French economist Jean Tirole won the 2014 Nobel Prize for Economics for showing the inter-relationship between markets and government regulations. According to Matt O’Brien’s explanation, government regulation of company’s “excess profits” is assumed to be a good thing.
A lot of markets are natural monopolies. That means it costs less for one company, rather than many, to make something, because you have to spend so much upfront to enter the market. Broadband is a classic example: once the first-mover has built all the infrastructure it needs, it’s not worth it for anyone else to even try to. If they do, the incumbent company can just temporarily lower prices until it’s not profitable enough for the other to continue.
But governments don’t like monopolies, natural or otherwise, so sometimes they break them up into highly-regulated oligopolies instead. That is, a few companies dominating the market instead of just one. There’s still a problem though. How exactly should the government regulate them? It wants to get rid of these companies’ excess profits without getting rid of their profit motive altogether. In other words, it doesn’t want big companies to gouge their customers, but it does want them to keep investing in a better customer experience. The easy answer is put caps on what they can charge — which makes them try to boost profits by cutting costs — but that doesn’t always stop them from making quasi-monopolistic profits.
And that gets at the real problem: the government doesn’t know how much it costs these companies to make things. Or, in econospeak, there is asymmetric information about the cost of production. If the government knew what the companies do, it could set the “right” price on any cap. But it doesn’t, and it can’t. That’s why Tirole just looked for a way around this issue—not a solution, but an answer.