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I’m arriving a bit late to Jean Tirole’s Nobel in economic science, and many people have already weighed in on his contribution. But I thought I might still have something useful to say about what the New Industrial Organization (of which the French economist was the most important figure) actually did – namely that it made it safe to be strategically silly, to the great benefit of economics.
What do I mean by that?
Before the new I.O., economists wrote about perfect competition and monopoly, then acknowledged (if they were honest) that most of the real economy seemed to consist of oligopoly – or competition among the few – but did little there except some hand waving.
Why? Because there was no general model of oligopoly.
And there still isn’t. When you have a small number of players, each able to have a significant effect on prices, lots of things can happen. They can collude – maybe implicitly, if there is an effectively enforced antitrust law.
But what are the limits of collusion, and why and when does it sometimes break down? We like to assume that firms maximize profits, but what does that mean when there are small-group interactions that create prisoners’-dilemma-type situations?
And yet you do want to model the economy, to think about stuff – and sometimes that stuff can’t be modeled without addressing imperfect competition.
Before the new I.O. came along, the way economics dealt with such issues was to assume them away. Increasing returns as a cause of trade? We can’t deal with that because we don’t have a theory of imperfect competition, so we have to assume that it’s all the result of comparative advantage. Investment in research and development, and the temporary market power that results, as a source of technological progress? No can do.
What the new I.O. created wasn’t so much a solution as an attitude. No, we don’t have a general model of oligopoly — but why not tell some stories and see where they lead? We can simply assume a noncooperative price (or quantity) setting; yes, real firms are probably going to find ways to collude, but we might learn interesting things by working through a case where they don’t.
We can make absurd assumptions about tastes and technology that lead to a tractable version of monopolistic competition; no, real markets don’t work like that, but why not use this funny version to think about increasing returns in trade and growth? Basically, the new I.O. made it O.K. to tell stories rather than prove theorems, which in turn made it possible to talk about and model issues that had been ruled out by the limits of perfect competition. It was, I can tell you from experience, profoundly liberating.
Of course, there came a later phase when things were too liberated – when a smart graduate student could produce a model to justify anything. Time for empirical work! But by then a lot had been achieved.
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