Ideas & Debate

Economics Nobel winner offers lessons on market power

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Mr Jean Tirole won the Nobel in economics. AFP PHOTO

The American Economic Review (AER) is among the world’s highly rated academic journals in economics.

So what crosses your mind when it publishes an article, as it did in May 1984, titled: The Fat-Cat Effect, the Puppy-Dog Ploy, and the Lean and Hungry Look? Well, I thought so. You are almost exclaiming that that is precisely what is wrong with economists!

Fortunately, that is a reaction that you will not share with the Royal Swedish Academy of Sciences. The academy decided to award the 2014 Sveriges Riksbanks Prize in Economic Sciences in Memory of Alfred Nobel to Jean Tirole, the co-author of the AER article. 

In the admittedly persuasive view of the academy, Tirole – a professor of economics at Toulouse Capitole University, France – has been the leading researcher whose body of work informs the behaviour of firms with substantial market power and how to regulate them.

He is in fact considered to have dominated the field of economics called industrial organisation.

Regulation of market power, the basis of this year’s prize in economic sciences, is in our case the mandate of the Competition Authority of Kenya (CAK).

The award therefore presents an opportunity to ask one question: does the CAK really care what the Swedish think about market power and competition?

An attempted answer will necessitate a look at the “market power-competition-regulation” triangular aspect from a private policy and public policy viewpoints — even though the Nobel citation implicitly focused on public policy.

Let us start with private policy as an entry to informing possible public policy responses. 

There is the unquestioned wisdom that an enterprise seeks to expand so that it will benefit from the so-called economies of scale — lower cost of production per unit as the enterprise grows.

Whether that reduction in cost per unit translates to consumer benefits depends on the structure of the industry where the enterprise operates, the two extremes being on the one monopoly and on the other perfect competition.

Obviously the real picture is one comprising oligopoly — competition amongst few. In an oligopolistic setup, Tirole tells us, it is possible for a firm to make a “strategic” decision to “overinvest” as a way of deterring entry or expansion of rivals; this is what Tirole and his co-author, Drew Fudenberg, call the “fat cat effect”.

A good example of this can be seen in the attempted entry of SABMiller into the Kenyan market in late 1990s that ended in 2002.

It is obvious that the exit of SABMiller after just four years can be blamed on the bruising battle apparently waged by the incumbent dominant beer maker, the East African Breweries.

It is interesting that the battle ended in a sweetheart deal where SABMiller ceded the production of its key beer brands— notably castle Larger — to East African Breweries Limited (EABL).

The “icing” in the deal was when East African Breweries later stopped the production of Castle Lager, effectively killing the presence of South Africa’s beer in Kenya.

That the Monopolies and Prices Department — the predecessor of CAK — whose mandate was to encourage competition in the economy was not explicitly startled can mean two things: either the “fat cat effect” was not apparent or there was ineffectiveness in ensuring that competition thrives. In other words the work of Tirole and others was either unknown or not invoked.

It is theoretically possible, as Tirole elegantly demonstrates, that the strategic decision by East African Breweries could have been the exact opposite of “the fact cat” demeanour and could lead to the same consequence.

If the competition regulator’s real or perceived prowess were a binding constraint then increased investments as a response to competition may be a strategic handicap; it may reduce the incentive of the firm to act aggressively to impending competition.

In this case, a “lean and hungry look”— where the war arsenals are not being assembled in broad daylight —could actually end up deterring competition.

Similarly, it is theoretically possible that SABMiller could have used a different entry strategy and the outcome could have been different. The script for this strategy is authored by Keroche Breweries.

As a new entrant into a market with an incumbent who has a cost advantage, the knowledge that given a chance – even half a chance – such incumbent could wipe out the newcomer is important.

Such incumbent could cannibalise high volumes and high margin sales to regain a small market share. The Keroche strategy is what Tirole would call the “puppy dog ploy” where the entry is “soft”, the capacity is low and so is the price, and the market target is such that it is low enough not to cause alarm to the incumbent.  

As the formal brewing business experience illustrates, the insights of Tirole (prominently) and others is that there is more that public policy needs to be interested in when it comes to markets that are oligopolistic.

The interest of the CAK may be persuaded to stretch beyond assuming co-operative price (or quantity) setting behaviour in a market with few firms having enormous power.

Beyond having a keen interest on one supermarket chain seeking to acquire a few branches of a competitor, the CAK may find it interesting – even from purely an intellectually curiosity and not necessary legally inevitability — to take an interest in the Safaricom and Equity Bank duel over the thin-sim technology proposal by the latter.

In there could be a “fat cat effect–lean and hungry look” episode. In other words, while it is possible that firms could find ways to collude, there is a whole lot of interesting stuff to learn by working through the case where they don’t.

It is no matter that the process that Tirole has had to go through to provide such insight — and in the process earn himself a Nobel prize—is very mathematically tight.

But there are no shortcuts here; some observers have it that the mathematics needed as economics gets ever closer to the real world is likely to get harder and harder.

The correct perspective though is to see the mathematics as some intellectual scaffolding, essential for the construction process but preferably to be removed at the end.

Ultimately, the policy applicability of the world of Tirole makes a mockery of those who love quipping that “an economist is someone who finds something that works in practice and wonders whether it would work in theory”.

And if one is still thinking that Tirole’s 1984 article in the AER is simply “academic”, then economist Stanley Fischer has a question for you: “You mean the conclusions follow from the assumptions and the arguments are logical?”

Mr Osoro is the Director of Kenya Bankers Association Centre for Research on Financial Markets and Policy.