2937706

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Review Author(s): Dennis W. Carlton Review by: Dennis W. Carlton Source: Journal of Political Economy, Vol. 98, No. 3 (Jun., 1990), pp. 668-671Published by: The University of Chicago PressStable URL: http://www.jstor.org/stable/2937706Accessed: 22-09-2015 14:27 UTC

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668 JOURNAL OF POLITICAL ECONOMY Theory of Industrial Organization. By JEAN TIROLE. Cambridge, Mass.: MIT Press, 1988. Pp. 479. $35.00.

Jean Tirole has written a masterful book that should be invaluable to those who want a lucid presentation of the significant recent theoretical developments in industrial organization. The book should be required reading for graduate students and professors specializing in industrial organization.

There has been a burst of theoretical research in industrial organization, much of it inspired and conducted by Tirole. Once considered by theorists as a wasteland, industrial organization has now emerged as a place in which the most advanced theoretical tools can be applied. This book eloquently de- scribes these major theoretical developments. Tirole is a good writer and is at his best when he provides simple (or pretty simple) mathematical models to illustrate new ideas. His ability to capture the essential idea and strip away needless complexity is remarkable and reflects his sharp analytical thinking.

This review first discusses the book's contents and then the topics not covered. Next, I assess the difficulty of the book and finally suggest the courses for which it is most appropriate.

I. Subjects Covered The book is almost entirely theoretical with a focus on the latest theoretical advances. An introductory chapter on the theory of the firm provides an excellent overview of principal-agent theory. The book is then divided into two parts. The first part (chaps. 1-4) covers single-firm behavior, while the second part (chaps. 5-11) covers multiple-firm behavior and is the distin- guishing feature of the book. Each chapter is wonderfully written.

Chapters 1-4 consider the monopolist's optimal choice of durability, quality, prices, and control of distribution. The heuristic proof of Coase's result regarding the lack of monopoly power in a durable-good industry is one of the clearest I have seen. The discussion of quality goes through the Spence result on optimal product diversity and the signaling literature when consumers must infer quality from a firm's pricing. I have always been skeptical about the empirical importance of the signaling equilibria in which a firm signals quality by sinking costs; after reading Tirole's discussion, I remain skeptical. The discussion regarding asymmetric information and government interven- tion is all right but sometimes comes close to confusing the theoretical possi- bility of remedying an externality with the practical ability to do so.

The discussion of price discrimination goes through first-, second-, and third-degree price discrimination in more detail than is typically done. The material in the supplementary section on optimal nonlinear tariffs is excellent but a bit difficult. It is hard to find this material anywhere else in such a readable form. For example, Tirole concisely discusses the condition on the distribution function of consumer types that is needed for the optimal nonlinear price to be concave-a difficult but key topic in nonlinear pricing. I would have spent more time on two-part tariffs and stressed more some of the relationships between consumer heterogeneity and the optimal two-part tariff. (For example, the fixed fee tends to rise and marginal charge fall as consumers become more homogeneous.) Tirole does a good job of proving

I thank Andrew Rosenfield and George Stigler for helpful comments.


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the welfare properties of price discrimination. One minor quibble is that the section entitled "Welfare" (p. 158) talks about output, not welfare.

Vertical relationships is the last topic in part 1. It is not clear that this chapter belongs in the first part of the book on single-firm behavior since the point of many vertical restrictions is to improve a firm's ability to compete with its rivals. Vertical relationships is a topic in which empirical examples abound and in which a student may need help understanding the empirical relevance of the models. Tirole does provide some empirical glimpses, but the professor will need to supplement them. Tirole's discussion of the antitrust laws on vertical control is so short (one paragraph) that no student will under- stand it. Tirole discusses many of the most important reasons for vertical foreclosure and control but omits some. For example, the rationale for exclu- sive dealing as a way to prevent free-riding among manufacturers is omitted. Tirole seems overly modest in the discussion on foreclosure and stresses the premature nature of any conclusions. Still, I am concerned that antitrust enforcement agencies will read Tirole to say that foreclosure is a potentially serious worry that has the support of theoretical models. I would have pre- ferred a statement such as "Although some models of vertical foreclosure have been developed, most rely on strong assumptions of asymmetry between incumbent and entrant. It appears then that foreclosure is likely to succeed only when such asymmetry can be preserved over time. Vertical foreclosure is an area in which more work is needed." Some of Salop's work on foreclosure and raising a rival's costs could be profitably discussed at greater length.

Part 2 analyzes competition among firms. Chapter 11 (which is an appendix to the book) should be read before one begins part 2 since it provides the basics of game theory used in the remainder of the book. It starts out with simple concepts but quickly gets into sophisticated topics such as Bayesian perfect equilibrium. It is an excellent primer, but if students have never seen Bayes's theorem, the end of this chapter will be too hard. The supplementary section is clearly designed for advanced students interested in existence proofs that freely utilize notions of compactness, quasi concavity, and Jensen's inequality. In short, this chapter will be challenging even for top graduate students.

Part 2 goes on to analyze static models and dynamic models of oligopoly and monopolistic competition. The analysis of the standard models (Cournot and Bertrand) is insightful as is the discussion of monopolistic competition. The discussion of dynamic models treats subjects that are not presented else- where in the same detailed but readable way. Tirole is careful to emphasize that, at the current stage of development, there is an "embarrassment of riches" in the sense that in many dynamic games almost any type of behavior can be justified as an equilibrium. He candidly admits that little attention has yet been paid to empirical implications of these models. The discussion of how a rival's earlier behavior can affect others' beliefs about the rival and benefit the rival is clearly expressed and is an important concept that students will easily grasp. The supplementary sections of several of these chapters contain material that will appeal exclusively to advanced graduate students.

The last three chapters (chaps. 8-10) really form the heart of the book. These chapters apply the insights of game theory to strategic competition. They contain clear and detailed discussions of topics that students might find inaccessible if they relied on published articles. Tirole characterizes precom- mitments in two-period games by how they affect a rival's decisions in the future, and he goes quite a way in making empirically testable theoretical


670 JOURNAL OF POLITICAL ECONOMY

predictions. He stresses the importance of strategic complements (e.g., in a Bertrand game, if one rival cuts price, the other does too) and strategic substitutes (e.g., in a Cournot game, if one rival raises quantity, the other lowers quantity) and explains how the object of a strategic game is to soften competition. He then provides a survey of excellent theoretical examples of how rivals can affect their reaction curves. These examples include tie-in sales, use of retroactive price clauses, complementarity of products with a rival, and choice of location. The last chapter covers patent races and time of technology introduction. The chapter also discusses the adoption of stan- dards and licensing. Overall, it highlights some recent and valuable new developments.

II. Subjects Not Covered Tirole is completely forthright in explaining that his text covers selected theoretical topics and is not intended as a general overview of industrial organization. There are two major (and intended) omissions as compared with a standard textbook. First, the text makes no systematic attempt to survey the empirical literature that bears on the theoretical topics. Tirole candidly admits in several places that the empirical implications of several of the advances in game theory have yet to be developed and tested. The omission of empirical discussions could leave readers in doubt about the relevance of the models and virtually guarantee that skeptics of the game theory approach will remain skeptical. For these reasons, this book is most appropriate for advanced students who have already been exposed to some of the evidence. Tirole recommends reliance on other texts for empirical evidence, but that approach may be a bit difficult since other texts may not be organized in the same way as Tirole's and may not discuss the same models.

The second major omission is the lack of any systematic treatment of regulation and antitrust. It is in keeping with the theoretical focus of the book to omit antitrust developments, but it would have been consistent to have a chapter on the recent theoretical advances in the theory of regulation. In- deed, the recent developments regarding regulation with asymmetric information would fit in nicely with the excellent introductory chapter on the theory of the firm. The theory of natural monopoly and sustainability would also fit in nicely with the rest of the book. The profession would benefit if Tirole had written such a chapter given his remarkable ability to explain complicated ideas in a simple fashion.

III. The Level of Difficulty and Pedagogical Features The level of difficulty of the book raises some questions about whether undergraduates could handle the material. Tirole excels at simplifying and present- ing simple mathematical models. Overall, he does a terrific job of minimizing reliance on complicated mathematical techniques. Even so, undergraduates could find the mathematics tough or intimidating. Line integrals are discussed in the preface, control theory is needed for a problem in chapter 1, and game theory is used extensively (after being presented in a clear but difficult appendix) later in the book. None of these techniques is so complicated that a mathematically sophisticated undergraduate should be put off, but I suspect that most undergraduates will be at least a little nervous.

The chapters of the book vary in their level of difficulty. The book does not


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progress from simple to difficult. The first chapters on principal-agent theory and the Coase problem of durable goods seem more difficult than those at the end of the book. In particular, the chapters on strategic competition are not, for the most part, mathematically demanding.

Each chapter contains a supplementary section for advanced students, lots of well-thought-out exercises within the chapter and at the back of the book, and worked-out solutions. The text is a delight to teach from because the exercises provide a great way to illustrate ideas that Tirole mentions but does not have time to treat. The instructor will never have to worry about questions for problem sets or final exams. The difficulty of the exercises is indicated (three levels), a helpful pedagogical idea. The only pedagogical improvement I could suggest is the addition of an author index. It is hard to guess in which chapter an article falls, and an index of this type would help.

IV. What Courses Can Use This Book? I would use this book as a sole text only in a specialized, advanced graduate course in industrial organization because of its idiosyncratic coverage of topics, but I would use parts of the book to complement other readings in a more general graduate course. I have taught graduate industrial organization with Robert Gertner at the University of Chicago for several years and have used the Carlton-Perloff (1990) textbook (which is slightly less advanced than Tirole's, especially on dynamic games under uncertainty, but deals with empirical and theoretical topics) and selected chapters of Tirole plus journal articles. In particular, Gertner and I use several of Tirole's chapters to discuss strategic behavior (chaps. 8-10) and to introduce game theory (chap. 11). I would feel comfortable using parts of selected chapters in an advanced undergraduate course. Again, parts of chapters 8-10, the heart of the book, would be the most appropriate, not too hard, and most valuable.

In summary, this book takes as its objective the presentation of several of the latest theoretical advances in industrial organization. It succeeds admira- bly in achieving its objective. Tirole is a gifted writer who excels at explaining the essence of complicated models.

DENNIS W. CARLTON University of Chicago

Reference

Carlton, Dennis W., and Perloff, Jeffrey M. Modern Industrial Organization. Glenview, Ill.: Scott, Foresman, 1990.


Article Contentsp. 668p. 669p. 670p. 671

Issue Table of ContentsJournal of Political Economy, Vol. 98, No. 3, Jun., 1990Volume InformationFront MatterPermanent and Transitory Movements in Labor Income: An Explanation for "Excess Smoothness" in Consumption [pp. 449 - 475]Advertising and Entry: The Case of Physician Services [pp. 476 - 500]International Evidence on the Size of the Random Walk in Output [pp. 501 - 518]Habit Formation: A Resolution of the Equity Premium Puzzle [pp. 519 - 543]Compensation and Productive Efficiency in Partnerships: Evidence from Medical Groups Practice [pp. 544 - 573]Liability and Large-Scale, Long-Term Hazards [pp. 574 - 595]A Nonparametric Investigation of Duration Dependence in the American Business Cycle [pp. 596 - 616]International Coordination of Fiscal Policy in Limiting Economies [pp. 617 - 636]Job Search Outcomes for the Employed and Unemployed [pp. 637 - 655]CommentCold Houses and Warm Climates Revisited: On Keeping Warm in Chicago, or Paradox Lost [pp. 656 - 663]

Book Reviewsuntitled [pp. 664 - 667]untitled [pp. 668 - 671]

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