadjusted, etc. When the policies are reviewed, the regulator typically has some discretion. Even if along-run contract exists, it will typically be quite incomplete, and this gives rise to the same kind ofcommitment problem as in the absence of long-run contracts. Laﬀont and Tirole (1993, Chapter 16)
provide a diﬀerent justification for the lack of long-term commitments, namely changing administrations.
16
See Laﬀont and Tirole (2000) for an analysis of regulation and investment in the telecommunicationsindustry.
17
We abstract from the hold-up problem by assuming there are no long-run investments.
18
Laﬀont and Tirole’s work on dynamic regulation is somewhat diﬀerent from the bulk of their workin that they did not use mechanism-design theory. A fundamental result of this theory, the revelation
principle, states that maximum social welfare can be achieved by a revelation mechanism. Laﬀont andTirole (1986) used the revelation principle to find the o.s.m., but they did not use it in their later workon dynamic contracting. (For a general statement of the revelation principle, see Myerson, 1991, Section
6.9. To capture a lack of commitment, the regulator could be considered a player subject to moral-hazard
constraints.)

13

Pareto-improvement exists).19 We now discuss these models in turn.
Short-run contracting under asymmetric information Following Laﬀont and Tirole (1988a), suppose the regulator is unable to write any long-run contract with theregulated firm, but instead has to govern the relationship by a sequence of short-run(one-period) contracts. This gives rise to a ratchet eﬀect, which is well-known from theliterature on central planning (Weitzman, 1976). If an agent works hard and shows agood result, the principal may demand even better results in the future; anticipating
this, the agent has little incentive to work hard in the first place. Restricting their analysis to linear contracts, Freixas, Guesnerie and Tirole (1985) provided the first formal
analysis of optimal short-run contracts in the wake of such ratchet eﬀects. They showed
how the principal might initially sacrifice short-run eﬃciency to induce more informationrevelation from the agent.
Laﬀont and Tirole (1988a) considered optimal short-run contracting in the two-period
version of the Laﬀont and Tirole (1986) model, without imposing any functional-form
assumptions. Recall that the perfect commitment outcome would be to oﬀer the o.s.m.
in both periods, but this outcome requires a credible commitment to a long-run contract.
To see that it cannot be implemented through a sequence of short-run contracts, recall
that the manager’s type is the same in both periods.20 Now suppose the regulator oﬀers
the o.s.m. in period 1, and the firm self-selects thereby revealing its type (property S1of the o.s.m.).21 In period 2, the regulator no longer faces asymmetric information, andso prefers to oﬀer a contract which induces first-best eﬀort  = ∗ and expropriates therent of the firm,  = 0. Anticipating this outcome, the firm is unwilling to reveal its
type in period 1. Indeed, Laﬀont and Tirole (1988a) proved a no-separation result: withshort-run contracting, no period-1 mechanism can induce full revelation of types.22 There
will always be some degree of pooling, so after period 1 the regulator will in general notknow the firm’s true type. Intuitively, the ratchet eﬀect implies that information unfolds
slowly, as the manager tries to protect his information rents by not revealing his true
type.
Characterizing the set of equilibria in the two-period model is quite complex. Technically, the problem arises because the incentive-compatibility constraints can bind in both
directions, not just downwards as in the static model. That is, the regulator has to worry
not only about low-cost (low ) types pretending to be high-cost (high ), but also abouthigh-cost types pretending to be low-cost. The latter concern is due to the fact that high types may “take the money and run”. To encourage low  types to self-select, theregulator must oﬀer them a large payment in period 1, because low  types expect that,19
An alternative model of regulation with limited commitment was developed by Baron and Besanko(1987).
20
More generally, the arguments require a positive correlation between period 1 and period 2.
21
Recall that the optimal mechanism for the one-period Laﬀont-Tirole model described in subsection
2.2, referred to as the o.s.m., had three key properties: (S1) self-selection, (S2)   ∗ for all types except
, and (S3)   0 for all types except .
22Here is a sketch of a proof by contradiction. Suppose type ̂ reveals itself in period 1, so in period
2 it gets no rent. Therefore it chooses the first-period contract that maximizes its first-period payoﬀ.
By imitating type  0  ̂, in period 1 the firm would not lose anything to the first order (since it waschoosing its best contract). But it would gain a second period rent proportional to  0 − ̂, so it would
be made better oﬀ overall, a contradiction.

14

if they reveal themselves, the regulator will extract their rents in period 2. Now the high type may be tempted to pretend to have low , take the high payment in period 1, butthen reject the period-2 contract and exit the industry (take the money and run).
Thus, Laﬀont and Tirole show that the commitment problems can be quite complex.
The main point is that — as already suggested by Freixas, Guesnerie and Tirole (1985) —the firm will be reluctant to reveal that its costs are low, fearing that its information rents
will be expropriated (the ratchet eﬀect). Therefore, as suggested by the no-separation
result, the regulator must refrain from getting “too much information”. These important
insights have become recurrent themes in subsequent research on dynamic contractual
relationships.
In practice, a regulator may employ various strategies to remain ignorant about thefirm’s cost. For example, the regulator may try to commit to infrequent reviews of a pricecap.23 If this commitment is credible, the firm will have a strong incentive to minimize
its production cost. However, if the commitment is not credible, the firm expects thatany cost reductions will quickly trigger a tighter price cap, and the incentives for costminimization vanish.
Long-run renegotiated contracts Now suppose that the regulator and the firm canwrite a long-run contract, and that each party can credibly commit not to unilaterally
deviate from the contract terms. Can the perfect-commitment outcome, where the firm
receives the o.s.m. in both periods, be implemented in this case? Laﬀont and Tirole(1990b) suggested that the answer may be no, as the regulator and the firm may jointly
benefit from renegotiation. Recall property S1 of the o.s.m. — the manager reveals histrue type — and property S2 — if his type is    then his eﬀort is less than first-best(  ∗ ). If the manager reveals his type    in period 1 then both parties know that a
Pareto-improvement is possible in period 2, because the o.s.m. outcome is not first-best.
So the perfect commitment outcome is not renegotiation-proof. Of course, anticipatingthat the contract will be renegotiated in period 2 changes the manager’s incentives inperiod 1, and this makes the overall outcome worse than under perfect commitment.
Thus, the regulator would like to commit, if possible, to never renegotiating the initial
contract. Unless such a commitment is possible, the commitment solution cannot be
implemented even when long-run contracts can be written.24
A mechanism that is not renegotiated in equilibrium is called renegotiation-proof,a concept that derives from Dewatripont (1989). Hart and Tirole (1988) applied thisconcept to a model of dynamic contracting between a buyer and a seller when the buyer’s
type (his valuation of the good) is private information. They compared period-by-period
renting of a durable good with outright selling, with or without long-term (renegotiable)
contracts. With only short-run contracting, equilibrium of the rental model is similar toLaﬀont and Tirole’s (1988a) equilibrium, with pooling caused by a ratcheting eﬀect. But
with a renegotiable long-term contract, the rental model has the same equilibrium as thesale model. Moreover, they demonstrated a close parallel to the problem facing Coase’s
23

For a discussion of optimal regulatory lags, see Armstrong, Rees and Vickers (1991).
In theory, a commitment not to renegotiate might be accomplished by contracting with a third party,
who is promised a large payment if the regulator renegotiates the original contract. However, entering
into such third-party agreements may not be possible for institutional reasons, so it is reasonable toassume that the regulator cannot commit not to renegotiate.
24

15

(1972) durable-goods monopolist: when it is impossible to commit not to renegotiate
long-run contracts, the equilibrium has Coasean features (a declining price path). We
shall return to this theme in Section 4.
Laﬀont and Tirole (1990b) applied a similar analysis to renegotiable long-run contracts in the twice-repeated Laﬀont-Tirole (1986) model. Since long-run contracts arefeasible, the regulator can commit to give the firm rents in period 2. (Pareto-improving
renegotiation would not eliminate this rent.) Therefore, take-the-money-and-run is not
a problem, and the incentive-compatibility constraints only bind downwards as in thestatic model. In this sense, the case of renegotiation-proof long-run contracts is morestraightforward than the case of short-run contracting. With renegotiation-proof longrun contracts, full separation of types is feasible, but it is not optimal for the regulator(see Laﬀont and Tirole, 1993, Chapter 10). As in the case of short-run contracting, theregulator’s renegotiation-proof optimum involves pooling of types, i.e., the regulator mustrefrain from getting “too much” information.25
Fully characterizing the regulator’s renegotiation-proof optimum with a continuumof types is technically challenging. However, the solution can be readily explained forthe case of two types,  and  with   . If the regulator and the manager are
suﬃciently patient (period-2 payoﬀs are suﬃciently valuable), then separating the two
types in period 1 is never optimal. In period 1, the regulator oﬀers the firm’s manager
a choice between a long-run fixed-price contract that induces first-best eﬀort in both
periods, and a short-run contract that does not induce first-best eﬀort. The high-cost
type ( = ) chooses the short-run contract for sure, but the low-cost type ( = )
randomizes between the two contracts. The short-term contract induces pooling, i.e.,
both types produce at the same cost. Thus, after period 1, the regulator will never know
for sure that the manager is the high-cost type (as the low-cost type chooses the short-run
contract with some probability). If the firm chooses the short-term contract, in period
2 the regulator makes an oﬀer which is conditionally optimal given his posterior beliefs.
Since the long-run contract induces the first-best eﬀort in period 2, there is no scope forrenegotiation. Moreover, similar to the case of short-run contracting, pooling is more
likely the more patient the regulator and the firm are.
The general lesson of Laﬀont and Tirole (1990b) is thus quite similar to that of Laﬀont
and Tirole (1988a). When the regulator cannot commit to a long-run contract, he will
be tempted to take advantage of information revealed by the firm. To avoid succumbing
to this temptation, the regulator must refrain from becoming too well-informed. In theconstrained optimum, the more important the future payoﬀs, the less well informed hewill be. These insights hold whether or not long-run contracts can be written, as long as
renegotiation is possible.

2.5

Institution Design: Regulatory Capture or Motivated Agents?

Game-theoretic modelling requires explicit assumptions about human behavior. Tirole
has studied regulatory capture under the assumption that regulators obey the standard
selfishness axiom and thus maximize their own private welfare (rather than social wel25
The main diﬀerence is that with long-run renegotiation proof contracts, separation of types is feasible
but not optimal. With short-run contracts, separation is not even feasible (the “no separation” result).

16

fare). However, he has recently found it necessary to modify this axiom, allowing someindividuals to have more pro-social motives than just lining their own pockets. This subsection describes Tirole’s most important results on regulatory capture and motivatedagents, respectively.
Regulatory capture In recent decades, economists have become more attuned to theidea that sector-specific regulation is a perilous task which, at worst, can be captured by
the regulated industry. Simply put, regulation may end up benefitting producers rather
than consumers (Stigler, 1971). A growing body of empirical studies backs this up by
documenting various regulatory dysfunctions (Dal Bó, 2006). In fact, regulatory capture
is an example of a more general phenomenon: collusion in hierarchical organizations.
The first formal game-theoretic analysis of this was Tirole’s (1986a) model of a three-tierstructure consisting of a principal, a supervisor and an agent. We discuss this model andits importance in Section 6.4.
Laﬀont and Tirole (1991) adapted the three-tier structure to the problem of regulatory
capture. Suppose a higher authority designs a framework for regulation and, within thisframework, the regulatory agency interacts with the regulated firm. Suppose further thatthe regulatory agency occasionally obtains verifiable information about the firm’s costconditions: for simplicity, the firm’s cost-type is either high  =  or low  =   .
While such information is potentially useful, Laﬀont and Tirole (1991) argued that theagency cannot be relied upon to internalize the higher authority’s objectives. This is
not a problem if the agency observes high-cost conditions,  = , as the firm’s manager
does not mind revealing that his task is diﬃcult. If, however, the agency learns that costconditions are favorable,  = , the firm does not want this information to be known.
Because of this conflict of interest, there is room for collusion between the agency
and the firm. In eﬀect, the firm’s manager may bribe the agency to suppress informationthat may hurt the firm.26 In the model, the maximum bribe the firm is willing to pay
depends on the prospective information rent it receives if its type is not revealed. If
this rent is large, the firm has a large incentive to bribe the regulatory agency, and thehigher authority will find it diﬃcult or costly to prevent collusion. One way for the higher
authority to reduce the threat of collusion is therefore to reduce the information rent.27
Recall that in the Laﬀont-Tirole (1986) model, reducing information rents requires a
greater distortion of the high-cost type’s eﬀort (by giving it something akin to a cost-plus
contract). This verifies the insight, first put forward by Tirole (1986a), that the threat ofcollusion makes low-powered incentive contracts more desirable. Again, we find that lowpowered incentives do not necessarily indicate a poor regulatory design. It may instead
be an optimal response to a threat of regulatory capture.
26
The term “bribe” is used as a short-hand for any compensation or favor. For example, the regulated
firm may oﬀer the regulator a lucrative job.
27
Another (costly) way to prevent collusion is to increase the incentives for the regulatory agency toreveal detrimental information. Suppose the higher authority pays  to the regulatory agency wheneverit reveals that  = . Then the agency will be captured (will not reveal that  = ) if the firm oﬀers
a bribe of at least . If the firm is willing to pay a large bribe to protect a large information rent, thenthe higher authority can only prevent collusion by choosing  very large. This is costly because  mustbe financed by distortionary taxation.

17

Motivated agents So far, we have only discussed models which assume that all agentsare purely selfish. While this assumption simplifies the analysis, human nature may beless dismal. Some agents may want to promote social welfare or more generally “do theright thing”. As Bénabou and Tirole (2011) demonstrate, personal values as well as desire
for social esteem may sometimes change optimal incentives quite strongly, and this is an
important research frontier.
One intriguing question is how to regulate agents if the principal is uncertain about
the agent’s motives. This problem is perhaps greatest when the agent takes decisions notabout how hard to work (as in the simple regulation model we have considered so far)but about some other action, the consequences of which appear only in the longer run.
In this case, a selfish agent should ideally be tightly controlled or strongly incentivized,
as before, but a pro-socially motivated agent should ideally have a free reign.
In joint work with Eric Maskin, Tirole has argued that the regulation of politiciansand other holders of high oﬃce (such as high-court judges) largely reflects a trade-oﬀ
between containing conflicts of interest and allowing socially motivated experts suﬃcientleeway. In Maskin and Tirole (2004), the contract is an institution that specifies: (i)who gets to make what decisions, and (ii) procedures for inducing public decision makers(informed agents) to act in the interest of the broader population (less informed principals). Their central assumption is that the informed agents are concerned not onlywith material benefits or other private returns to power, but also with making sociallybeneficial decisions and thereby leaving a valuable “legacy”.28
Since agents diﬀer in the strength of their pro-social motives, power will sometimes
be abused. Thus, the population will only leave extensive discretion to hired agents when
the decisions either require a lot of expertise or when direct democracy is likely to entail
undue exploitation of minorities. In these two cases, decisions may be delegated to longserving experts (“judges”). At the other extreme, if the population believes that issues are
straightforward and the majority’s benefits are not outweighed by the minority’s costs,
it prefers direct democracy. In the intermediate case, where issues require expertise, butdecisions can be evaluated relatively quickly, it will delegate decisions to agents operating
within term-limits — politicians in a representative democracy.

3

Industrial Organization: Strategic Behavior in Imperfectly Competitive Industries

The field of Industrial Organization (IO) studies how markets function. The main emphasis is on how firms exercise their market power in imperfectly competitive markets,
how they interact with other firms, the welfare implications of such behavior, and thejustifications for government intervention. In the case of natural monopolies, the government may directly regulate the monopolist (as discussed in Section 2). However, manymarkets allow more than one firm to operate, and it may be in the public interest to
promote competitive behavior in these industries (as will be further discussed in Section
4). Oligopoly theory provides a scientific foundation for such interventions.
28

To be precise, it is assumed that the agent is an impure altruist who does not primarily get satisfaction
from socially desirable outcomes, but from his own contribution to those outcomes.

18After a brief historical background, subsections 3.2, 3.3 and 3.4 will discuss some ofJean Tirole’s most noteworthy contributions to oligopoly theory.

3.1

Historical BackgroundIn the first half of the 20th century, the industrial organization literature contained
many detailed descriptions of specific oligopolistic industries, but with very little formal analysis. Except for a few deep and prescient contributions in the 19th century(notably Cournot 1838, Bertrand, 1883, and Edgeworth, 1897), the theoretical analysisof oligopoly before World War II was far from the modern standards of rigor and logicalconsistency. This classical theory certainly did not aﬀect any empirical work — whichat the time was mainly descriptive, with little formal statistical analysis, no attempts
to estimate parameters of an underlying structure, and no serious attempts to uncovercausal relationships.
In the 1950s, the work of Joe Bain (1951, 1956) propelled the so-called StructureConduct-Performance (SCP) paradigm. The basic idea was that industry conditions (thenumber of sellers, the production technology, and so forth) determine industry structure,
which determines firm conduct (pricing, investment and so forth), which in turn determines industry performance. A typical study in this tradition would use cross-industry
data to regress a performance measure — such as accounting price-cost margin — on a concentration measure — e.g., the Herfindahl Index, or the combined market share of the threelargest firms. Prescriptions for government policies, particularly with regard to horizontal mergers, reflected the SCP paradigm and were largely based on these concentration
measures.
In the 1960s and 1970s, the “Chicago School” (e.g., Demsetz, 1973) questioned thevalue of the cross-industry studies that formed the basis for the SCP paradigm. Diﬀerent
outcomes in diﬀerent industries could be due to variables not included in these studies,so the fundamental problem was the interpretation of a correlation as a causal eﬀect.
Proponents of the SCP paradigm typically interpreted a positive relation between concentration and profitability across industries to mean that a higher concentration leads
to higher industry profits. But an equally plausible interpretation is that highly eﬃcient (and therefore profitable) firms drive ineﬃcient rivals out of the industry, leading
to higher concentration. These two interpretations have very diﬀerent implications for
public policy, but there was no way to distinguish between them based on the typical
SCP study (see Schmalensee, 1986, for a critical discussion).
The Chicago School raised legitimate questions, but lacked the formal tools to analyze
the strategic behavior of firms in imperfectly competitive industries. Formal modellingat the time was basically restricted to the two polar cases of perfect competition andmonopoly. This did not allow a rigorous analysis of how the industry-specific conditions
unearthed by empirical researchers would determine the performance of these industries.
In the 1980s, the game-theory revolution in IO closed the circle by supplying the tools
necessary to take these industry-specific conditions into account. Since then, game theory
has become the dominant paradigm for the study of imperfect competition, providing arigorous and flexible framework for building models of specific industries, which has facilitated empirical studies and welfare analysis. Subsections 3.2, 3.3 and 3.4 will describe
some important advances made during this revolution. We focus on theoretical research,19

but we stress that the theoretical advances fundamentally aﬀected the empirical IO literature as well (see, e.g., Sutton, 1991, 2007; Berry and Reiss, 2007; Doraszelski and Pakes,
2007).
We also do not attempt to provide a comprehensive survey of modern IO theory.
Instead, we focus on the most important contributions by Tirole. A more complete
description of the state of the art in IO theory as of the late 1980s can be found in his own
influential textbook (Tirole, 1988). This book surveys the theory of monopoly behavior(e.g., price discrimination and vertical control), as well the main game-theoretic models
of imperfectly competitive industries, including many major advancements that will not
be discussed here. More than 25 years after its publication, Tirole’s book remains an
excellent introduction to the field and a standard reference. In fact, the book was always
more than a textbook: it defined modern IO theory by organizing and synthesizing themain results of the game-theory revolution.

3.2

Strategic Investment and Short-Run Competition

To what extent can a dominant firm block entry into its industry, or otherwise manipulate
the behavior of smaller rivals? Before the game-theory revolution, such questions had
been analyzed by rather blunt methods. For example, one might postulate that otherfirms believe that entry will not cause an incumbent firm to change its output (the socalled Sylos-Labini postulate). To block entry, an incumbent should thus produce aquantity that would make entry unprofitable. However, there was no real justification
for such postulates. Perhaps the incumbent’s output level would be fixed in the shortterm, but why would it not eventually adjust its behavior in the wake of entry? Previous
Economics Laureates Reinhard Selten (winner in 1994) and Thomas Schelling (winner in2005) rigorously analyzed these kinds of questions in more general settings, introducing
new concepts like subgame-perfect equilibrium and credible commitments. In the late1970s, the time was ripe for incorporating these general ideas into IO. The 2001 Economics
Laureate Michael Spence (1977, 1979) studied how incumbents (first-movers) could use
strategic investments to manipulate the behavior of rivals (second-movers). But Dixit(1980) was the first to properly analyze this kind of problem using the concept of subgameperfect equilibrium. His model was based on Spence (1977) but, unlike Spence, Dixit ruledout non-credible threats by considering Nash equilibria in the post-entry game.29
Credible commitments Game theory thus made it possible to carry out a rigorous
analysis of strategic investments in physical capital, R&D, advertising and the like. Suchinvestments have commitment value because they are irreversible and change payoﬀrelevant state variables. Quantity or price decisions typically have much less commitment
value, because they are so much easier to reverse. This was made clear by Dixit (1980).
However, contributions by Fudenberg and Tirole (1984) and Bulow, Geanakoplos andKlemperer (1985) revealed that an analysis of strategic investment is quite sensitive tothe details of the market environment.
29

Fudenberg and Tirole (1983) applied the concept of subgame-perfection to the Spence (1979) model.
They found a continuum of “collusive” subgame-perfect equilibria, where firms refrain from investing
because a unilateral deviation would lead to a continuation where each firm invests much more, lowering
the profits of both firms.

20

We illustrate these findings in a simple example, based on Fudenberg and Tirole(1984). Consider an industry with an incumbent monopolist and a potential entrant.
First, the incumbent moves: he makes a publicly observed investment denoted ; perhaps
expanding productive capacity, or investing in R&D to lower production costs. Then,
having observed the investment, the (potential) entrant moves: she decides whether or
not to enter. Without entry, the incumbent enjoys monopoly profit   (). With entry,
we have a competitive subgame: the incumbent and the entrant take actions (price or
output decisions) denoted  and  , respectively. Assuming the incumbent’s investment
 does not directly influence the entrant’s profits, the incumbent’s and the entrant’s
profits in the competitive subgame are denoted   (    ) and   (   ), respectively.
Importantly,  is a credible commitment which cannot be changed ex post. For example,
if an incumbent expands productive capacity, he cannot undo this investment after entry.
In subgame perfect equilibrium, actions  and  in general depend on . Formally, =  () and  =  (), where  () maximizes   (   () ) and  () maximizes  ( ()  ). The entrant will enter if she can make positive profit in the competitive
subgame, i.e., if   ( ()  ())  0 Thus, if the incumbent decides to deter entry, heshould choose  = ∗ which maximizes monopoly profit  () subject to the constraint  ( ()  ()) ≤ 0 But deterring entry is not necessarily the incumbent’s best option.
If he instead decides to accommodate entry, he should choose  = ∗ which maximizes
his profit   ( ()  () ) in the competitive subgame. His best option is to deter entryif  (∗ )   ( (∗ )  (∗ ) ∗ )
This model can be used to rigorously analyze the conditions under which entry will be
deterred.
Strategic interactions Fudenberg and Tirole’s (1984) main insight was that the incumbent’s optimal strategy depends on several aspects of the environment, such aswhether the investment makes the incumbent firm “tougher” or “softer” and whether
short-run competition involves strategic substitutes or strategic complements (in the terminology of Bulow, Geanakoplos and Klemperer, 1985). Suppose short-run competition
is in prices: then  and  are the prices set by the incumbent and the entrant in thecompetitive subgame. For almost all common specifications of demand conditions, prices
are strategic complements: if one firm lowers its price then the other firm’s best response
is to lower its price as well. Furthermore, suppose the incumbent’s investment  reduces
his marginal production cost. This investment makes him tougher — i.e., he will tend to
set a low price in the competitive subgame, which (by strategic complements) will induce
the entrant to set a low price as well. The more the incumbent invests, the more fierce
the competition in the competitive subgame, which tends to lower both firms’ profits.
Therefore, the optimal way to accommodate entry is for the incumbent to under-invest:
he makes sure his marginal cost is quite high in order to soften the price competition.
If the incumbent instead wants to maintain his monopoly and deter entry, he may haveto over-invest: he makes sure his marginal cost is very low so that the entrant cannot
profitably enter.30
30

Fudenberg and Tirole (1984) formally defined the concepts of under- and over-investment. Here, we
simply highlight the intuition.

21

These conclusions relied on the assumptions that the investment makes the incumbent
tougher and short-run competition is in prices. The conclusions are quite diﬀerent if theinvestment makes the incumbent softer, or if short-run competition is in quantities. In
eﬀect, Fudenberg and Tirole (1984) classified the environments where particular businessstrategies would be optimal. This became a recurring theme of the game-theory revolution in IO: rather than proving sweeping results that apply to any industry, certain
characteristics of an industry dictate a certain outcome. Game theory thus gave empirical IO a framework for organizing the data and understanding the diverse behaviorof real-world markets. This way, the field could return to the theme of the first half ofthe century — industries are quite diﬀerent from each other — but on a much more solid
footing.

3.3

Long-Run Competition and Markov Perfection

The early game-theoretic IO literature, such as Dixit (1980) and Fudenberg and Tirole(1984), relied on simple two-stage models, where firms make irreversible decisions instage 1, and short-run competition occurs in stage 2. The more recent IO literature
has emphasized dynamic models with many periods — indeed, with a game that does
not end on any fixed date. However, such infinite-horizon games typically allow for aplethora of subgame-perfect equilibria. This is because choices in one period may dependon the whole history of play, giving rise to “bootstrap” equilibria that would disappear
if the game were truncated after a finite number of periods. These bootstrap equilibria
sometimes require an unrealistically high degree of shared memory and coordination. For
many questions that IO researchers are interested in, such as the commitment value of
irreversible decisions, it is useful to refine the notion of subgame-perfect equilibrium toeliminate these bootstrap features.
Markov Perfect Equilibrium: an example Together with 2007 Laureate Eric Maskin,
Jean Tirole introduced such a refinement, the Markov Perfect Equilibrium (MPE), andshowed that it could be profitably used in a number of applications in IO (Maskin andTirole, 1987, 1988a, 1988b).31 In MPE, choices in each period only depend on payoﬀrelevant state variables, i.e., variables entering directly into payoﬀ functions (e.g., byinfluencing demand or cost conditions). This restriction makes models of long-run competition more tractable and the notion of MPE has become very influential, especially inempirical work (see further below).
Although the concept of MPE is quite general, the early Maskin-Tirole papers focussed on games with alternating moves. Maskin and Tirole (1988a) considered quantitycompetition. Suppose two firms compete in the market. At each time ∗ , firm  wants tomaximize the discounted sum of its future profits∞X∗−   

=∗

31

An early precursor to the concept of MPE exists in 2012 Laureate Lloyd Shapley’s work on stochastic
games (Shapley, 1953).

22

where  is the discount factor and   is its profit in period . To produce a strictly positive
output in any period requires paying a fixed cost   0. A firm that incurs the fixed
cost has entered the industry in this period. Suppose the fixed cost is large enough that
only one firm, and not two firms, can profitably operate in the market.
In odd-numbered periods , firm 1 chooses its output level 1 , which remains unchanged until period  + 2. Thus, output choice is irreversible and the firm is committed
to it for two periods. Similarly, firm 2 chooses its output 2 in even-numbered periods.
The Markov assumption is that a firm’s strategy depends only on the payoﬀ-relevant
state — here, this is the output chosen by the other firm in the previous period. Thus,
firm ’s decision in period  − 1 determines the state firm  must react to in period .
Formally, firm ’s strategy is a dynamic reaction function  , where  =  (−1 ) is firm
’s output in period  when firm  chose −1 in period  − 1.
An MPE is a pair of reaction functions forming a subgame-perfect equilibrium, andMaskin and Tirole showed that there exists a unique symmetric MPE in the quantitycompetition model. This equilibrium has a deterrence output level ̄ — i.e., an output
level above which the other firm is deterred from entering and below which the otherenters with positive probability. After an initial transitory period, if a firm operates atall, it does so at or above the deterrence level. Thus, in equilibrium a firm either drops
out of the market forever, or induces the other firm to do so. This model formalizes
the commitment value of irreversible decisions in a way that is reminiscent of the earlier
two-period models of entry-deterrence (Dixit, 1980, Fudenberg and Tirole, 1984), but in
an infinite-horizon dynamic model.
When the discount factor  is large enough, then ̄ is above monopoly output: todeter its rival from entering, a firm must produce above the profit-maximizing level ofa single firm. Even though only one firm is active, its price is lower than the monopoly
price, just as in the older literature on limit pricing (e.g., Kamien and Schwartz, 1971). In
fact, as  tends to 1, the incumbent’s output approaches the level that would result fromperfect competition, just as in the literature on contestable markets (Baumol, Panzar,
and Willig, 1982).
Maskin and Tirole (1988b) instead considered price competition with alternating
moves. In contrast to the uniqueness result under quantity competition, the pricecompetition model has multiple equilibria. Specifically, there exist both “kinked-demandcurve” equilibria and “Edgeworth-cycle” equilibria. In the former, prices eventually settle
down to a focal price, which is sustained by each firm’s fear that, if it undercuts, the otherfirms will do so too. Charging more than the focal price is not profitable because theother firm will not follow. The Edgeworth cycle is an asymmetric cyclical pricing pattern, where price wars are followed by sharp price increases. During price wars, firms
successively undercut each other to increase their market share, until the war has become
too costly and one firm increases its price. The other firm then follows suit and raises its
price, and then price cutting starts again.
Empirical relevance and applications The notions of kinked demand curves andEdgeworth price cycles have a long history (Edgeworth, 1925, Hall and Hitch, 1939,
Sweezy, 1939), but the treatments were mainly informal. Similarly, the literature oncontestable markets contains heuristic justifications for why a monopolist under threat of23

entry may behave (almost) like a perfectly competitive firm. Maskin and Tirole showed
how all these notions could be rigorously derived from an equilibrium model. This helps
us understand how imperfectly competitive industries might behave over time, and canhelp identify patterns in empirical data. For example, several empirical studies havefound Edgeworth price cycles in retail gasoline markets (Noël, 2007, and Zimmerman,
Yun and Taylor, 2013).
Since the early papers of Maskin and Tirole, the MPE concept has been applied
to many dynamic IO models and has stimulated a large amount of empirical research,which has led to a better understanding of oligopoly dynamics.32 In fact, the importance of MPE extends far beyond the study of IO. The refinement is routinely applied
within macroeconomics, political economics, development economics, and other fields. In
general, MPE dynamics can be quite complex and analytic results hard to obtain. But
empirical researchers interested in a particular industry can estimate the parameters of
their model, use those estimates to compute the industry equilibrium, and then numerically study the dynamic evolution of the industry. Indeed, computational methods forfinding MPEs of dynamic IO games have become increasingly popular in the new literature that pursues structural estimation for specific markets. Much of this literaturebuilds on the framework developed by Pakes and McGuire (1994) and Ericson and Pakes(1995).

3.4

Innovation and Adoption of New Technologies

Economic theory increasingly emphasizes how new technologies drive economic growthand deliver the benefits of competition to consumers. Within private firms, researchers
are given monetary incentives to develop these new technologies, and the patents become
the property of their employers.33 IO theorists want to understand how investments in
R&D depend on market structure, how the benefits from R&D are allocated among firms
and consumers, and if there are reasons for government intervention.
Patent races R&D competition among firms is often portrayed as a race to obtain apatent, where a firm that spends more resources increases its chances of winning.34 The
firm that has invested the most in R&D in the past is the leader in that race — i.e., it
has the highest probability of winning. Thus, past (irreversible) investments can createa first-mover advantage and a follower may not even want to participate in a race heis unlikely to win. This logic was formalized by Fudenberg, Gilbert, Stiglitz and Tirole(1983). They showed that if past R&D expenditures are perfectly observed, and if thepatent is a one-time discovery (there are no intermediate discoveries), then the follower
will indeed be deterred from entering the race. However, if past R&D expenditures are
32

The literature inspired by Maskin and Tirole’s early papers typically drops some of their stringent
assumptions, such as alternating moves. As Maskin and Tirole (2001) show, the concept of MPE can be
defined naturally and consistently in a large class of dynamic games.
33
An interesting question is how the contracts between employers and innovators should best be formulated; for an early contribution to this literature, see Aghion and Tirole (1994). We leave this question
aside here.
34
Important early contributions to the theory of patent races include Dasgupta and Stiglitz (1980),
Lee and Wilde (1980), Loury (1979) and Reinganum (1982).

24not perfectly observed, the more plausible case, the follower may be able to leapfrog theleader, and the competition to obtain the patent becomes very stiﬀ (unless the leader
is very far ahead, in which case the follower gives up). Similarly, competition is stiﬀ ifintermediate discoveries can be made — in this case, the follower can leapfrog the leader
by making the first intermediate discovery.
The results of Fudenberg et al. (1983) suggest that a patent race will be very intense,with high R&D expenditures from both firms, when the race is close. Thus, at least
under some conditions, intense competition will stimulate R&D eﬀorts. If the leader is
too far ahead, the follower gives up, and the leader reduces his R&D expenditures, as heis no longer challenged.
Open-source software The literature on patent races assumes that R&D investments
are driven by the traditional profit-motive. However, economists are increasingly realizingthat not all new technologies originate in this way. An important example is Open Source
Software (OSS), where programmers at many diﬀerent locations and organizations sharecode to develop new software. This process was important in the development of theInternet, contributing such software as TCP/IP, BIND, Perl, Sendmail, Linux, Mozillaand Apache. What initially baﬄed economists was that OSS developers did not seem tobenefit financially from their eﬀorts. OSS is, in eﬀect, a public good, which raises thequestion why OSS programmers contribute voluntarily, without pay, to the public good.
Lerner and Tirole (2002) argued that economic theory may, in fact, be able to answer
this question. Their main hypothesis is that software developers have career concerns.
Contributing to the OSS may be a credible signal of one’s programming ability, which
may lead to job oﬀers, shares in commercial open source-based companies, or access tothe venture-capital market.35 Drawing on a previous literature on career concerns (e.g.,
Holmstrom, 1982), they argue that the signaling motive is stronger the more visible isperformance, the higher the impact of eﬀort on performance, and the more informative
performance is about talent. They find support for the signaling motive in four casestudies (Apache, Linux, Perl and Sendmail). Subsequent research also found support for
Lerner and Tirole’s (2002) signaling theory, at least for some OSS projects (e.g., Hann,
Roberts and Slaughter, 2013, for Apache). However, programmers seem to contribute to
OSS for a variety of reasons, perhaps including altruism. A satisfactory explanation of
OSS development may require a mixture of signaling theory and insights, like those of2009 Economics Laureate Elinor Ostrom, into how cooperative behavior can be supported
by norms and other social mechanisms (O’Mahony, 2003).
Adoption of new technologies When a new technology first becomes available it
may be quite costly to adopt. Over time, adoption becomes cheaper, but waiting too longto adopt puts a firm at a competitive disadvantage. Thus, the adoption of a technology
becomes a game of timing. Fudenberg and Tirole (1985) showed that the subgame-perfectequilibria of such games can be highly ineﬃcient.
35
Lerner and Tirole (2002) also considered a complementary hypothesis of “ego gratification”: contributing to the OSS leads to peer recognition which is inherently valuable. They consider that thishypothesis, as well as career concerns, falls under the heading of signaling.

25

Tirole (1988) illustrates this ineﬃciency by a simple example. Consider a price-setting(Bertrand) duopoly where the two firms initially have per-unit production cost ̄, but a
new technology reduces the cost to   ̄. The innovation is non-drastic, in the sense thata monopolist with production cost  would still charge a price above ̄. Suppose the newtechnology is not patented; at any time , each firm is free to adopt it at a cost ()  0At time 0, the adoption cost (0) is prohibitively high, but the cost decreases over time: 0 ()  0 Before the new technology is adopted, both firms set the price  = ̄ and makezero profit. In subgame-perfect equilibrium only one firm adopts the new technology ata particular time ∗ ; after that, it supplies the whole market at the old price  = ̄36 It
earns a monopoly rent, because its production cost is only   . The other firm will
not adopt, because subsequent Bertrand competition would yield zero profit. The key
point is that the equilibrium adoption time ∗ is such that the present value of the future
monopoly rent equals the adoption cost (∗ ). If this were not the case, preemption
would be worthwhile.
This equilibrium is highly ineﬃcient: in fact, there are no social gains from the newtechnology. The monopoly rents are completely dissipated by the adoption cost, andthe consumers gain nothing, because the price remains at ̄. This extreme result reflects
the special assumptions, but the intuition is clear: intense competition for monopoly
rents tends to dissipate the gains from new technologies. Thus, while highly competitivemarkets may indeed bring about adoption of new technologies, this does not necessarily
bring about great social benefits. While this may seem counter-intuitive, it actuallyformalizes an old insight (see Posner, 1975): competition for monopoly rents may cause
these rents to be dissipated in a socially wasteful way.
Co-marketing, patent pools, and standard-essential patents To what extent
should sellers of diﬀerent products be allowed to engage in joint marketing and pricing?
Standard economic logic suggests the following: On the one hand, it is desirable to allow
sellers of complementary products to cooperate, as this will facilitate reasonably priced
bundles. On the other hand, it is undesirable to allow sellers of substitute products tocooperate, as this may facilitate collusion on higher prices.
However, as Lerner and Tirole (2004) show, this argument has limited value because
it may be diﬃcult to know whether products are substitutes or complements. Indeed,
it may depend on current prices. For example, consider the demand for two indivisible
products. Suppose a customer of type   0 values the products at () = ( +  ()) ,where  is the number of products that the customer purchases,  is an indicator variable
that takes the value 1 if  ≥ 1 and 0 otherwise, and  (2)   (1)2 If both prices are
below  (2) −  (1), the customer will either buy both products or none. Hence, if one
price goes up a little (but stays below  (2) −  (1)), demand for the other product will
either stay constant or fall, depending on the size of  — the products are complements.
On the other hand, if both prices are above  (2) −  (1), the customer will either buy
the cheapest product or none — the products are substitutes.
In such circumstances, should policy-makers let firms cooperate on how to price product bundles, or should they insist on price competition where each firm sets its own price?
36

With a non-drastic innovation, this is the standard “textbook” outcome of Bertrand competition
with asymmetric firms.

26

Lerner and Tirole (2004) propose the following intermediate policy: allow firms to collaborate on the pricing of bundles, but at the same time insist that any firm is always free toprice its component as a stand-alone oﬀer. The point is that firms will not desire to makesuch stand-alone oﬀers when the optimal bundle price entails lower average prices thancompetition, but will be tempted to do so when the bundling entails higher prices thancompetition. This policy does not require the authorities to have any knowledge about
demand conditions. Thus, the analysis produces a strikingly simple and robust piece ofpolicy advice: allow collaboration with respect to bundling, but do not allow firms tocontract on the pricing of independent oﬀers.
Although the argument is general, Lerner and Tirole (2004) focus on patent pools,
where innovators collaborate to license bundles of more or less related patents. Patents
tend to be complements at low prices and substitutes at high prices. When prices are low,users strictly prefer to use all patents conditionally on adopting the relevant technology,
so a decrease in the price of one patent raises the demand for the other patents. But
with high prices, users may want to use a subset of patents and thus the patents competewith each other. The policy advice is thus to allow the formation of patent pools, but toinsist that the pool admits independent licensing.
A specific problem related to the pricing of patents is that relatively minor innovations
can command a very high price if they happen to become part of a technology standard.
Indeed, an innovation that is worthless if the agreed standard includes a substitute innovation may be extremely valuable if it is instead included in the standard. Lerner andTirole (2014) argue that an unregulated marketplace will entail too high prices for suchstandard-essential patents, and that vague regulations imposing "fair pricing" will merely
entail extensive litigation (as is commonly observed). They propose that patent-holders
should commit to prices before standards are decided, as this will align private incentives
with social objectives.
Network competition and two-sided markets Current industrial policy has todeal with new forms of competition, often linked to the introduction of new technology.
Two examples are network competition (Laﬀont, Rey and Tirole, 1998a, 1998b) andtwo-sided (platform) markets (Rochet and Tirole, 2003, 2006). Tirole is a leader inthe study of these new forms of competition. Network competition will be discussed in
Section 5.1. In a two-sided market, the two sides (say, buyers and sellers) interact via
a platform. Examples include operating systems, payment cards (credit, debit or chargecards), shopping malls, and TV-channels.
A concrete example of a two-sided market is given by credit-card networks (such as
Visa, Mastercard, or American Express). The two sides of the market are the consumers
and the retailers. If a certain credit-card company charges retailers a high transactions
fee, a retailer might decide to not accept this card. This might, however, lead consumers
who prefer this card to shop elsewhere. On the other hand, there is a positive feedback
loop between merchant acceptance and consumer usage.37 In a pioneering article, Rochet
and Tirole (2003) analyzed the equilibrium of this kind of two-sided market, and studied
37

Rysman (2007) found empirical evidence for such a positive feedback loop in the regional correlation
between consumer usage and merchant acceptance.

27

its welfare properties.38 The model was generalized in Rochet and Tirole (2006). Keyquestions addressed in these articles include the equilibrium pricing structure, and theextent to which consumers and retailers use more than one network (“multi-homing”).
In platform markets, demands from the two sides can be very diﬀerent. For example,
advertisers might desire that there be many viewers or readers, whereas viewers andreaders often prefer that there be few advertisers. As a result, prices that would beclearly anti-competitive in a one-sided market can be highly competitive in a two-sided
market. For example, oﬀering newspapers for free would be a sign of predatory pricing if
the newspaper’s only source of revenue came from readers, but may be entirely consistent
with competitive pricing if advertising revenues are important. Because conventional
tests for anti-competitive behavior are not applicable in platform markets, the work by
Rochet and Tirole (2003) has had an immediate impact on competition policy (see Evans,2009). This work has also influenced the ongoing debate about network neutrality — i.e.,
regulation prohibiting broadband-access providers from charging content providers foraccess to broadband customers (see Musacchio, Schwartz and Walrand, 2009).

4Competition Policy

Since the days of Adam Smith, economists have realized that firms with market power may
try to restrict competition in their industries, whether by collusive agreements, predatory
behavior, or other means. Competition policy aims to prevent such activities. They are
subject to legislation in many nation states, as well as in international agreements suchas the European Union.
Regulated firms typically interact with other firms in various ways, so oligopoly theory,
optimal regulation and competition policy are closely linked topics. In industries such as
railways, telecommunications and electricity, the network infrastructure itself may constitute a natural monopoly, but downstream competition may be possible if competitors
can access the network. This was mentioned in Section 2.3 and will be further discussed
in Section 5.1.
When discussing competition policy it is useful to distinguish horizontal practices(involving firms in the same industry) from vertical practices (involving upstream anddownstream firms).
Horizontal practices Horizontal agreements may involve joint licensing or (more generally) co-marketing agreements and, as we saw in Section 3, Tirole has devised robust
competition policies in that area. Alternatively, rather than limiting competition by soft
cooperation, firms may use aggressive tactics to shut out their rivals, for example bypricing below cost. Of course, outlawing low prices is problematic for many reasons. One
reason is that firms may benefit from setting prices below cost in some segments evenunder sustained fierce competition; recall the discussion of two-sided markets in Section
3.4.
Horizontal mergers constitute an extreme form of limits to competition. The gametheory revolution, which Tirole helped launch, has shaped the modern understanding
38

Caillaud and Jullien (2003) and Armstrong (2006) were other important early contributions to this
topic.

28

of horizontal mergers, and this new understanding has influenced competition policy in
the U.S. and the EU (see Whinston, 2007).39 As always, game theory suggests a rather
nuanced view: the eﬀects of a merger depend on a host of factors, such as markets shares,
demand elasticities, price-cost margins, and the ability to price discriminate. To obtaindefinite results, Berry and Pakes (1993) advocate merger simulations, using a frameworkfor dynamic oligopoly analysis inspired by the work of Maskin and Tirole. Here, Tirole’s
policy influence is thus indirect rather than direct.
Vertical practices: background Jean Tirole has analyzed vertical practices in detailand in this area his work has had a great influence on both the academic literature andon competition policy. We devote the rest of this section to this topic.
Most firms do not sell their products directly to consumers but rather to other firms,
who either use them as inputs in production, or sell them to consumers. Vertical relationships are often characterized by contractual agreements known as vertical restraints.
For example, an exclusivity agreement between a manufacturer (the upstream firm) anda retailer (the downstream firm) may specify that no other retailer can carry the manufacturer’s product within a given territory, a region or an entire country. Alternatively,
an upstream firm may merge with a downstream firm in a vertical merger, and then denyits downstream rivals access to an input it produces so as to gain market power, so-calledvertical foreclosure.40
The Chicago School (Posner, 1976, 1981; Bork, 1978) argued that foreclosure is always
an irrational strategy. It cannot increase market power, it was argued, because upstream
firms can fully exploit their market power without engaging in exclusion. Therefore, themotivation behind vertical restraints and integration must be to enhance eﬃciency rather
than to restrict competition. For example, the service a retailer provides to its customers
typically yields a positive externality on a supplying manufacturer, since it influences
the demand for the product. If the retailer disregards this externality, the service levels
may be ineﬃcient. If an exclusivity agreement encourages the retailer to provide better
service, then it enhances eﬃciency.
The Chicago School’s arguments seemed convincing to many, and in the early 1980s
the principle of vertical foreclosure was indeed removed from the Merger Guidelines of
the U.S. Department of Justice. However, as we will see, vertical contracting arrangements have ambiguous welfare implications. This new and more nuanced view, which has
influenced academics, government enforcement agencies, and courts, is to a large extent
due to Jean Tirole and his coauthors. Kwoka and White (2013) discuss the impact of themodern analysis in a number of recent court cases.
39

As discussed above, the Chicago School challenged the usefulness of the structural presumption,i.e., the negative relationship between market concentration and performance. Since then, economists
have become less inclined to simply rely on concentration measures when evaluating the social cost ofhorizontal mergers.
40
The literature on vertical restraints also pays attention to the case in which a monopolist sells
directly to customers, but engages in “horizontal foreclosure” by bundling the monopoly product witha potentially competitive product. (For example, Windows was once bundled with Internet Explorer.)
The seminal modern analysis of horizontal foreclosure is due to Whinston (1990).

29

Vertical practices: the Coase theorem In the modern literature, vertical contracting is seen as a single-principal multi-agent problem, where the principal — typically an
upstream firm — designs a contract for his agents — typically a number of downstream
firms. In this setting, while vertical restraints may help internalize externalities between
the contracting upstream and downstream firms, it may also entail negative externalities
on third parties (final consumers, or other firms). Government regulation could therefore
be justified, but the heterogeneity of markets makes it hard to draw general conclusions.
Similarly, the eﬀects of vertical integration are now seen to vary across firms and markets.
Detailed analyses of specific markets are required to reliably identify practices that harmcompetition and should be prohibited.
Before proceeding to some formal examples, we recall the Coase theorem: if contracting between two parties is perfectly frictionless, then they can always negotiate an
optimal outcome and institutions are not so important. For this reason, recent generations of economists came to question old and rather simplistic arguments concerning thecosts and benefits of vertical integration. For example, it had previously been claimed
that vertical integration would avoid double marginalization (Spengler, 1950). That is,trade within the firm will take place at marginal cost, whereas trade between firms will
not. But the Coase theorem implies that the double marginalization argument must rely
on some restriction on contracting between the two firms. Indeed, upon closer scrutiny,
the argument restricts inter-firm trade to linear price schedules. A non-linear (two-part)tariﬀ would permit a separation between the division of surplus (which can be implemented through a lump-sum component) and the price of trading an extra unit (which
could be set equal to marginal cost), and this would eliminate double marginalization.
Much inter-firm trade is in fact conducted under this kind of non-linear pricing, so ruling
it out by assumption seems quite arbitrary. The challenge is to compare diﬀerent institutional arrangements without making ad hoc restrictions on contracting, i.e., by focusing
only on fundamental frictions. Such more fundamental models are not only more reliablefor policy analysis, but they often entail new testable predictions.
In the following, we consider two important early contributions which followed thispath. In Rey and Tirole (1986), the friction is asymmetric information about the state of
the world. Hart and Tirole (1990) the friction is instead the commitment problem causedby the possibility of secret contracting. These analyses provided two quite diﬀerent
reasons for why exclusionary practices, although privately rational, may have negative
welfare eﬀects.
Vertical practices: asymmetric information First, consider Rey and Tirole’s (1986)
model. The upstream firm is a monopolistic manufacturing firm. The downstream industry consists of retailers who are (potentially) competitive. The demand curve facing theretailers is  =  − , where  is quantity sold to the final consumers,  is the consumer
price chosen by the retailers, and  a stochastic demand parameter. To maximize profit,
the manufacturer would like  to vary with . However, there is asymmetric information:
while retailers observe the true value of  the manufacturer does not. The manufacturer
must therefore sell the product to the retailers at a per-unit price  which does notdepend on . If the retailers are allowed to compete freely with each other, they will allset  =  and make zero profit (assuming there is no cost of retailing, which wouldn’t
30

change the argument). With competition  is therefore independent of .
Now suppose the manufacturer eliminates the competition among retailers through an
exclusivity clause: each retailer can obtain an exclusive regional dealership in exchange
for a franchise fee  (in addition to a per-unit price  ). Other retailers are barredfrom selling in this region, i.e., there is foreclosure. This arrangement is beneficial to the
manufacturer because the local monopolist will make  a function of . The drawback isthat the retailer will be exposed to risk: he has to pay  even if there is a negative demand
shock. ( cannot depend on  since the manufacturer cannot observe .) If the retailer
is risk-averse, then the manufacturer will insure him by reducing  and raising  (thusindirectly also raising ). Still, as long as the retailer’s degree of risk-aversion is not too
great, the benefit to the manufacturer from the exclusivity clause exceeds the cost, so hewill use it. But one can show that the exclusivity agreement raises the expected consumer
price  which harms consumers. Indeed, if the retailers are suﬃciently risk-averse, thetotal (consumer plus producer) surplus is reduced by the exclusivity clause. Therefore,
an anti-competitive vertical restraint, although privately optimal for the upstream firm,
may be socially harmful.
Vertical practices: limited commitment Hart and Tirole (1990) considered a different kind of friction to contracting: the inability to make binding commitments. Except
for this constraint, they did not restrict the firms to any particular contractual arrangement, but rather derived the optimal contracts from fundamental assumptions. In theirmodel, there is again a monopolistic upstream manufacturer, and a potentially competitive downstream industry, which as before consists of retailers facing a demand curve =  − . However, now there is symmetric information about .
As mentioned, the Chicago School had argued that a rational upstream firm would
not use foreclosure to extend its market power. By contrast, Hart and Tirole show thatin general the upstream monopolist cannot fully exploit his monopoly power without
resorting to exclusion, and therefore foreclosure may be a rational strategy.41 To see this,consider the following two-stage game. In stage 1, the manufacturer oﬀers retailer  acontract in the form of a non-linear pricing schedule  (·); the retailer then orders  units
and pays  ( ) to the manufacturer.
In stage 2, retailer  sells his  units to consumersP
at price  = − where  = =1  is the total number of units ordered by all  retailers
in stage one.
Suppose all contracts oﬀered in stage 1 are publicly observed. The manufacturer canthen extract the full monopoly profit without any exclusion, as argued by the Chicago
School. He simply oﬀers  =   units to each retailer, at the per-unit price  =
 −  , where  denotes the monopoly output. The retailers all accept this oﬀer as
they make zero profit. Because total output   equals the monopoly output   themanufacturer earns the monopoly profit. There is no need to exclude any retailer.
But now suppose contracts can be oﬀered secretly, so the contract oﬀered to retailer
 is not necessarily observed by the other retailers. It can be easily checked that if  − 1
retailers each order   units, as in the previous paragraph, then the manufacturer andretailer  can increase their joint profit by increasing  above  . In fact, the optimalquantity would be given by the standard Cournot reaction function, given that the other
41

Other notable work on foreclosure includes Salinger (1988) and Ordover et. al. (1990).

31 − 1 retailers sell the aggregate quantity ( − 1) . Thus, if contracting can takeplace in secret, and if the manufacturer can use this secrecy to make mutually beneficial
deals with a retailer, then selling   units to each retailer is not credible.42
In the Hart-Tirole model, the manufacturer has a commitment problem: with a competitive retail market, he would like to promise to only deliver   units to each retailer.
But if contracts are secret, or can be secretly renegotiated, such a promise is not credible.
The manufacturer has an incentive to approach any retailer and oﬀer him more. The
unique equilibrium output is then the Cournot output, so the manufacturer does notearn the monopoly profit. However, if he can commit to dealing exclusively with only
one retailer his monopoly power is restored. If this is not possible, a vertical merger
between the manufacturer and a retailer solves the problem: it will be an equilibrium forthe manufacturer to sell  to his downstream aﬃliate, exclude all other retailers, andearn the monopoly profit. In short, exclusion is a rational strategy. Of course, consumers
are harmed by the exclusion, since prices will increase to  .
In the Hart-Tirole world, upstream firms would like to commit themselves to not
behaving opportunistically towards downstream firms, but if they are unable to do sothen the equilibrium outcome may be quite competitive. Indeed, as  → ∞ an upstream
monopolist cannot extract any rents at all. Vertical integration restores the monopolist’s
market power and thereby reduces the total social surplus.43 Other eﬀective commitment
devices might include renting (instead of selling) and contract clauses such as mostfavored-customer clauses or retail-price maintenance. Ironically, antitrust authorities’
challenge of price discrimination — insisting that all business customers should receive thesame price — helps the monopolist to extract rents.
Another irony is that the basic message had already been broadly understood in othercontexts. As Rey and Tirole (2007) note, the economics profession had long ago realizedthat patent holders and franchisors need to limit downstream competition in order toextract rents. For example, if someone makes a process innovation, and the potential
buyers are engaged in tough price competition with each other, the equilibrium priceof the patent is much higher if one buyer gets the exclusive right to utilize the newtechnology than if it is sold to all the competitors. Also, Coase (1972) had pointed outthat a durable-goods monopolist needs a credible commitment device for customers to
buy immediately instead of waiting for the price to drop — the famous Coase Conjecturesays that in the absence of credible commitments the monopolist is unable to extract
any rent. It was only the game-theoretic formalization and proof of this conjecture, byGul, Sonnenschein and Wilson (1986), that gave a deep enough understanding of themonopolist’s problem to enable the powerful policy analysis initiated by Hart and Tirole(1990).
We have thus seen that vertical restraints have ambiguous welfare eﬀects. To reliably
42
There are some technical issues regarding how to specify the retailer’s (out-of-equilibrium) beliefs
when he gets a surprising oﬀer to make a secret deal. But intuitively, the Hart-Tirole argument isconvincing because it only relies on the manufacturer and retailer being able to make mututally beneficial
trades, given the equilibrium contract oﬀers made to the other retailers (which, technically, is assured
by assuming passive beliefs).
43
This assumes the merger does not produce other eﬃciency gains that more than compensate for theincreased market power. As 2009 Laureate Oliver Williamson (1968) emphasized, the social cost of amerger should always be balanced against possible eﬃciency gains within the merged firm.

32

identify socially harmful practices, one must perform a detailed analysis on a case-by-casebasis. As an example, Chipty (2001) found that vertically integrated cable-TV operatorsin the U.S. tend to exclude rival program services, creating market power that reduces
consumer welfare — but he found that this anti-competitive eﬀect is outweighed by theeﬃciency gains of integration.

5

Applications

In this section, we discuss regulation in two industries that Tirole and his coauthors haveanalyzed in depth, namely telecommunications and banking.

5.1

Regulation of Telecommunications

Because of the significant fixed costs involved in building a telecommunications network,
the industry has historically been considered a natural monopoly.44 The industry was
dominated by an incumbent, either a private regulated firm like AT&T in the UnitedStates, or a public enterprise like British Telecom (BT) in the UK. A reform movementin the 1980s led to major changes: a wave of privatizations, and a switch from rate-ofreturn towards price-cap regulation.45 It became commonly accepted that new entrants
should be allowed to compete with the incumbents within most telecommunications segments. Among the motivations for these reforms was a belief that incumbent monopolists
had insuﬃcient incentives to reduce costs and improve quality, and that prices were determined by fairly arbitrary accounting procedures rather than by economic eﬃciency.46
In their 2000 book, Competition in Telecommunications, Laﬀont and Tirole analyzed theregulatory reforms and the emergence of competition in the telecommunications industry,
using a sequence of models inspired by their previous work on regulation.
Price caps and Ramsey pricing As mentioned in Section 2.3, Laﬀont and Tirole(1990a) showed that, under plausible assumptions, the eﬃcient price structure for a
multi-product monopolist is provided by Ramsey pricing formulas. Accordingly, Laﬀont
and Tirole (2000, Chapter 2) argue that Ramsey pricing is a reasonable benchmark foreﬃciency. They further show that price-cap regulation can implement Ramsey pricing
and thus lead to allocative eﬃciency. Intuitively, Ramsey prices are “business oriented”
in the sense that markups are proportional to the inverse demand elasticity, a rule an
44
For example, wiring every home twice in order to create two competing local networks would be very
expensive.
45
For example, AT&T was broken up in 1982 and BT was privatized in 1984. In 1989, the FCC
introduced price-cap regulation for AT&T, replacing the traditional rate-of-return regulation. Sappington
and Weisman (2010) document and evaluate the spread of price-cap regulation in the telecommunicationsindustry.
46
Although we focus on telecommunications, other industries such as electricity, gas, postal services
and railroads have faced similar issues. However, as Laﬀont and Tirole (2000) emphasize, all theseindustries diﬀer in many important ways. In the spirit of Tirole’s other contributions, one cannot simply
translate an analysis of one specific industry to other industries without careful consideration of these
diﬀerences.

33

unregulated monopolist would also follow. The problem is that the unregulated monopolist would set the average price too high, even though the relative price structure would
be appropriate. Laﬀont and Tirole show that this can be corrected by a price-cap whichconstrains the firm’s average price at the right level; subject to this constraint, the firm
can adjust relative prices. The decentralized price structure will become business oriented
and hence Ramsey oriented.47
Laﬀont and Tirole (2000, Chapter 2) also discussed prospective drawbacks of highpowered incentive schemes such as price-caps. These schemes leave large rents to eﬃcientfirms, and this is socially costly. Moreover, large rents give rise to a credibility problem:
when a regulated firm makes large profits, there will be political pressure to revise theregulatory policy and expropriate the profits.48 Laﬀont and Tirole emphasized that those
who believe in high-powered incentive schemes must be prepared to oppose such revisions,for otherwise the ratchet eﬀect may eliminate the incentives for cost-minimization. As
mentioned in Section 2, other potential problems with high-powered incentive schemes
include degraded service quality and regulatory capture. Therefore, in order to function
as intended, stronger incentives typically need to be accompanied by better monitoringand other organizational reforms.
Access pricing In network industries, incumbents often control bottlenecks to which
competitors in the retail market must be given access. For example, a new long-distance
telephone company such as Mercury in the UK may need access to the local telephone
network controlled by BT, the incumbent.49 In fact, Mercury bypassed the local networkby building direct links to large businesses, although it relied on access to BT’s local
network to provide long-distance services to residential customers (Laﬀont and Tirole,
2000, Chapter 1).50
What price should an entrant such as Mercury be charged for access? The dominantparadigm had been marginal-cost access pricing. However, Laﬀont and Tirole argued
that access pricing is just a special case of regulation of a multi-product firm. Since thefixed cost of building and maintaining the network must be paid for, the principles ofRamsey pricing apply. It is perfectly appropriate to set the access price above marginal
cost to help finance the fixed cost.
Laﬀont and Tirole (2000, Chapter 3) derived formulas for eﬃcient access pricing.
The key to their analysis is to consider the incumbent as subcontracting long-distanceservices to the new entrant. One can then view the incumbent as producing two longdistance services, one internal to the firm and one outsourced. For both services, eﬃcient
Ramsey-pricing implies markups which depend on marginal cost and demand elasticities.
In particular, the formulas take into account cross-elasticities — the price of a service
should be higher if a higher price raises the demand for another service. Correctly computed Ramsey prices therefore take into account possible “cream-skimming”, whereby
47

To calculate the price average, each price  should be weighted by the forecasted output level of good. Thus, to implement the optimal price cap may be computationally and informationally challenging.
48
Conversely, if the regulated firm makes losses, it will lobby for changes in the regulatory policy.
49
Many other industries have similar bottlenecks: railroad tracks and stations, power transmission
grids for electricity, pipelines for natural gas, etc.
50
Laﬀont and Tirole (1990c) develop a formal model of optimal regulation when high-demand customers may bypass the incumbent’s network and establish a direct link to one of its rivals.

34

an entrant attempts to attract the incumbent’s most lucrative customers. Intuitively, if
an entrant simply steals customers away from the incumbent without creating additional
value, this should be reflected in access prices. Giving the incumbent the responsibility
for covering the fixed cost of the network all by itself, and letting entrants free ride bypaying very low marginal-cost access prices, would ineﬃciently distort consumer choices
towards the entrant.51 Moreover, if the long-distance segment becomes very competitive,
the incumbent will primarily have to recover the fixed cost by setting high prices in othersegments where it still has a monopoly, such as local telephone services, implying large
distortions on those segments.
Although the formulas may be complex, the economic logic behind eﬃcient accesspricing is straightforward: the incumbent can be viewed as supplying multiple services,and optimal pricing follows familiar Ramsey principles. Laﬀont and Tirole (2000) not only
presented the academic arguments, but also crafted extensive verbal explanations aimed
at practitioners and policy-makers with little training in economic theory. Moreover, they
showed how the same principles apply in other situations, such as peak-load pricing, pricediscrimination and the adoption of new technologies. Finally, eﬃcient access (Ramsey)
prices are once again business oriented so they can be decentralized to the firm. The
regulator only needs to fix the average price level (although calculating the right levelcan be a complex task).
Competitive pricing Once entrants have access to the network, how should prices in
the competitive segment (e.g., long-distance phone calls) be determined? The dominantparadigm has been that regulating the competitive segment is unnecessary, since competition will foster low prices for retail customers. However, Laﬀont and Tirole (2000)
showed that a strict access-pricing policy (such as marginal cost pricing), that prevents
the incumbent from making money from access, may yield incentives to deny access byother methods than pricing. For example, the incumbent may claim that access requires
a costly upgrade to the network. Verifying such claims can be diﬃcult and involve heavyhanded regulation. If the incumbent manages to deny access, then the rival is excluded
from the competitive segment and the incumbent can extend its market power from theregulated segment, where its pricing is constrained, into the competitive segment, whereits pricing is unconstrained. This problem could be alleviated by either setting accessprices above marginal cost, as suggested by Ramsey formulas, or regulating the incumbent’s pricing in the competitive segment. In either case, the solution runs counter tothe doctrine of deregulating competitive segments while enforcing tight caps on accesspricing.
More generally, Laﬀont and Tirole (2000) argued that asymmetric schemes — wheresome parts of the incumbent’s business are tightly regulated and others less so (or not atall) — give rise to perverse incentives. For example, the regulated firm can benefit fromcross-subsidization, using both accounting and “real” decisions. It may allocate its mostproductive inputs (such as the most skilled managers) to the unregulated segment, andits least productive inputs to the regulated segment. Even if the regulated segment has aprice-cap, the ratchet-principle implies that, in reality, the cap will be adjusted to track51

On the other hand, very high access prices can lead to ineﬃcient bypass, whereby the entrant
establishes direct links to the most lucrative customers (see Laﬀont and Tirole, 1990c).

35

realized costs. Thus, allocating less productive managers to the regulated segment will
eventually allow the incumbent to raise prices there, while its most skilled managers will
generate immediate profits in the unregulated segments.
Laﬀont and Tirole (1994, 1996, 2000, Chapter 4) proposed a global price cap, where
all product lines are treated symmetrically. Only the average price is constrained which,as mentioned above, will induce the firm to set appropriate Ramsey prices. In particular,
network access should be treated as any other good, and be included in the computation of
the global price cap. This makes access services a normal business segment, and mitigates
the incumbent’s incentive to exclude competitors. Laﬀont and Tirole emphasized thatthe incumbent may still attempt to hurt its rivals by predatory pricing, and proposed the
Baumol-Willig “eﬃcient-component pricing rule” as a possible test for predation.52
Two-way access Nowadays, more and more entrants — mobile operators, cable companies, Internet-service providers — establish their own networks. This raises the issue of
two-way access: diﬀerent networks must be interconnected and services involving multiple
networks must be priced. For instance, if A makes a phone call to B, A’s network must
pay a so-called termination charge to B’s network — how will these charges be determined?
International calls represent a classical case of the two-way access problem. Traditionally, when a customer in country A called a customer in country B, the national telephonecompany in country B would charge a termination fee from the national company in country A. Although those fees were negotiated between large national companies, termination
fees would often be quite high. Indeed, the fees would often seem to exceed the level thatwould maximize the companies’ joint profits. Laﬀont, Rey and Tirole (1998a, 1998b)
developed a formal model of two-way access, based on the assumptions that the receiver
does not pay for calls (the caller’s company pay termination fees) and that telephonecompanies are free to set retail prices. The model was further elaborated in Laﬀont andTirole (2000, Chapter 5).53 Within this framework, they proved that termination fees are
ineﬃciently high under a variety of existing and proposed regulations. A regime that encourages head-to-head competition is problematic, since each firm has a motive to chargehigh fees on its monopoly segment, i.e., the termination fee. But a regime that allows
firms to cooperate may be no better, since the firms have a joint incentive to soften retailmarket competition by setting high termination fees. Cooperative agreements on mutual
access charges may in eﬀect facilitate collusion in the retail market.54 Motivated by suchproblems, Laﬀont, Rey and Tirole discussed new pricing models, some of which have later
been put to use as the number of mobile-telephone networks has proliferated.

5.2

Regulation of Banks and Financial Markets

Jean Tirole has made several important contributions to the area of financial regulation.
The first question is why financial intermediaries, such as banks and insurance companies,
need to be regulated at all.
52

For further discussion of entry-deterrence when access prices but not retail prices are regulated, see
Armstrong and Sappington (2007, Section 5.1.4).
53
A similar model was independently developed by Armstrong (1998).
54
However, Laﬀont and Tirole (2000, Chapter 5) discuss a number of factors, specific to the telecommunications market, that make it diﬃcult for firms to collude.

36

The basic reasons for regulation A first reason for regulation is that financial institutions are highly interconnected, through complex, often short-term, borrowing andlending arrangements. When a single large financial institution goes bankrupt, insolvency may therefore quickly spread to other financial institutions in a systemic financial
crisis with immense negative consequences for the economy, such as the one that followed
the Lehman failure in 2008. A second reason is that many de facto lenders to financial
institutions are ordinary consumers and households, e.g., through deposits and pension
savings. Since households may not have suﬃcient information to evaluate and monitor
the health of the banks where they keep their deposits, consumers can suﬀer severe consequences when a financial institution fails. This lack of information can also trigger
financial panics where many individuals “run” to withdraw their deposits from a bankthat is rumored to be failing (even if the rumor happens to be false), eﬀectively thencausing the bank to fail.
For these reasons, the government needs to be able to rescue — “bail out” — failing
institutions to avoid systemic crises and bank runs, and to protect consumers. But when
failing financial institutions are bailed out ex post, this may lead to moral hazard ex ante,
as bank managers have incentives to take on higher financial risk than otherwise. A
regulator may therefore need to restrict leverage and risk-taking at financial institutions
ex ante, such as through minimum requirements on bank equity capital and liquidity. A
common theme in Tirole’s work is the design of financial regulation that optimally trades
oﬀ ex post eﬃciency, i.e., intervening to avoid systemic crises, with ex ante eﬃciency, i.e.,
mitigating the moral-hazard problems that produce the prospect of crises to begin with.
Interbank markets Rochet and Tirole (1996a) built on the work of Holmström andTirole (1998, discussed in Section 6.2) to model the interconnectedness of banks and thecase for regulation. While decentralized interbank markets are prone to systemic crises,
decentralized interbank markets encourage peer monitoring across banks. This benefit isundermined when governments are expected to bail out failing banks ex post, since ananticipated bail-out makes it less worthwhile for a bank to monitor its counterparties ex
ante. The paper analyzes various regulatory mechanisms to deal with this problem, andforesees many of the problems that would eventually hit the financial system in the 2008
crisis. Similarly, Rochet and Tirole (1996b) compared the properties of diﬀerent clearing
and settlement systems, which have been at the forefront of financial regulation in theaftermath of the financial crisis.
Consumer interests In their 1994 book, The Prudential Regulation of Banks, Mathias
Dewatripont and Tirole focused on another problem: many bank lenders, such as depositors, are too small and dispersed to exercise any control over the bank. Then, the roleof regulation is to represent the interests of these lenders, exercising control over banks
and mitigating excessive risk-taking by bank managers. Dewatripont and Tirole used afinancial-contracting framework to analyze optimal regulation regarding solvency rules,
recapitalizations, accounting, and securitization.
Collective risk taking Emmanuel Farhi and Tirole (2012a) showed that financial
institutions may, collectively, use too much short-term debt and engage in correlated37

investment strategies. The reason is that this makes it more likely that a certain bankwill be bailed out in case of failure, because other banks will have problems at the sametime. Put diﬀerently, the choices of leverage and risk taking by diﬀerent financial institutions are strategic complements, exacerbating the risk of systemic crises. Based on
this insight, Farhi and Tirole derived optimal regulatory policies, contrasting interest-rate
policies (i.e., lower interest rates in a crisis to facilitate refinancing) and transfer policies(i.e., direct transfers to financial institutions in a crisis). Optimal policies involve ex anteliquidity requirements as well as interest-rate policies, despite the latter having distortionary costs. They also provided a rationale for so-called macro-prudential regulation,
where optimal regulatory interventions are based on the status not only of individual
financial institutions but also of the financial system as a whole.
Exit from financial crises Tirole (2012) asked how one may “jump-start” a financial
market in a crisis. Crises are typically triggered by adverse news about the value offinancial assets, like the negative shock to the perceived value of U.S. mortgage-backed
securities in the 2008-09 crisis. Due to adverse selection, small adverse news can completely freeze up the market for financial assets. As a bank has better information about
its own assets, when it tries to sell assets to finance necessary investments, this may leadother market participants to believe that it has inside information about its assets beingof low quality. When the market price of bank assets falls, banks with high-quality assets
find selling their assets to finance investments less worthwhile. As a result, the asset
market dries up, banks are not able to finance their investments, and the financial systemcannot restore its solvency. To counter such developments, many regulators (including
the Federal Reserve and the ECB) have intervened in asset markets, oﬀering to buy bankassets. This is costly to tax payers, however, since banks with low-quality assets havethe largest incentive to take advantage of this oﬀer. Tirole derived the optimal policy for
dealing with the problem: to buy back the weakest assets, and then provide financing
to banks with assets of intermediate quality, while retaining these assets on the firms’balance sheet. This leaves only the highest quality assets for trade, which restores thefunctioning of markets.

6

Other Contributions

Jean Tirole has made seminal contributions to many fields outside of regulation and
IO. In this section, we mention some of these, with the caveat that our treatment mustnecessarily be a rudimentary one.

6.1

The Toolbox: Game Theory and Mechanism Design

Among Tirole’s research on game-theoretic solution concepts, his aforementioned workon Markov Perfect Equilibrium stands out (Maskin and Tirole, 2001). But his work
on Perfect Bayesian Equilibrium (PBE) has also been highly influential (Fudenberg andTirole, 1991a). The notion of PBE relaxes the strong consistency requirements inherent in
the definition of sequential equilibrium (Kreps and Wilson, 1982). PBE is intuitively very
appealing and frequently used in applied work. Fudenberg and Tirole (1983) studied a38

two-person extensive-form bargaining game with incomplete information. In such games,
a player’s actions may convey information about his type, and it is not obvious how the
opponent will react to a “surprising” (out-of-equilibrium) action. By applying the conceptof PBE, the authors were able to study how exogenous parameters such as bargaining
costs influence the probability of concessions and bargaining breakdowns. Fudenberg andTirole (1991b) remains the most comprehensive graduate textbook in game theory.
Tirole has also conducted research on mechanism design. Here, his work on games
in which the designer (principal) has private information stands out (Maskin and Tirole,
1990, 1992). For example, a regulator may have private information about the demand
for a regulated good. When the principal proposes a contract to the agent, the proposal
may signal the principal’s private information. The critical issue is thus to understandhow the agent’s beliefs are aﬀected by the proposal. Maskin and Tirole (1990) considered
the case of private values, i.e., where the principal’s private information does not directly
enter the agent’s payoﬀ function. They established a correspondence between the (oneor many) PBE of the game, and the competitive (Walrasian) equilibria of a fictitious
exchange economy where the traders are the principal’s diﬀerent types. Maskin andTirole (1992) established a set of results in the more diﬃcult case of common values.
Tirole has made several other influential contributions to principal-agent theory, covering topics such as income-smoothing (Fudenberg and Tirole, 1995) and contract renegotiation (Fudenberg and Tirole, 1990).

6.2

Financial Intermediation and Liquidity

Together with Bengt Holmström, Jean Tirole has made a number of influential contributions that explore the eﬀect of liquidity on financial markets and intermediation.
Holmström and Tirole (1997) built a simple model to analyze the role of financial
intermediary capital. Here, firms are liquidity constrained because of moral-hazard problems, and financial intermediaries can partly alleviate these moral-hazard problems bymonitoring. However, intermediaries may also act opportunistically themselves, and sotheir ability to raise external funds are limited by their internal equity. The authors
derived predictions for how investment and costs of capital will react to contractions
in firm capital (collateral squeeze), in intermediary capital (credit crunch), or in uninformed capital (savings squeeze). They also prescribed that optimal capital requirements
for intermediaries should be pro-cyclical, since it is easier to ensure monitoring by intermediaries in recessions, when returns to monitoring are higher. Pro-cyclical capitalrequirements have become part of the new financial regulation in the wake of the financial
crisis of 2008-2009. The Holmström-Tirole (1997) model has indeed become a workhorse
for analyzing issues in financial intermediation as well as corporate finance.55
Holmström and Tirole (1998) highlighted the importance of liquid assets to the financial system, and the government’s role in providing such assets. Firms need to ensure
access to future liquidity to meet future shocks, and can do so by hoarding liquid assets
ex ante. But this is ineﬃcient, since firms will keep excess liquidity when it is not needed.
A more eﬃcient way for the firms to insure against future shocks is to get a credit linefrom a bank, which it can use if shocks are realized. However, there must be enough55

See Acharya et al (2007), Allen et al (2011), Parlour and Plantain (2008), and Chen (2001).

39

liquidity in the banking system as a whole to honor the claims of firms when they need
it. This is diﬃcult in the wake of macroeconomic shocks when many firms experienceshortfalls at the same time. Holmström and Tirole used this argument to highlight a rolefor public liquidity provision. Governments issue public bonds, which serve as a store ofvalue for the private sector and can be liquidated in case of a liquidity shortfall.56

6.3

Bubbles in Asset Markets

A long-standing question in asset-pricing theory is whether we can have rational bubbles— i.e., a price above the net present value of the asset’s returns, broadly defined. For
example, the high price of a scarce stamp is probably best seen as a bubble: people pay
dearly for such stamps, not because they yield a stream of returns (in money or viewing
pleasure), but because they expect the stamp to increase in value. A rational bubble issustained by the expectation that, on average, its value will increase at the discount rate.
Such a rational bubble may not inevitably burst, but can instead grow indefinitely.
Tirole has made two fundamental contributions to the theory of rational bubbles.
In Tirole (1982), he proved that purely speculative bubbles cannot exist if markets arecomplete and people are suﬃciently rational. In Tirole (1985), he showed that if markets
are incomplete then rational bubbles can not only exist, but also perform a useful function.
While this possibility had already been raised by 1970 Laureate Paul Samuelson (1958),
his result assumed that there were no other stores of value. Building on previous workby 2010 Laureate Peter Diamond (1965), Tirole showed that this essential insight carries
over to a growing economy where people can save in physical capital. As economists
continue to investigate whether real-world financial markets are incomplete enough tofoster rational bubbles — and how this ought to shape monetary and fiscal policies —they owe an intellectual debt to Samuelson, Diamond, and Tirole for providing the rightfoundations.
More recently, Tirole has combined his early work on bubbles with his more recent
work on financial regulation in joint research with Emmanuel Farhi.57

6.4

Organizational Economics

Jean Tirole has made seminal contributions to organizational economics. Tirole’s (1986a)
principal-supervisor-agent model, mentioned in Section 2.5, is the workhorse for modeling hierarchies in organizations. Its three-tier structure describes the essence of many
situations better than the standard principal-agent model (a two-tier structure without
a supervisor). Many organizations have at least one layer of supervisors, who report
56

Holmström and Tirole (2001) built on Holmström and Tirole (1998) to derive asset pricing implications from the private sector’s liquidity demand. They showed that assets with high (low) value instates of aggregate liquidity needs will trade at higher (lower) prices and equivalently have lower (higher)
expected returns.
57
Farhi and Tirole (2012b) analyzed bubbles in the context of Holmström and Tirole’s (2008) liquidityshortage problem. Bubbles are more likely to emerge, the scarcer the supply of outside liquidity and theless pledgeable corporate incomes. A positive aspect of bubbles is that they alleviate financial constraintsof firms, and boost investment by increasing corporate access to sources of value. A negative aspect of
bubbles is that they are a very imperfect form of liquidity, since they tend to burst exactly when thecorporate sector needs liquidity the most.

40

information to principals on the behavior or circumstances of agents. For example, accountants primarily collect and communicate such information. A general theme of theliterature generated by Tirole’s article is that low-powered incentives may be an optimal
response to the threat of supervisor-agent collusion. Instead of being tough watchdogs
who reveal when the agent’s task is easy, supervisors tend to act as advocates for inefficient agents, revealing only information that suggests the task is diﬃcult. As a result,
agents who claim to be high-cost, but cannot be verified as such, are given extremely
low-powered incentives.
Another influential paper in organizational economics is Aghion and Tirole (1997),
which used the model of incomplete contracting due to Grossman and Hart (1986) toanalyze the allocation of decision authority in organizations.58 Delegating tasks increases
the initiative of agents, but at the cost of the principal losing control. One implication isthat delegation increases the agents’ incentives to collect and use information as a basis for
decisions. Empirical work has examined this prediction, and found considerable support,
for example by examining the reliance on soft versus hard information in bank-lending
decisions (e.g., Berger et al, 2005; Liberti and Mian, 2009).
Yet another significant contribution is that of Dewatripont and Tirole (1999), which
considers the phenomenon of advocates in organizations, i.e., agents whose goal is todefend a specific “cause” rather than the overall welfare of the organization. One example is courts, where lawyers explicitly defend the interests of the defendant, whileprosecutors do just the opposite. The rationale for the advocates organization is thatcompetition among advocacy groups may lead to more eﬃcient decisions, due to more
eﬃcient collection and use of information.

6.5

Corporate FinanceTirole has also made contributions to corporate finance. One is his graduate textbook(Tirole, 2006). Like his textbook on IO, it provides more than a recap of earlier work, bysynthesizing a vast literature within a unified framework, as well as containing a numberof new applications and results. Not surprisingly, it has become a standard reference andis used in graduate corporate-finance courses at universities around the world.
Another important piece is that of Holmström and Tirole (1993). They considered how
to provide incentive-compensation contracts to ensure that a manager provides suﬃcienteﬀort. They first showed that the stock price of a firm can only be a suﬃcient statistic
in the manager’s compensation contract when speculators have an incentive to collectand profit from information. This requires a suﬃcient amount of liquidity in the market,
which in turn requires widespread enough ownership. As a result, the ownership structureof the firm influences the value of market monitoring: a more concentrated ownershipdecreases liquidity, the informativeness of the stock price, and hence its usefulness inmanagerial compensation. In this way, the paper highlights a reason for firms to go
public beyond the desire to raise capital, namely to improve managerial incentives.
Dewatripont and Tirole (1994b) is a significant contribution to the financial-contracting
literature, which aims to explain the capital structure of firms as the outcome of an opti58

Aghion and Tirole (1994) is a related earlier contribution. Tirole has also made several methodological contributions to the theory of incomplete contracts, which we do not discuss here.

41

mal contracting problem between investors and the entrepreneur or manager. They built
on Aghion and Bolton (1992), who had exploited an incomplete-contracting framework(Grossman and Hart, 1986) to explain why investors tend to get state-contingent control
rights when company performance is bad. One example is when a firm defaults on its
debt, which transfers control to creditors. Dewatripont and Tirole focused on the optimal relationship between control rights and cash-flow rights. They showed that when
performance is poor, the party in control should have a cash-flow claim that is concavein performance (such as debt), while when performance is good more control should betransferred to holders of convex cash-flow claims (such as equity). The model is one of
the first to explain the coexistence of distinct external sources of financing, such as debt
and equity.

6.6

Behavioral Economics

Most of Tirole’s work invokes the conventional assumption that people behave rationallyand selfishly. But some of it does not. We have already mentioned the central role ofaltruism and image motives in Lerner and Tirole (2003) and Bénabou and Tirole (2011)
and of legacy motives in Maskin and Tirole (2004). Together with Roland Bénabou,
Tirole has also made extensive contributions to more basic research on people’s motives
and beliefs. This area, where economics meets psychology, is usually labeled behavioral
economics.59 Without any doubt, this is an important field with ramifications for many
areas of economics. In the future, it may even oﬀer the prospect of true (re)integrationof the social sciences. However, it is also a field in which knowledge has had less time tosettle, and we therefore do not discuss these contributions here.

7

Conclusion

Jean Tirole’s research is characterized by respect for the particulars of diﬀerent markets
and the skillful use of new analytical methods in the economic sciences. He has developed
deep analytical results about the essential nature of imperfect competition and contracting under asymmetric information. Tirole has also distilled his own and others’ results
into a unified framework for teaching, policy advice, and continued research. His contributions provide a splendid example of how economic theory can be of great practicalsignificance.

59

For example, some of their work has reconsidered the value of powerful material incentives, arguingthat such incentives may backfire. One of their explanations is that people who would like to convey
their altruism can be deterred by material incentives because others might get the wrong idea about
their motives (Bénabou and Tirole, 2006).

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47

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48

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