17. Licit and Illicit Responses to Regulation: Revisited

If a regulation raises the price of a given good, consumers will tend to consume less of that good and to substitute other goods. The higher price will also elicit a supply response. The standard neoclassical model focuses principally on these price and quantity substitution effects, but substitution exists along many other margins.

At a given time and place, the set of goods available in the marketplace is merely a subset of all goods that are potentially available. The set existing in the marketplace is established as the outcome of an equilibrium process that depends on competition, production possibilities, income, and the formal and informal rules of the game. Changes in regulation can affect these factors and hence change the available set of goods. This alters not only the range of substitutes available to consumers but also other features of the economy and governance.

Historically governments have often banned products. There are many illustrations of how the substitution effect plays out.

In 1689 the English banned the import of French wines. King Louis XIV of France supposedly commented, “I have substitutes for their manufactures, but they have no substitute for Champagne.” However, the ban resulted in such high prices for French wines that the English substituted beer consumption for wine consumption. The English government then increased the tax rate on beer. This beer tax became a major source of revenue for the British government, helping to support the growth and maintenance of the British navy and the British empire (Nye, 2007).

In the United States, Prohibition was in effect from 1920 to 1933. During this period the transportation and sale of alcoholic beverages were illegal. There were, however, exceptions. These included “medicinal whiskey” which could be legally sold to individuals who presented a medical prescription for diagnoses such as anxiety, depression, or cancer. The medical prescription itself cost about $3 (several hours of an average wage then). The patient could then pay another $3 or $4 to have this prescription filled at a pharmacy for a pint of whiskey. This could be repeated every 10 days (Gambino, 2013). Even Winston Churchill found this system helpful. In 1932 as he was recuperating from an automobile accident in New York City, Dr. Otto Pickhardt provided him with a universal prescription stating “This is to certify that the post-accident convalescence of the Hon. Winston S. Churchill necessitates the use of alcoholic spirits especially at meal times. The quantity is naturally indefinite, but the minimum requirements would be 250 cubic centimeters” (Sharp, 2023). This system generated a substantial income for physicians and pharmacies, encouraged new interest groups and also the Mafia, and altered features of the healthcare industry. For example, at the beginning of Prohibition, Walgreens was a small pharmacy chain with 20 stores. It marketed medicinal whiskey actively, and by 1929 it had expanded to 525 stores.

In 1867, the Russian government sought to raise revenue by monopolizing the production of matches. The resulting matches were expensive. One box could cost two-thirds of a worker’s daily wage. And these matches were physically large. Impoverished entrepreneurs then started splitting each large match into four or five smaller matches and selling them separately at a lower price. The Russian government then increased the severity of punishment for match-splitting and also redesigned the matches so they would ignite only when struck against a government-produced matchbox.

Governments commonly attempt to raise the price of certain products, sometimes by becoming a new buyer in the market and commonly underestimating the elasticity of supply. The classic example is agricultural price supports. These subsequently lead to increased output which soon requires production controls which in turn cascade into other outcomes which require additional regulation.

An extreme example of such government intervention occurred during World War II (WWII) when the Allies sought to prevent Germany from obtaining tungsten, essential for weapons production. At that time, Spain was selling tungsten to Germany. To foreclose this source for Germany, the Allies started trying to purchase the entire supply of Spanish tungsten, and the price was rapidly bid up, eventually increasing 15-fold. The supply response in Spain was large, indeed much larger than expected—from 20 tons annually before WWII to 2000 tons annually late in the war—a hundred-fold increase (Bowen, 2006).

One further example of supply response: in Canada, the government of British Columbia attempted to reduce overfishing by reducing the number of fishing licenses and by shortening the fishing season from 60 days to 6 days. Fishermen then bought larger fishing vessels. During their new 6-day season, the total volume of halibut they caught was 50% greater than before. This also meant that most consumers could only obtain frozen halibut, rather than fresh (Libecap, 2018; Ménard & Shirley, 2022).

Regulation also affects the equilibrium attributes of goods. Even “simple” goods have many attributes beyond their money price, such as size, color, quality, reliability, warranty, availability of credit, associated service, location, and waiting time. All of these can vary with market conditions and regulations. The standard economic model assumes that money price and quantity are the two dimensions along which adjustments take place between buyers and sellers and that these adjustments continue until net gains are zero for the marginal unit exchanged. Through these adjustments, sellers and buyers minimize the deadweight loss. As Yoram Barzel (1997) has discussed, the same logic applies to the non-money attributes of goods: buyers and sellers jointly adjust these other attributes until the net gains are zero for marginal changes there. When a regulation alters one attribute (or a few—it can never control all of them), it is in the mutual interest of buyers and sellers to minimize the deadweight loss by varying other attributes.⁴

Depending on the substitution possibilities, therefore, regulation of money prices can lead not only to shortages or surpluses and welfare losses but also to changes in other attributes. Consider the price ceilings on gasoline in the United States in effect 1971–1974. Faced with regulated prices set below the market-clearing level, service stations reduced their hours of business to the minimum needed to sell their allocation, lowered their quality of service, and offered lower-octane fuel. Customers waited longer in line to obtain gasoline. They purchased new vehicles designed with larger gas tanks. Buyers and sellers jointly sought the lowest cost adaptation to the regulation.

Hong Kong rent controls provide another illustration. The first regulations, imposed in 1921, prevented landlords from raising rents except when they demolished an existing building and replaced it with a new one. In such cases, the existing tenants received no compensation. A building craze ensued. By 1923, some landlords were even replacing buildings that were only 2 years old, and many former tenants were sleeping in the streets (Cheung, 1975).

The building owners captured some of the returns from attribute substitution (a building just constructed vs. a building already some time in use), but many potential gains were dissipated by excessive construction. Even when rent controls carried over into new buildings, the new tenants would give the owners “key money” for access to the apartments. These side payments could not easily be regulated because they could be disguised as the sale of other items such as old chairs. In principle, key money could be paid on a continuing basis to keep a landlord from tearing down a building, but this was illegal, and it also involved high costs of collective action, since most buildings had multiple tenants.

Eventually, in 1955, under another rent control regulatory system, the government introduced an enforced-compensation scheme for displaced tenants. This new scheme clarified ownership rights and greatly reduced the transaction costs of negotiations between landlords and tenants. It better aligned incentives for recognizing costs borne by displaced tenants and costs for new construction. Steven Cheung argues that the Hong Kong rent control system at that time was highly efficient compared to rent control systems elsewhere in the world. He argues further that Hong Kong’s continuing growth through the twentieth century would not have been possible without relatively low transaction costs between tenants and landlords.⁵

Certain regulations, such as ceilings on money profits in firms, lower the cost to the firms’ decision-makers of consuming amenities. Whenever the money profits of a regulated firm are potentially greater than the maximum permitted, this reduces the opportunity cost to the firm of having elegant company dining rooms, chauffeured cars, congenial colleagues, good relations with the unions, nepotism, and the quiet life (Alchian & Kessel, 1962). During the years when US banking regulations severely constrained competition among banks, imposing fixed interest rates, restricted entry, and limited branch banking, the top executives in that industry should have led less stressful lives than their counterparts in more competitive industries. A study of executives’ life expectancy during that time period found that bankers indeed had a longer average life expectancy than did executives in other industries. This is consistent with the view that these regulations reduced the costs to the bank executives of choosing a desirable lifestyle (Yen & Benham, 1986). Of course the bankers working in this environment benefitted, but the reduced competition implied higher costs for the consumers of bank services.

Regulations and taxes are often less onerous for non-profit organizations than for for-profit firms. This lowers the cost of non-profits surviving, and the “profits” can be taken out in alternative forms like salaries and amenities, in retaining less productive colleagues or undertaking costly and unproductive missions.

When regulation lowers the transaction costs of using barter instead of money, barter will obviously become more prevalent. Trade restrictions and foreign exchange controls can have a major impact here. In recent years, approximately 10% of world trade has been conducted through barter.⁶ Historically, barter on a wide scale has been a common occurrence. Consider the case of Germany in the period around World War II. In 1936, before the war, the German government froze prices. At the end of the war, the occupying military governments retained these price controls. In 1947 the money in circulation was ten times as great as in 1936, and real income had fallen by half. Official prices did not reflect the existing scarcity, and the black market was confined to a narrow range of consumer goods. Barter was illegal, but in order to obtain raw materials, firms developed a complicated chain of barter arrangements. Even under the direct control of the British military government, Volkswagen utilized 5% of its production for barter arrangements. Legal wage levels were set too low to secure a regular supply of employees, so employers compensated employees with goods in kind, which could then be used to barter for food (Carlin, 1989). Against the devastation of the war and the harsh regulations of the period, barter and other adaptations kept real income and output from falling further. Subsequently in Eastern Europe during the Soviet central planning period, money prices were suppressed, and barter was widespread as an adaptation. For example, a champagne producer in Hungary regularly sent out truckloads of champagne to barter for machinery repair parts.

In addition to barter, many other substitutes for money arise where they are cost-effective. Radford gives an instructive example in his study of the economics of a prisoner-of-war camp (Radford, 1945). Money was very limited in the camp, and barter began. This was then superseded by the use of a money substitute as the medium of exchange, cigarettes, which were reasonably homogeneous, divisible, and durable.

Regulations such as price controls and cartel pricing enforcement can alter the relative advantages of vertical integration versus market exchange. Price controls decrease the relative cost of internalizing production within the firm and can fundamentally affect transaction costs within and across firms. This was strikingly illustrated in the United States during and immediately after World War II, when the imposition of price controls led to a substantial increase in vertical mergers.

Another example comes from Germany in the late nineteenth century, when the government encouraged the formation of cartels. Thereupon the Rhenish-Westphalian Coal Cartel increased its coal prices substantially. After that, many electricity and gas utilities, railroads, and even municipalities acquired their own coal mines to produce their own coal and avoid the high cartel prices (Stockder, 1932).

Regulations that affect the existence or costs of particular markets such as future markets affect the incentives for vertical integration. Among its many roles, a future market serves as a synthetic storage mechanism and thus an alternative to vertical integration into storage. When the future market in oil began in the United States in 1983, this lowered the cost to firms of using the market to obtain oil in the future as compared with storing the oil themselves. This was followed by a reduction in vertical integration in the oil industry and by changes in the terms of contracting (Sykuta, 1994, 1996).⁷

Similar arguments apply to regulation of the insurance market. For example, firms seeking to keep the costs of theft down will provide fewer or more guards depending on the cost of insurance. Insurance is a partial substitute for guards. Firms, insurance companies, and regulators jointly influence preventative actions. Insurance also affects criminal incentives and criminal behavior, and this criminal behavior coevolves with the behavior of other participants. For example, insured property owners are less likely to use guards and violence to self-protect. Criminals have an interest in knowing that. The regulation of insurance thus involves complex tradeoffs. As an illustration, insurers of stolen artwork may have an interest in providing a reward for information from someone who “just happens to know” where that painting is hidden. This helps recover that painting at lower cost than fully compensating the legal owner, but this raises the returns to art theft overall. It is not so easy to sell stolen art—a registry of stolen art is available to potential buyers, and in addition an “innocent” buyer of stolen art runs the risk of having to return the stolen art without compensation to the original owner when the location of the art is discovered. There are thus limits to how far various participants want these rewards to go leading to regulatory limits on such rewards.⁸

Households produce goods and services both for their own consumption and for trade with the external market (Yoram Ben-Porath, 1980). As Robert Pollak describes it (1985, pp. 605–606):

The transaction cost approach views marriage as a ‘governance structure,’ emphasizes the role of ‘bargaining’ within families and draws attention to the advantages and disadvantages of family and to the special roles of ‘altruism’ and ‘family loyalty.’ It also recognizes the disadvantages of family governance: conflict spillover, the toleration of inefficient personnel, inappropriate ability match, and inability to realize economics of scale. If activities are assigned to institutions in an efficient or cost-minimizing fashion, the balance of these advantages and disadvantages plays a major role in determining which activities are carried out within families and which are performed by firms, nonprofit institutions, or the state.

Levels of transaction costs within the family and within the external market will affect the extent and type of household production. Regulations that increase the costs of impersonal exchange in the market will increase the importance of household production and other forms of personalized exchange. In the Soviet Union, when the market system was severely repressed, families vertically integrated into food production for themselves by working on their small garden plots in the countryside. In many settings, land regulations limit individuals’ ability to obtain property rights that are clear and protected. This leads to difficulties in finance and contracting. Houses built in such settings are often constructed by the hands of the household members, with bricks purchased when cash is available (de Soto, 1989).

One way to characterize regulatory regimes is the extent to which there is impersonal exchange, personalized exchange, or little exchange at all. Indeed, Douglass North (1991) has described the process of economic development as a movement from personal to impersonal exchange.

Impersonal exchange requires low costs of measurement and enforcement. Adam Smith’s invisible hand depends upon a regulatory regime that encourages impersonal exchange by keeping transaction costs low. By altering such costs, regulation affects the extent of impersonal exchange. Some regulations like standardization can lower measurement and enforcement costs and thus promote impersonal exchange. Many other kinds of regulations raise transaction costs and thereby promote more personalized exchange. When regulatory regimes are arbitrary, impose excessive entry costs, establish price controls, or generally cause high transaction costs, then personalized exchange is likely to dominate.⁹ For example, in late twentieth-century Egypt, the markets for many goods were heavily regulated. Shortages arose, and it was often difficult to obtain goods in the impersonal market. Egyptians adapted in part by developing their own reciprocity networks of personalized exchange. These informal networks increased the likelihood of locating rationed goods or finding jobs (Singerman, 1995).

Firms and households shape their governance structure—the forms of contracting, ownership, and decision-making—in part by efforts to economize on transaction costs. Since regulations affect transaction costs, changes in regulations can affect governance structures. This argument holds a central place in the work of Oliver Williamson (Williamson, 1985; Williamson & Masten, 1995; Williamson, 1999) and in the associated literature on transaction cost economics.

To illustrate, consider the impact of unit banking regulations in the United States. Historically some US states prohibited bank takeovers by other banks, while other states did not. In states that permitted takeovers, the banks were more efficient and had higher profits. Why? Permitting takeovers increased competition. Where takeovers were not possible, managers were subject to less outside scrutiny. This was somewhat mitigated by changes in bank ownership structure. Where bank ownership is more concentrated, some individual shareholders are more likely to have sufficient stakes to make it worthwhile for them to monitor the managers. In the US states that prohibited takeovers, ownership concentration was indeed higher. This reduced the inefficiencies associated with the restrictions on takeovers, but it was not a perfect substitute for a takeover market (Schranz, 1993).

In many markets, regulatory standards exist for advertising, disclosure, and measurement. These regulations affect the types of information and goods produced and can give rise to dramatically different configurations of economic organization—sometimes improving efficiency and sometimes not. In the case of the market for eyeglasses, regulations in many US states historically restricted severely the types of advertising that could be provided to consumers. This greatly limited the ability of the large firms, which were the low-cost providers, to compete. These regulations were also associated with higher prices of eyeglasses to consumers, lower frequency of purchase, and more adverse effects for those with less education (Benham, 1972; Benham & Benham, 1975).

Regulations that lower the costs of measurement, such as standardization of weights and measures, can increase enforceability and credibility, thereby enhancing the efficiency of markets. Regulations of quality standards for food can increase the credibility of brand names. Together these appear to have assisted the development of the market for manufactured foods. Food-manufacturing firms in the United States at the beginning of the twentieth century recognized this, and they themselves supported the introduction of quality-control regulations (Law, 2003a, b).

Although seemingly innocuous, even regulations concerning how land is measured can have a substantial impact. Libecap and Lueck show this in their study of the two land delineation systems used in Ohio in the early nineteenth century: (1) the metes and bounds method of land measurement, based on natural features of the landscape and artificial markers, and (2) the grid system, based on centralized grid of uniform square plots. Two centuries later, land measured with the grid system had substantially higher land prices, lower levels of violence, and higher population density relative than nearly identical land measured in metes and bounds (Libecap & Lueck, 2011).

Note that even if a regulatory environment lowers the costs of measurement and enforcement, this does not mean that the total resources in the economy devoted to transaction costs will necessarily decline. The transaction costs per transaction may fall, but the total number of transactions may increase dramatically, so that total transaction costs rise. John Wallis and Douglass North (1986) have evidence that bear on this issue. Between 1870 and 1970 in the United States, specialization and per capita income grew enormously. Simultaneously, the transaction sector—those activities which involve measurement and enforcement, such as accounting and law—increased from 25% of GNP to 45% of GNP.

The underground economy, the “informal economy,” includes (a) legal activities conducted outside the formal legal system (manufacture of legal goods without a permit, providing services like house repairs without reporting income to tax authorities), and (b) illegal activities (illegal drugs, stolen goods, prostitution, gambling). Informal economies play a significant role throughout the world; their relative importance varies by country.¹⁰ Available evidence suggests that variation in regulatory climate is a major reason for variation in the size of the underground economy.

Of particular relevance here are barriers to entry, perhaps the most intensively studied form of all regulation. In 1776 Adam Smith gave them a central place in The Wealth of Nations (1776). In the 1980s Hernando de Soto (1989) documented startlingly high regulatory barriers to small-business entry in Peru.¹¹ A great proportion of business in Peru was transacted informally. In the early 2000s, Djankov et al. studied regulations governing business entry in 85 countries and found high official costs of entry in most countries. Djankov et al. (2002) and Djankov (2003) also found that where regulation of entry is more extreme, the unofficial economy is larger, corruption is higher, and the quality of public service is not better.

If the norms encouraging group cooperation are sufficiently strong and the formal governance structure is sufficiently weak, then long-term violation of the formal rules can be sustained. In 2011 the Japanese Olympus Corporation was exposed as having hidden $1.7 billion US in losses for decades. How could this persist for so long, and what was the catalyst for exposure? Michael Woodford, a British executive who had worked his way up through the ranks of the Olympus Corporation, became CEO in October 2011. This was the first time a non-Japanese had been named to the top role at Olympus. Woodford noticed unusual large transactions, and after documenting some of the specifics, he urged the Board to resign and to allow a full investigation of the company’s accounts. The Board voted unanimously to dismiss him from his position as CEO, citing a management culture clash.

After his dismissal, Woodford made his concerns public. The ensuing scandal led to the resignation of the company’s chairman and president and to official investigations in Japan, the United Kingdom, and the United States. They confirmed that Olympus had indeed been hiding substantial investment losses for more than a decade. The scandal led to an 80% decline in the company’s share price and criminal charges for several senior Olympus executives. The extent to which there are powerful cooperative norms within an organization—and Japan is a comparatively homogeneous society with strong norms of cooperation—makes such private arrangements more sustainable.

Regulations can alter the price of discrimination and thereby influence the extent of discrimination. They can also work indirectly. For example, if the money profits of a regulated firm are restricted below the level achievable, this will lower the cost to the firm of employing workers who are less productive but who have preferred characteristics along other dimensions. In other words, regulatory limits on profits will lower the cost to the firm of engaging in discrimination (Alchian & Kessel, 1962).

The regulation of US physicians in the early 1900s provides another illustration. At that time, medical licensure came under the monopoly control of state medical associations which regulated standards. This strengthened the medical associations’ position as an interest group, and they dramatically reduced the number of medical schools. As a result, physicians’ earnings increased, and applications to the surviving medical schools increased. The long waiting lines for applications for admission lowered the cost of discrimination to the admissions committee. The relative numbers of women and blacks admitted to medical schools then declined sharply (Kessel, 1970).

How a change in the rules can affect the price of discrimination and hence its extent is also illustrated by a change in regulations in US baseball. Until 1947, baseball was a segregated sport with a separate Negro league. This color bar broke down in 1947, permitting all teams to hire players from the Negro league, which had excellent players available at lower salaries. The teams quickest to stop discriminating then improved both their team performance and their box office returns relative to the remaining teams. As the color bar diminished, baseball owners who persisted in discriminating paid a higher price for their preference. Eventually the color bar fell for all teams (Gwartney & Haworth, 1974).

Regulations that raise the cost of engaging in voluntary exchange will affect the extent to which private coercion is used, individually and through illegal organizations. Regulations such as prohibitions on alcohol, drugs, and gambling increase the potential gains of dealing in these arenas and thereby facilitate the rise of illegal organizations like the Mafia.

Regulations that increase uncertainty concerning ownership of property rights can lead to environmental problems like land invasions, violence, and deforestation. In Brazil, the conflicted regulatory environment concerning property rights has led to all of these (Alston et al. 1999, 2000). In southern Italy in the nineteenth century, the formal rules were changing, but the institutions for enforcement were weak; hence the claims of ownership and control became less certain. Violence and threats of violence became more relevant for de facto ownerhip. This led to a a great increase in the strength of the Mafia which had a comparative advantage in violence and contract enforcement (Gambetta, 1993).

Corruption is the use of public office for private gains in carrying out a public task. Regulations can significantly affect the benefits and costs of engaging in corrupt practices. In settings where regulations are excessive or arbitrary and where civil servants have discretion over enforcement, where discretionary permits are highly valuable, and/or where the likelihood of exposure is low, in these settings corruption is likely to be extensive.

The number of possible corrupt practices is very large. The organization of corruption and the property rights to associated payoffs vary considerably by country (Shleifer & Vishny, 1993). Where the property rights to bribes are clearly held and enforced, a given level of corruption may produce less inefficiency. If the highest-ranking politicians and political parties are disciplined enough to refrain from seeking additional payoffs after initial lump sums have been paid, then corruption on the margin may be circumscribed. In South Korea, for example, political parties are highly disciplined, and bribery has been highly centralized. Many payoffs are lump-sum contributions by major business leaders to presidential campaigns. This arrangement does not tax economic activity at the margin. If the government is weak and fragmented, however, local government regulators often engage in decentralized looting. This undermines credible commitments in both public and private sectors and can be particularly damaging to economic performance (Bardhan, 1997).

Regulators are often active in this process. They may intentionally introduce regulations to create further opportunities for corrupt exchanges. If corruption becomes common in one sector (say, because of high import duties or restrictions on gambling), then the cost of spreading corruption to other sectors falls. This in turn lowers the returns to normal entrepreneurial activity, which further slows down economically productive activity, which induces more people to engage in corrupt practices, and so on (Murphy et al., 1993). Furthermore, it may be easier to introduce corrupt practices than to reduce them: long periods of time may be needed to move from a corrupt to a non-corrupt equilibrium.

Accession of Eastern European countries into the EU provides a natural experiment of the impact of an external change in regulation oversight procedures on corruption. When a new country aspires to join the European Union (EU), it must undergo a rigorous accession process that requires it to adopt, implement, and enforce a wide range of EU rules and regulations. The role of the legacy interest groups within the country is thus altered. This new external oversight process has helped reduce corruption problem in the countries admitted, but the experience varies. Corruption is more persistent where the old legacies and networks are more enduring (Ganev, 2019).

Small initial regulatory choices can lead to large downstream effects. Ronald Coase found this in his detailed investigation of the origins of radio broadcasting in Britain (Coase, 1947). Initially, the transmission of sound by radio was regarded as a new means for sending telephone messages. Because of this, regulation of broadcasting was assigned to the organization that had jurisdiction over telephones: the Post Office. To avoid the problem of broadcast interference and to avoid having to select from among the many firms who would seek the valuable radio spectrum, the Post Office favored having a single broadcasting company.¹³ Strategies that could have been used to allocate the radio spectrum, including assigning property rights to the spectrum and selling them off, were not on the agenda at that time.¹⁴ The main advocates for radio broadcasting at that time were the radio manufacturers, who sought their revenues from the sale of radios rather than from broadcasting. Newspapers did not want competition for their advertising revenue and therefore opposed commercial forms of radio broadcasting. There was thus little opposition to the Post Office’s proposal to create only one broadcasting company and to finance its programming and transmission from taxes on radio sales. There followed a broadcast monopoly that limited British citizens to BBC programming for many decades. Non-BBC programming could not even be transmitted by wire (although that involved no problem of externalities). When television was eventually introduced, the BBC monopoly was extended to cover television.

In the years just before World War II, the BBC gave the major political parties control over access to the airwaves for political speeches. The political parties then allocated their shares of airtime to politicians who endorsed their standard party positions. When Winston Churchill sought to criticize the government’s appeasement policy toward Hitler, he was unable to get permission to speak on the BBC. Given the rules of the game, this result is not surprising. An apparently small regulatory choice driven by specific historic circumstances had these profoundly important later consequences.

Sugar production in the United States offers another example of the downstream impact of initial regulatory decisions. Sugar is the only US agricultural good now excluded from global free trade. In 2021 raw sugar prices in the United States were twice as high as the world spot price. All 11,800 US sugar farmers receive subsidies. As a result of these subsidies, the Everglades region in Florida has been planted with sugar cane, creating significant ecological problems. Sugar-processing and sugar-using industries have moved out of the United States because of the high domestic sugar prices. The total costs of this program are vast. How did all this happen?

Anne Krueger’s classic study (1990) shows how the complexity and the cost of current sugar regulation can be understood only by an appreciation of past policies. Through most of the nineteenth century, 90% of the sugar consumed in the United States was imported. Tariffs on sugar were originally imposed as a revenue source. Then in the late 1800s, the US Department of Agriculture took initiatives to encourage domestic sugar growing and processing. The sugar industry developed because of this government-initiated program, rather than the reverse.¹⁵

Several historical accidents appear to have had a major impact on the subsequent evolution of the program, including idiosyncratic committee assignments in Congress and a focus on foreign relations issues. Once the very complex sugar program was in place, a network of program specialists arose in government and industry and became independently influential. Various interest groups were involved over time. A long-standing—and unlikely—coalition of sugar producers, processors, and users persisted until 1978. At that time a new corn-based substitute for sugar began to take market share. Corn producers benefited from having high prices for sugar, and they therefore supported a sugar quota system, opposing plans that would have permitted the US sugar price to fall to the world level.

The high domestic price of sugar has led to many market responses: the use of sugar substitutes, the importing of products such as cake mixes with high sugar content, and the subsequent ban on imported cake mixes. Diplomatic complications have been associated with the allocation of sugar import quotas across countries, e.g., Cuba. Although this program has been very costly to consumers and to sugar-using industries, there appear to be few long-term rents earned by domestic sugar producers and processors. Most of the subsidies are dissipated in inducing production where it would not otherwise take place.

Examples from many other industries could be provided. The regulation and deregulation of natural gas, standards for automobile emissions, pharmaceutical regulation, medical licensure, and airline regulation all show a history of interest group politics in which new regulations frequently create new interest groups.

The previous examples have shown that small initial regulations can lead step by step to major downstream consequences. On the other hand, Draconian regulations are sometimes followed by surprisingly resilient responses over long time periods. Consider the case of the Old Believers in Russia.

Starting in the seventeenth century, the Old Believers were heavily persecuted for refusing to conform to the new religious doctrines of the Russian Orthodox Church. During the period of most intense persecution, the Old Believers were subjected to removal of all their legal rights, forced exile, no standing in court, and even mass executions. Although the intensity of persecution diminished over time, they remained for centuries without full legal status. However, the Old Believers survived and eventually prospered by developing strong informal norms of trust, honesty, sobriety, and cooperation within their own community. These norms lowered their internal transaction costs substantially, permitting them to trade over space and through time in ways that outsiders in the broader Russian society could not. By the mid-nineteenth century, in relatively unregulated sectors like the textile industry, they were the leading entrepreneurs in Russia. When the government’s direct regulatory role increased in the late nineteenth century, their role in this sector then diminished (Raskov, 2002).

In the Russian economic system, informal norms evolving over long periods of time had fundamental consequences for who did what and how efficiently. When excluded from formal state contract enforcement, the Old Believers developed their own informal system of transacting and enforcement. The later state regulations that elevated the importance of political connections, such as state licensing for entry, put them at a disadvantage.

These three historical examples illustrate the broad range of responses to regulation that arise from interest groups rather than from individual action. New regulations create new interests and destroy old interests. The rise and demise of shared interests can change the original politics irreversibly. The overall response to a regulation depends only partially on responses at the level of resource allocation. How the various interest groups respond to the regulation and which ones seize the regulatory mechanisms over time are very significant issues. At this stage in our knowledge, these outcomes are extremely difficult to predict.

Innovation creates new possibilities and is essential for long-term growth. However, when new technology is changing the landscape rapidly, it can also create new opportunities to circumvent the existing regulatory policy. This is illustrated by the 2023 trial of Sam Bankman-Fried, CEO of FTX, one of the largest exchange platforms for cryptocurrencies. After his exchange collapsed, trial testimony showed that adding just one line—“allow_negative”—to the FTX code permitted Bankman-Fried to access 65 billion dollars of his customers’ accounts without their permission. Public trials such as this make clear the limited extent to which regulations protect customers, especially where technology is evolving rapidly. This highlights the importance of understanding alternative approaches to address externalities, risks, and uncertainties. Options include not only the fine-tuning of complex regulation—which can and often does retard innovation while simultaneously giving citizens a false sense of security—but also educating citizens concerning risks and caveat emptor.