Unintended Consequences: Origins of an Enduring Idea

“In Washington, truth is just another special interest—and one that is not well financed,” observed Michael Mussa, the University of Chicago economist who became a member of President Ronald Reagan’s Council of Economic Advisers, and, later, chief economist at the International Monetary Fund.

Mussa’s friend and colleague Sam Peltzman, now Ralph and Dorothy Keller Distinguished Service Professor Emeritus of Economics at Chicago Booth, investigated what was going on behind the wisecrack in a series of papers in the 1970s. His research, culminating in the 1976 paper “Toward a More General Theory of Regulation,” brought an economist’s understanding to the decision-making behind regulatory policy, highlighting the trade-offs and unintended consequences inherent in regulation. As one of the most cited papers in the history of economics, it has strongly influenced scholarship and policymaking, and its echoes continue to reverberate.

Peltzman’s research emerged from the intellectual ferment within the University of Chicago economics department and Graduate School of Business in the 1970s, when academic heavyweights such as Milton Friedman, George J. Stigler, and Gary S. Becker—who all went on to become Nobel laureates—argued over ideas and grilled visiting academics about their work.

Although they often disagreed, these luminaries shared an approach—essentially, to extend economics to the study of everything. According to the Chicago view, issues such as environmental pollution, race relations, and marriage, previously considered beyond the purview of economics, could be analyzed using a market framework.

Regulation was no different. Traditionally, economists had viewed government regulation as a deus ex machina: there were problems in the world, and they could be solved by government intervention on behalf of the public interest. In the 1960s, Stigler broke with this tradition by asking whether regulation actually achieved anything. Did prices go down? Were consumers better served? His conclusions were that regulation did not have much of an impact.

By 1971, Stigler had come to a stronger view, which he outlined in his paper “The Theory of Economic Regulation,” in which he proposed the notion of regulatory capture. In the market for regulation, Stigler argued, producers ended up capturing regulators, since producers were typically few in number and could organize to persuade regulators to protect their interests, while consumers were usually diffuse and not well organized. Consequently, regulation operated in favor of producers against consumers.

This theory described well how some industries operate. In US banking, for instance, regulation caps that set a limit on deposit rates had been introduced in the 1930s with the rationale of preventing ruinous competition, but the caps ended up protecting incumbents and harming consumers. A very different example is the current US licensing regimes that regulate who can work as a barber or a beautician and that prevent people from entering those professions and keep costs for these services high for consumers.

Stigler’s insight was undoubtedly powerful, but it was simplistic and far from comprehensive. It could not explain, for example, how regulations that forced electric utilities to charge consumers the same rate, whether they lived next door to the grid or 500 miles from it, were in the producers’ interest. For years following Stigler’s 1971 paper, there were fervent efforts by other researchers to add complexity and nuance to his central idea.

On January 17, 1976, to mark Stigler’s 65th birthday, the University of Chicago held a conference on the economics of politics and regulation. Peltzman presented the main paper, “Toward a More General Theory of Regulation,” which would be published later that year in a special edition of the Journal of Law and Economics. In it, he sought to present a richer account of regulation than that described in Stigler’s deterministic model.

Peltzman, who received his PhD from the University of Chicago in 1965 and returned in 1973 to join the GSB faculty, aimed to look beyond the narrow dichotomy of producer and consumer interests. He stressed the interaction between the two, arguing that it was more fruitful to think in terms of costs and benefits, both for producers and consumers. Moreover, whereas Stigler saw regulators as passive recipients, Peltzman argued that regulators had a role to play, that they had to think of their political futures, and that they could assemble coalitions.

Since regulatory policymakers are either elected politicians or the officials they appoint, regulators respond to political incentives. Regulators, for Peltzman, stood between consumers and producers, facing a range of trade-offs in their policy decisions. While consumers and producers try to maximize their returns, financial or otherwise, regulators try to maximize political support, which interest groups offer in exchange for favorable regulation. This support might be in the form of votes or campaign funding, and legislators balance these at an equilibrium point that maximizes their political returns, such as their chance of being reelected, so the rule-makers must deal with competing interests. Any move from the equilibrium, such as a change in regulation, benefits some producers or consumers, and makes the regulator’s reelection more or less likely. In this way, Peltzman thought both more broadly and in more detail about the trade-offs involved in crafting regulation, and about how regulators approach the market for regulation. As he wrote, “In my general model, every identifiable group contains winners and losers.”

Thinking about the trade-offs provided an empirical basis for analyzing the effectiveness of regulation and the consequences of proposed regulatory changes. “The usefulness of the model developed here awaits tests of these implications,” Peltzman wrote.

In fact, he had already begun to flesh out the implications in several papers that had informed his general theory. In 1973, Peltzman had published “An Evaluation of Consumer Protection Legislation: The 1962 Drug Amendments” in the Journal of Political Economy, in which he began to demonstrate some of the inefficiencies and trade-offs entailed in regulation.

The 1962 legislation in question demanded that the US Food and Drug Administration approve all claims made about the efficacy of new drugs before they could be sold. Peltzman argued that the cost of delaying the introduction of new drugs overwhelmed any benefit by orders of magnitude.

It was a potent example of the trade-off in action. Of course, everyone wanted new drugs to be safe. However, terminal patients might be willing to risk side effects to take an experimental drug. In the years it takes for a drug to be approved, many patients die who might live longer if they were given the option to take it.

Peltzman’s argument was well understood by economists, but it had little traction in mainstream thinking until the HIV/AIDS epidemic of the 1980s. That crisis illustrated starkly the choice between long and rigorous testing on the one hand, and the possibility of prolonging or easing the lives of tens of thousands of suffering people on the other. This situation forced a realization of the painful trade-off involved, and recognition that the pendulum might have swung too far toward regulation and away from innovation. By the late 1980s, AIDS campaigners successfully pressured the FDA to allow AIDS patients to receive drugs after the treatments had completed only Phase I testing.

In 1975, a year before the Stigler conference, Peltzman had authored “The Effects of Automobile Safety Regulation,” published in the Journal of Political Economy. In that controversial paper, Peltzman argued that mandatory safety devices such as seatbelts reduce the likelihood that drivers are harmed if they crash, but also encourage drivers to be more reckless. Holding other factors constant, he found that the 1968 regulation mandating seatbelt use caused more accidents, but those accidents were less harmful, so the net number of driver fatalities was unaffected. His time-series analysis produced some evidence that the regulation had reduced driver fatalities, but that car accidents involving pedestrians and cyclists increased, as did their death rates due to cars, so total deaths were unchanged.

While the paper’s use of data was subsequently criticized in ways that Peltzman accepted, its enduring contribution was to highlight the unintended consequences of regulation. Although seatbelts did turn out to save lives, a portion of the benefit from improved driver safety was offset by more reckless driving and more nondriver deaths. It underlined, again, that regulation—even in mandating something as beneficial as seatbelts—always creates a trade-off. Others had talked about the theory of unintended consequences, but Peltzman was the first to do so in a systematic, empirical way.

Gary S. Becker offered his own, richer model of regulation in a 1983 paper, in which he noted that interest groups were not a monolithic bloc, but comprised competing interests—an idea that was implicit in Peltzman’s paper but not fully fleshed out. In financial services, for example, there is competition between insurance companies, banks, investment banks, and others. Becker argued that this competition among interest groups could lead to an optimal regulatory outcome. Incumbent groups that benefited from existing regulation had an incentive to protect their interests, but the system also gave incentives to competitors; the greater the regulatory capture, the more incentive for other groups to organize. This offsetting of interests could in theory lead to optimal outcomes. That is not to say that Becker thought current regulation was optimal so much as that we could imagine a situation in which it might be.

Stigler, Peltzman, and Becker began an intellectual conversation that continues in the work of scholars such as my colleague Luigi Zingales, Robert C. McCormack Distinguished Service Professor of Entrepreneurship and Finance at Chicago Booth, and in my own work on banking regulation, trade policy, lobbying, and campaign contributions.

Peltzman’s ideas have also had a direct impact on policymaking. In 1980, the US Congress created the Office of Information and Regulatory Affairs, which performs cost-benefit analyses of regulatory changes, and reviews the effectiveness of existing legislation. In addition, the FDA has backpedaled several more times in the face of campaigns demonstrating how patients suffer because of the rigor of lengthy drug trials.

As the regulatory impulse has returned in the wake of the 2007–10 financial crisis and the 2010 Dodd-Frank Act, Sam Peltzman’s observations about trade-offs and unintended consequences remain highly relevant. Policymakers would do well to keep them top of mind.

Randall S. Kroszner is Norman R. Bobins Professor of Economics.