Note to Silicon Valley: Jean Tirole is Relevant

Most Nobel Prize winning economic work is ignored by people trying to understand Silicon Valley, and for good reason. Subjects like macroeconomics and trade theory are rarely relevant for what people are doing on a day to day basis. Even the issue of efficient markets is a non-question. The venture capitalists don't believe and the people trying to automate wealth management accept it is true as a matter of faith.

But the work of Jean Tirole, who was awarded The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for 2014, is far more applicable to understanding the ecosystem of the technology sector. His work spanned many areas, but it is primarily on how to understand and regulate industries with few powerful firms. The Swedish Royal Academy of Sciences released a short summary of Jean Tirole's work here and their in-depth look is here - or just read Tyler Cowen's summary.

But why is this relevant for understanding the technology ecosystem? As Peter Thiel makes clear in Zero to One, one of the goals of a startup is to create an area where they are a monopoly. Google has an effective monopoly in online search. Facebook is the internet's most complete personal directory and the world's largest photo sharing company, LinkedIn owns everyone's online rolodex. Airbnb, Uber and many other successful new companies are successful because they essentially own their respective domains. Understanding the dynamics of market power is essential to understanding the most successful technology companies.

Once a firm is first to market, the question of what extent they should go to in order to deter competitors is a complicated question. In 1984, Jean Tirole and Drew Fudenberg plublished a paper on whether firms in various scenarios should over invest to protect their monopolies or if they should accept that they are going to face competition and stay lean and agile. The paper also highlights scenarios where the large initial investment to claim market share reduces a company's incentive to innovate, leaving them ripe for disruption after they have enjoyed the benefits of monopoly profits for a decade or two.

Another interesting question often faced today is that there is a company with a monopoly over one area, but how can they take that advantage to profit in other sectors? Tirole wrote many papers on vertical integration and monopoly power, and he did a literature survey of the field with Patrick Rey. Even if the goal of the literature is to figure out when to regulate these monopolies, companies can also use these strategies to find ways to expand their profit and market share. A mild version of this tactic is utilized by Microsoft when they release subpar versions of Microsoft Office to Mac so that power Excel users will be pushed to remain on the Windows platform.

Many startups are looking to build platform companies, where one company owns a two sided market and sells to both consumers and producers. Others may just want to better understand the incentives of the stores they are using to get their product to consumers. Jean was one of the first people to understand that maybe newspapers should be giving away their paper for free if that means they can charge businesses more for ads. This type of competition by the newspapers can drive their competitors out of business, but this seemingly monopolistic practice is benign - in many scenarios platform companies make is so everybody (except the platform competitors) wins. Here is a paper on Platform Competition that Tirole wrote with Jean-Charles Rochet - or better yet, a literature survey published three years later.  Alex Tabarrok and Vox have short posts addressing some of his work on platform markets.

This is only scratching the surface of his work, but it shows that many of the ideas driving value creation in Silicon Valley today have been analyzed in academia to a significant degree. These are complicated problems and sometimes returning to look at what the theory says can keep practitioners from making avoidable mistakes.