Paul Krugman's Comments On Jean Tirole's Nobel Prize

A lot has already been written about Jean Tirole's research, and Paul Krugman provides a link to some of the comments in his post.  He chose to discuss his own research and how Tirole's work in the area of industrial organization made it easier for him to win his Nobel prize in trade theory.  His work on trade theory suggested that firms benefited from trade because it led to higher returns from economies of scale.  Their cost of production declined in relation to their market size.  This violated the assumption of perfectly competitive markets in which large numbers of small firms competed primarily on price.  It was much easier to build economic models of perfectly competitive markets than it was to model the real world in which economies of scale operated to produce oligopolistic markets where a small number of very large firms dominated most industrial markets.

Krugman argues that Tirole's research on industrial organization was liberating.  However, it left the economics profession with a big problem.  The real economy is oligopolistic but there is no theory of an oligopolistic economy.  Tirole used game theory in an effort to describe how an industry with only two firms might compete with each other.  It is much more difficult to use game theory to understand how industries that consist of several very large firms might compete with each other.  Ordinarily, it would not be in their interest to compete on price.  Price competition would reduce the profitability of the industry.  The beer industry in the US provides an interesting perspective on how the real economy works.  The beer industry was comprised of small firms that competed in local markets.  It was transformed over time into an industry in which a few very large firms dominated a national beer market.  Budweiser gained over 50% of the market and shared that market with a handful of smaller firms.  There is little price competition in the beer market.  Budweiser's economy of scale is in advertising.  Because of its size, its advertising cost per barrel of beer is much lower than any competitors.  It is very difficult for smaller firms to compete on a national scale against Budweiser.  The cost of advertising is a huge barrier to entry into the national market.  Some small firms manage to grow outside of local markets but they often get acquired by the larger firms as they gain market share.  There are exceptions to this rule but the beer market is dominated by a small number of very large firms that do not compete on price.  This is a far cry from the perfectly competitive markets that are idealized in economic theory and sold to the public.  It is OK to talk about market imperfections but the implication is that they should be reduced as much as possible so that the markets can work like they are assumed to work in theory. 

If the global economy is primarily oligopolistic we need to have a better understanding of large large firms and how they compete in their specific industries.  They often use their national governments to help them to grow profitably and they also invest in strategies to reduce their tax burdens.  In fact, they have a common interest in reducing their tax burdens.  They share the cost of influencing government decisions on tax policy.  Firm strategies are also influenced by large investors whose interests may not be consistent with the long term interests of the firm.  We live in very different world than the world that exists in the textbooks.