Liquidity Makers and Takers: A Nobel Prize

Retail Investing 19 Oct 2014

tiroleThe Nobel Prize in Economics, formally the “Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel,” went this year to Jean Tirole, a French economics professor at the Toulouse School of Economics, and the chairman of the board of the Institut d’Economie Industrielle(IDEI).

One somewhat unusual fact about this award: Tirole doesn’t have to share the glory or the money with anyone. In recent years, most of the economics awards have been shared among two or three economists who have done related work (last year it went to Fama, Hansen, and Shiller for “their empirical analysis of asset prizes.”)

Sometimes, the academy has two economists share the prize for work that isn’t especially related, as if they are simply satisfying both halves of a hung jury. In 2009, for example, the award went to Elinor Ostrom, for her inquiries into the so-called “tragedy of the commons,” and to Oliver Williamson, for his work on the boundaries of the firm. The academy threw the vague phrase “economic governance” over both halves of this award, but many commenters observed at the time that these were two very different bodies of work.

Going back much further, the 1974 award was famously split between Gunnar Myrdal and Friedrich Hayek, a split that suggested a left/right political divide in the deliberations.

At any rate, an unshared award must be that much sweeter.

The Eyes of the World

This award draws the world’s attention, albeit one expects only briefly, to a body of work that has a number of points of interest for the alternative investment community.

Alex Tabarrok, writing in the blog Marginal Revolution on the morning of the announcement, focused on one such aspect of this: Tirole’s writings on platform markets. Whenever there is any sort of platform that brings two sides together, in any capacity more complicated than buyers and sellers (game players and game developers, for example), the price charged to one side of a market will influence not only the demand for the product from that side, but the demand for the product from the other side as well. If Microsoft charges too much for players of its Xbox, it will as a trivial matter lessen the number of potential players actually using that product, and it will as a further non-trivial consequence lessen the demand for access to that market by game developers.

A Seedy-Seeming Practice

Indeed, it is quite common in platform markets for the platform’s promoters to sell one side of its product at cost or even below cost, in order to build demand on the other side.

This practice often looks seedy. It isn’t difficult for regulators, or antitrust enforcers and their enthusiasts to argue (ignoring the game developers’ side of the story in the process) that if Microsoft sells the Xbox to gamers for below cost the company is employing predatory pricing, locking out potential competitors. But Tirole, in a paper co-authored with Jean-Charles Rochet in 2005, modeled these “two-sided markets” in general terms and offered some ammunition to the allegedly seedy party in such disputes.

The extension of the Rochet/Tirole model specifically to the liquidity maker/taker relationship is a more recent development. Here is a link to a paper on the subject by three European scholars in 2012. Explicitly working on the basis of the Rochet/Tirole model, they evaluated the effectiveness of a then-recent fee change by BX, and found that BX had apparently miscalculated, over-subsidizing the makers at the expense of the takers and losing revenue, despite the fact that, through the consequences of the subsidy, the trading rate did increase.

As the above may already suggest, Tirole is thought of as a numbers-crunching analytical economist, not an ideological warrior or public-affairs pundit in the manner of some other recent winners (cough, Krugman, cough).

There is a good deal more to his body of work than the matter I’ve focused on here, of course, and I recommend for your attention a detailed (54 page) discussion on the website of the Royal Swedish Academy devotes to its honorees.

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