Telecommunications insiders tell me it couldn't believe its luck. Its costs were falling far more quickly. Then called Telecom Australia, and actually owned by the government, it didn't let on how much it was continuing to cream off its powerless customers. Had the government wanted to it could have made the cap more stringent, and it did in later years. At one stage it climbed to CPI minus 7.5 per cent, but Telstra wore it, perhaps knowing its costs were sliding faster still. It's easy to see the problem the government faced. If it imposed a cap that was too lenient Telstra would continue to rip off its customers. But if it strengthened it, and went too far Telstra would go broke. And without seeing Telstra's books it would never know how far to cut or when to stop. A solution to the problem has just won French economist Jean Tirole this year's Nobel Prize in economics. A couple of decades later the Australian government was at it again. This time it was worried about electricity distributors ripping off their customers. Distributors are the middle link in the chain between the generators and the retailers. Just like the owners of telephone wires, the owners of electricity wires enjoy a natural monopoly. Because they don't face competitors they can charge what they like. Their customers have nowhere else to turn.

Perhaps mindful of the problem it had with Telstra the government tried a different approach. Instead of imposing a ``top down" price unrelated to costs it imposed a ``bottom up" price determined by the actual cost of providing the service plus a margin. A quasi judicial body known as the Australian Energy Regulator would determine the cost and set the price. What could possibly go wrong? What went wrong was a soaring electricity price, at times jumping 20 per cent a year and poisoning the public's mind against the-yet-to-be-introduced carbon tax. The prices soared in large part because the Energy Regulator approved continual increases. It did this because the distributors were able to make oh-so-reasonable sounding arguments about why upgrades and extra maintenance were urgently needed. The cost would have to be passed on, with a margin as decreed by the legislation. Without an incentive to control costs and with an incentive to expand them the retailers kept piling them on, and piling on lawyers and economists and engineers prepared to front up to the regulator to justify them.

We've a "gold plated" electricity distribution system as a result and a high cost structure that will linger for decades. The problem with regulation based on costs is that there's no incentive to restrain them. And finding out which costs are necessary and which are not is difficult for the regulator for the same reason that it's difficult to set price caps - the company being regulated knows more about its costs than does the regulator. A solution to that problem has also won French economist Jean Tirole the Nobel Prize. It's the same problem. Neither top-down nor bottom-up price caps are likely to set the right price, unless there's some way to get the the companies themselves to divulge their internal information. And that's what Jean Tirole has come up with. In earlier lives an engineer and a mathematician, he has applied game theory to problems that other economists find too hard (or define away by saying they won't exist if there's perfect competition, ignoring the reality that in many industries there are necessary monopolies).

His solution is hard to describe. Economist Tyler Cowen says "many of his papers show 'it's complicated'. rather than presenting easily summarisable, intuitive solutions which make for good blog posts". Part of it involves getting the firms themselves to choose between top-down or bottom-up price setting. The choice they make "purely out of self interest" will tell the regulator whether it is easier for them to restrain costs or wind back margins. He has done a lot more besides, much of it relevant to the behaviour of quasi monopolies such as Microsoft, Apple and Google. He is a thinker but he is a technician, one who recognises that real world problems are different from those in the text books and that textbook answers are too simple. Peter Martin is economics editor of The Age.