Strategy Lessons From Jean Tirole

by: Justin Fox

bigstock_Wait_A_Minute_230869Why did Jean Tirole win this year’s economics Nobel?

Here’s one key reason: “Jean has a bit of magical quality of being able to take very complex situations where there are a lot of different moving parts and a lot of institutional details and structuring the essence of it in a relatively simple model,” says Harvard Business School professor Josh Lerner, who has co-authored several recent papers with Tirole. “Obviously models have to simplify reality, but one of the real skills is essentially being able — it’s an art, not a science — to say, ‘What are the key levers here? What are the aspects that distill the situation down to its very essence?’”

In other words, Tirole does what modern academic economists do, only better than almost anyone else. He is the eighth most-influential economist on the planet among his peers, according to the weighted RePEc citations ranking, and three of those above him on the list already have Nobels. Unlike Paul Krugman, another MIT PhD of Tirole’s generation with similar renown as a model builder who has gone on to a second career as a highly visible and controversial public intellectual, Tirole has mainly just kept on building those models — and at a seemingly youthful 61 will presumably just keep building them unless the prize curse gets to him.

The models Tirole builds are mathematical in nature, and start with individuals or firms that are assumed to be rational creatures out to maximize their utility, their profits, or something else along those lines. He then usually brings in the tools of game theory, in which his protagonists have to contend with other rational actors and the moves they might make.

In the “Scientific Background” essay on Tirole’s work provided by the Nobel committee, the focus is on Tirole’s work on industry structure, which has had a big impact on antitrust and other regulation, especially in Europe. The basic story is that early antitrust and regulatory ideas that didn’t have much basis in economic theory were brushed aside in the 1970s and 1980s by the University of Chicago-based “law and economics” movement, which basically taught that competition conquers all, even in pretty concentrated industries. Then a new generation of economists, with Tirole at the lead, showed that a rigorous, orthodox economic approach, if you threw in a little game theory and information asymmetry, actually delivered much more complicated results. Sometimes business regulation improved social welfare, sometimes it didn’t, usually the key was exactly how the regulation was structured.

The implications of this for, say, broadband Internet regulation have been discussed at length elsewhere, so I’ll leave it there. But Tirole’s 1980s work on industrial organization also found its way into thinking about business strategy. The academic study of strategy took a big leap forward in the 1970s when Michael Porter of HBS looked at earlier economic research on industry structure and noticed that market power — which economists wanted to minimize — was the same thing as sustained profitability, which corporate executives wanted to maximize. Porter then used the tools of microeconomics to craft advice for executives on how to get and hold on to that power.

In the early 1980s, the game theory approach to studying industries promised to be the next big wave in strategy. A series of papers (sample title: “The Fat-Cat Effect, the Puppy-Dog Ploy, and the Lean and Hungry Look”) by Tirole and game theorist Drew Fudenberg, who is now at Harvard, seemed to promise firm answers to timeless business questions like, “Should we enter this industry?” “Should we lower our prices?” “Should we increase production?”

“When I was just starting at HBS [as a professor] in 1983, Fudenberg and Tirole were kind of the reigning duo of young theorists,” says Pankaj Ghemawat, who now teaches at NYU’s Stern School and the IESE Business School in Barcelona. “Every single working paper of theirs was eagerly awaited.” For Ghemawat, what followed was a bit of disappointment. Game-theoretic models of industry did indeed often offer wonderfully explicit advice. But it turned out that slight changes in the initial conditions in a model might deliver wildly different advice. And so since the 1980s, he says, “the interest has shifted more to empirical work out of concerns that you can rationalize just about any kind of behavior with a game theoretic model.”

Still, that work has continued to be informed by Tirole. His 1988 book The Theory of Industrial Organization became the standard graduate textbook on the topic. “Many of us who have wound up teaching strategy and doing research in strategy grew up learning game theory from Tirole’s textbook,” says Jan Rivkin, the chair of the strategy unit at HBS. “Game theoretic thinking certainly influenced the strategy field, and Tirole was as influential as anyone in that shift.”

As an example, Rivkin cites the notion of commitment, which Ghemawat wrote a book on. “Game theory models, including some of Tirole’s models, show that a firm can sometimes advance its interests in odd ways,” Rivkin says. “For example, a firm can change its own payoffs and make it attractive to respond aggressively to a rival’s move. If the rival understands those payoffs, the rival might forego the move. Many of us teach such ideas — that one firm’s commitments can change another firm’s actions — in our classes today.”

More recently, Tirole put himself back on the strategy professors’ radar with a 2002 paper, co-authored with Jean-Charles Rochet, now of the University of Zürich, that examined the dynamics of competition in “two-sided markets” that “are characterized by the presence of two distinct sides whose ultimate benefit stems from interacting through a common platform.” This describes lots of modern digital enterprises — think Google and Airbnb — as well as most traditional media companies, and has been discussed a lot already in this week’s coverage. But the significance of the paper seems less in that offers any definitive answers to how to think about the phenomenon than that it kicked off what is a now a rich (if still not exactly conclusive) literature on what are now also called multi-sided platforms. “I don’t know how profound you can say the influence will be,” says Joshua Gans, a professor of strategic management at the University of Toronto’s Rotman School of Business, “but it was at a time where he was a pioneer racing to the fore in terms of thinking about strategy in those sorts of markets.”

Gans thinks Tirole’s most remarkable accomplishment might be his graduate-level textbooks. The Theory of Industrial Organization was just the first. Together with Fudenberg, Tirole wrote Game Theory in 1991. In 1993 it was A Theory of Incentives in Procurement and Regulation with Jean-Jacques Laffont, the late founder of the Industrial Economy Institute at the University of Toulouse, where Tirole has taught for almost two decades. Then, in 2006, came The Theory of Corporate Finance — not a field Tirole had really been known for. “That appeared out of nowhere,” says Gans. “Corporate finance? Since when? Sheesh, when did he do it?”

Gans wrote right after the Nobel announcement that he has “a whole shelf … and not a decorative shelf” of such books by Tirole and has relied on them throughout his career. “There’s very few people who can really absorb more than one of these. They think Jean Tirole is the IO guy or the corporate finance guy or the game theory guy.”

The aim here clearly hasn’t been making money — for that you need to write introductory textbooks for undergraduates. It’s to teach and to influence Tirole’s fellow economists, both in the academy and in government, mainly in the direction of carefully formalizing their analyses and arguments in mathematical terms. This is of course the direction economics has been headed in for more than half a century — Tirole certainly didn’t start it, and he’s been more careful and less ideological about it than many of his peers. But there is ideological content to the very methods that economists use, which Tirole acknowledges with dry humor near the beginning of his corporate finance textbook.

“Many politicians, managers, consultants, and academics object to the economists’ narrow view of corporate governance as being preoccupied solely with investor returns,” he writes. Then, after promising to revisit that debate a few pages later, he adds, “we should indicate right away that the content of this book reflects the agenda of the narrow and orthodox view.”

In recent years Tirole has taken some steps beyond the narrow and the orthodox, although always with his mathematical-economic toolbox in hand. A 2003 paper with Princeton economist Roland Bénabou starts out by agreeing with psychologists’ and sociologists’ long-standing critique that the use of economic incentives (paying your kid to do homework, for example) often backfires. But Bénabou and Tirole then go on to try to explain that backfiring in purely economic terms. Those are the tools Tirole knows how to wield so brilliantly, after all.

About the Author

Justin Fox is Executive Editor, New York, of the Harvard Business Review Group and author of The Myth of the Rational Market.

Article source: http://feeds.harvardbusiness.org/~r/harvardbusiness/~3/Q-BMviD5aRA/

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