The present economic situation has caused a fundamental rethinking – some of it thoughtful, some of it knee-jerk – of the ability of markets to coordinate the oft-self-interested behavior of producers and consumers and to channel that behavior in directions that work more or less to the best interests of society as a whole. Media reporting and political debates regularly remind us of a period in time – the 1930s – when similar questions were being raised about financial and industrial capitalism, as unemployment numbers mounted and market values plunged.

This earlier era saw the publication of a number of works that questioned both the ability of the received economic theory to explain observed economic outcomes and the acceptability of the economic status quo. One of the most prominent of these is The Modern Corporation and Private Property (Reference Berle and Means1932), written by Adolf Berle and Gardiner Means. Berle, a lawyer, and Means, an economist, suggested that the increasing concentration of corporate power was at the heart of many of the problems with the capitalist system and was not consistent either with traditional legal theory or with traditional economic analysis.Footnote ¹ Much of the problem was ascribed to the organization of the modern corporate form and, specifically, the separation of corporate ownership from corporate control. The basic thesis of The Modern Corporation is that corporations are not run by the owners – the stockholders – but by a class of professional managers. With the increasing dispersion of stock ownership, ‘control is maintained in large measure apart from ownership’ (Berle and Means, Reference Berle and Means1932: 117), and owners do little more than ‘supply the means whereby the new princes may exercise their power’ (p. 124). The problem that arises, according to Berle and Means, is that the self-interested behavior of these managers may cause them to make decisions that are at odds with the interests of corporate ownership and, ultimately, of society as a whole.Footnote ²

The Berle and Means thesis – essentially a thesis of market failure resulting from the effects of corporate organization – attracted significant attention and support from a variety of quarters.Footnote ³ It also influenced a number of subsequent commentators, including Robert A. Gordon (Reference Gordon1945) and John Kenneth Galbraith (Reference Galbraith1967), whose work called into question the veracity of various aspects of neoclassical economic analysis. One place where the Berle and Means thesis had little traction was within the Chicago school, where George Stigler in particular went to great lengths over the years to discredit many of the themes of The Modern Corporation and Private Property, including those related to the implications of the separation of ownership and control for the efficient management of the corporation and its congruence with the profit-maximization thesis of neoclassical (and Chicago) price theory.Footnote ⁴ In a conference sponsored by the Hoover Institution in 1982, Stigler and Claire Friedland (Reference Stigler and Friedland1983) painted The Modern Corporation as little more than an exercise in mythology, one that offered no theory of the causes or consequences of the separation of ownership and control and which contained a host of undocumented assertions that, in retrospect, were contradicted by the data of the time. Harold Demsetz (Reference Demsetz1983) offered a similar take, arguing against Berle and Means that the ownership structure of the firm is ‘an endogenous outcome of a maximizing process’ and that ‘a broader perspective on the problem of the optimum ownership structure makes the fears of Berle and Means meaningless’ (p. 377). Demsetz's strongly worded conclusion perhaps sums up the traditional Chicago perspective as well as any: ‘In a world in which self-interest plays a significant role in economic behavior, it is foolish to believe that owners of valuable resources systematically relinquish control to managers who are not guided to serve their interests’ (p. 390, emphasis added).

It thus comes as something of a surprise to find in the article by Richard Posner (Reference Posner2010) published in this issue of the Journal of Institutional Economics and in his new book on the current economic situation, A Failure of Capitalism (Reference Posner2009b), echoes of the very themes that were raised by Berle and Means more than seven decades ago. Witness the following ‘un-Chicago’ statements that Posner has made in the past year:

These are clearly not the sort of statements that many have come to so closely associate with the Chicago school in general and with Posner in particular.

Coordination failure: Berle and Means

At the time that Berle and Means penned The Modern Corporation, the standard micro-theoretic approach to firm behavior posited decisions made by profit-maximizing owners, with little attention to the actual structure of business organization. In effect, decision making at a small family-run grocery and at a large steel factory were assumed to be explained by the same model, in spite of the fact that most decisions for the latter entity were made by a group of managers rather than the owners.

The inaccuracy of this theory was not necessarily important. If the managers operated in a manner consistent with the interests of the owners (maximizing corporate profits), then a model that failed to differentiate between the family grocery and the large steel company might well be perfectly serviceable. And, argued Berle and Means, in the early part of the industrial revolution, management operation was ‘presumably in the interests of the owners’ (Reference Berle and Means1932: 119). Whether this was still true of the modern corporation in the 1930s, they said, is an open question, the answer to which depends ‘on the degree to which the self-interest of those in control may run parallel to the interests of ownership, and, in so far as they differ, on the checks on the use of power which may be established by political, economic, or social conditions’ (p. 121).

Berle and Means allow that ‘The interests of control are not always so easily discovered’ (p. 121), but they seem prepared to accept the general notion that individuals in control of corporations are motivated by self-interest. They go on to argue that if the managerial pursuit of self-interest translates into seeking a maximum of personal profit, the interests of control diverge from that of ownership: ‘the controlling group, even if they own a large block of stock, can serve their own pockets better by profiting at the expense of the company than by making profits for it’ (p. 122; see also p. 333). This leads Berle and Means to conclude that ‘the interests of ownership and control are in large measure opposed if the interests of the latter grow primarily out of the desire for personal monetary gain’ (p. 123). Though Berle and Means are not prepared to take a firm position on motives – or on the direction in which self-interest points control – they are convinced that traditional economic analysis is of little help in understanding managerial behavior within the modern corporation (p. 350).

Berle and Means contend that law had only just begun to cope with the implications of the extensive separation of ownership and control and the ‘complete’ power of control (the directors and officers of the corporation) over the corporation (p. 233). This, they said, raises the policy issue of whether ‘social and legal pressure’ should be brought to bear in order to align the efforts of management with those of ownership or with those of some wider group, such as the nation as a whole (p. 333). Even if one's priors suggest an affirmative answer, the problem is that making effective policy here is no easy matter:

The deregulation measures of the last few decades have, in the minds of some, only further reinforced these problems, and both academics and policy makers are now struggling to determine what types of controls, if any, can effect desirable changes without simultaneously imposing costs that do more harm then the proffered cure.

Given the wide-ranging scope of his scholarly and popular work, it is not surprising that Posner has chosen to weigh in on a number of these issues. What some may find surprising, however, is the nature of his explanations and prescriptions.

Coordination failure Redux: Posner's ‘un-Chicago’ turn

The history of Chicago price theory is one of both continuity and change. The latter is evidenced at various points, including in the focus of the theorizing. Under Frank Knight, Jacob Viner, Henry Simons, and Milton Friedman – that is, from the 1920s through the 1950s – the focus of the analysis was market-level activity, a legacy of the approach found in Marshall's Principles and the particular brand of Marshallianism found in the Chicago analytical framework. The 1960s, though, saw the beginning of a change in focus from the market to the individual – the individual consumer or household, the producing agent . . . – deemed to be a rational decision maker over some objective function, a transformation driven by Stigler, Gary Becker, and a host of Becker's students. Running through both the earlier and more recent periods of Chicago price theory, but lurking alongside and in the background, was the analysis of institutions, derivative of Aaron Director's work on antitrust and related issues of corporate and marketplace regulation and Ronald Coase's work on the firm and on the legal environment of the market. This firm-level analysis gave substantial credence to the efficiency of organizational structures, as reflected, for example, in the work of Alchian and Demsetz (Reference Alchian and Demsetz1972).

In contrast to the institutionalist flavored analysis of Berle and Means, Posner takes as his tool modern organization theory, a more rational choice-oriented approach to the problems of the separation of ownership and control that were raised by Berle and Means. Agency theory has taken multiple forms, some pointing to the problems of agency a la Berle and Means, and others showing how the capitalist system can devise efficient solutions to agency problems. The standard Chicago version of agency theory falls into the latter camp, emphasizing the adaptability of corporate capitalism and its attendant ability to devise coordination mechanisms that align incentives to channel self-interest in beneficial directions.Footnote ⁵ That is, the story here is one of organizational success rather than, as with Berle and Means, organizational failure. In Posner's recent work, however, we see the Chicago analysis of organizations taking a very different turn, with Posner noting how markets and firms usefully (that is, efficiently) adapt in certain situations but fall short of the mark (and sometimes substantially so) in others. Posner argues that agency problems – and, more importantly, agency costs – are amply evident in the corporate arena and that one particular instance of their effects is in the area of executive compensation. Here, Posner breaks ranks with the standard Chicago view.

Where Berle and Means and those who built on their work, such as Robert A. Gordon, saw a system in which those in control of corporations had the power to reward themselves at levels well beyond what the theory of competitive labor markets would suggest, Stigler and Friedland (Reference Stigler and Friedland1983) argued that compensation was squarely in line with standard theory. Posner, however, takes a rather different path, arguing that agency costs often are not overcome by coordination devices that align the incentives of ownership and management, and one of the effects of the presence of agency costs is the facilitation of levels of executive compensation well in excess of what the received economic theory would dictate. As Posner notes, executive compensation is deemed appropriate according to agency theory only when that compensation is equal to that which would persist if agency costs were zero. The self-interested agent will seek to maximize his compensation package, and the principal's interest is in compensating the agent in direct proportion to his productivity. While competitive labor markets ensure that productivity-based compensation would allow the company to retain the executives, Posner contends agency costs tend to get in the way of this outcome and engender levels of executive compensation well beyond what the theory of competitive markets dictates.

Posner points to several factors that weigh in favor of a verdict of the failure of corporate organization to align the interests of executives and stockholders. Working from the assumption that executives are rational maximizers and will pursue their own gains, Posner adopts a stance similar to Berle and Means when he says that in a corporation with widely dispersed ownership in which each owner owns only a negligible share of the corporation, each owner has little incentive to devote resources to monitoring management, because other owners would simply free-ride on their efforts. He is also siding with Berle and Means, as against Stigler and Demsetz, when he argues that boards of directors are very imperfect representatives of the interests of ownership (the larger group of stockholders),Footnote ⁶ pointing out that directors typically devote little time to the companies on whose boards they serve, have little stake in the success of the corporation, and have little incentive to gather information about things like CEO performance.

These factors combine with others – including the difficulty of measuring CEO success, the role of CEOs in selecting members of boards of directors, and the substantial representation of CEOs on such boards − to suggest, to Posner (Reference Posner2010: 8–15), that the compensation of corporate CEOs is excessive. Further problems arise from two of the primary mechanisms for compensating executives: stock options, which are not tightly correlated with CEO performance, and generous severance packages tend to induce executives to take risks that are not in the best interest of the shareholders. In addition, greater compensation to CEOs also promotes a focus on short-run profits unless compensation is back-loaded, which it has not been to any great extent prior to the onset of (and because of its role in precipitating) the current crisis (p. 14).

One obvious effect of executive overcompensation, says Posner, is that it effects a transfer of wealth from stockholders to management, something that Posner goes so far as to label ‘a kind of theft from shareholders’ (Reference Posner2009a: 1042). But it also has the attendant – an economically more real – effect of increasing the cost of raising capital in equity markets. What we have here, then, is a straightforward instance of market failure. The question thus becomes what to do about it. The standard political solution – one with more than a bit of currency in certain heterodox economic circles, not to mention Democratic party politics – is to suggest that the government should impose caps on the compensation of corporate executives. Against this, the traditional Chicago view holds that restrictions on executive compensation will generate inefficiencies. Posner suggests an intermediate path, resisting caps on executive compensation on efficiency grounds, but arguing that several measures should be implemented to solve what he sees as a problem of overcompensation: (1) full disclosure of executive compensation; (2) backloading compensation; (3) substantially increasing the marginal tax rates on those with very high incomes; and (4) increasing the ease of waging proxy fights to more democratically empower shareholders (Reference Posner2009a: 1045–1046). In the end, though, Posner is insistent that ‘The question is not whether, but how best, to limit executive compensation’ (p. 1047).Footnote ⁷

Pragmatism, eclecticism, and ideology

Posner's analysis in his recent work on organizations and on the current economic crisis brings to bear the basic insights of price theory, as applied to the organization, on certain issues raised by (among others) Berle and Means in The Modern Corporation and Private Property and draws conclusions in line with those reached by Berle and Means and at odds with those set out by his late Chicago colleague and teacher, George Stigler.

What does all of this imply for Chicago price theory? Many of the readers of this journal no doubt would argue that if Berle and Means are correct, then Chicago price theory should be cast aside. But such a position is as absurd as the Stigler and Demsetz laments about the analytical frameworks of Berle and Means and the larger Chicago claims regarding the emptiness of institutional economics.Footnote ⁸ Chicago price theory has proven to be a remarkably powerful tool for the analysis of market processes and a fairly wide range of individual behavior. From showing how certain instances of ostensibly anti-competitive behavior in fact are consistent with competitive practices (e.g., Director on antitrust) to showing how special interests capture regulatory agencies, to explaining behavior in the legal arena or within the household, Chicago price theory has illuminated any number of facets of market and non-market behavior as against other approaches to these phenomena.

But the approaches to price theory on offer at Chicago over the decades have not been all-encompassing. Certain facets of market and non-market behavior are simply not consistent with or amenable to explanation within the traditional Chicago frameworks. By the same token, the institutionalist approach, while illuminating certain facets of social-economic activity not well dealt with by the Chicago approach, has difficulty explaining well many important market and non-market phenomena that the Chicago approach handles fairly well. If there is a moral in all of this, it is that no single approach to economic analysis is capable of providing satisfactory solutions to economic and broader social issues. The old adage, ‘horses for courses’, is apposite: it is only through the use of a broad-based set of tools and frameworks that economists can offer satisfactory solutions to the diverse range of problems faced by society.

Posner's willingness to seek solutions beyond the framework identified with Chicago and with his own pathbreaking work in the economic analysis of law is both surprising and refreshing. It is no doubt rooted in the pragmatism that Posner has been espousing for some two decades. I suspect that George Stigler would be unpleasantly surprised by some of the attitudes adopted by his protege here. When Stigler and Friedland reviewed the reactions to The Modern Corporation, one of the groups they surveyed was ‘The Lawyers (and Other Amateurs)’. Perhaps Stigler would not rank Posner among the amateurs given his quiver full of price-theoretic tools. But in Posner's hands, at least, those tools lead to some of the same conclusions as the less ‘scientific’ methods of the ostensible amateurs. Many within both the Chicago and the institutionalist camps could learn from Posner's perspective.