In the featured article, ‘From the New Institutional Economics to Organizational Economics’, Judge Richard Posner (Reference Posner2010) argues for the relevance of the economics of organization to the new institutional economics by showing how its focus on agency cost and efficiency would shed light on the working of various institutions/organizations. New institutional economics, alternatively known as transaction cost economics, Posner suggests, can presumably benefit from the rigor of analysis and formalism that the economics of organization can bring to the table.

Richard Posner tries to demonstrate his contention by discussing five cases, one private organization and four public organizations. The private organization discussed by Posner is ‘the modern publicly held business corporation’ in the US. The four public organizations examined are the US intelligence community and the FBI, on the one hand, and the two contrasting judicial systems of Common Law as practiced in the US and of Civil Law of the Continental Europe and Japan, on the other. In my comments on Posner, I will focus on his contrasting views on the privately held business corporation and the judicial systems.

Posner's judgment that the compensation of CEOs of the publicly held business corporations in the US is excessive seems very timely, especially in light of the popular backlash against executive compensation of firms bailed out by massive government funding. Posner offers five reasons why American CEO compensation is excessive: (1) Given the great dispersion of ownership of corporations, individual owners do not have incentive to closely monitor CEO compensation, leaving it to the board of directors. (2) The members of the board of directors, who are supposed to exercise independent supervision over the CEO, in turn, often do not have incentive to do so and, indeed, end up doing the bidding of the CEOs, including their compensation. (3) The putative disciplinary power of the market in the form of potential take-over is highly over-rated as the CEOs are often well protected with a golden parachute when they underperform and the firm becomes a target for take-over. (4) The greater degree of dispersion of the ownership of the publicly held business corporation in the US than in Europe possibly accounts for much greater CEO compensation in the US than in Europe. (5) Possibly, the differences in the degree to which people are prone to envy may account for why American CEOs can get away with the much higher level of compensation when such is rarely seen among their European counterparts. Of the five, only the last two have not been aired frequently in the popular media. Explaining the differences in the compensation of CEOs in the US and in Europe by differences in the degree of ownership dispersion, while consistent with the focus of the economics of organization, raises a number of questions. The explanation of the difference by means of envy, though novel, seems to have little, if anything, to do with the Economics of Organization. I will briefly comment on the last two explanations.

Posner's explanation of differences in the compensation of CEOs in the US and Europe by differences in the degree of ownership dispersion does not say that the compensation of CEOs in the US is excessive while that in Europe is not; he simply says that the former is greater than the latter, which leaves the possibility that both are excessive. The reason for this ambiguity is that Posner offers no acceptable criterion for an appropriate (or efficient) level of CEO compensation. What Posner offers as a definition of excessive compensation is hardly useful: ‘Compensation is “excessive” in an economic sense when it is greater than it would be if agency costs were zero’ (p. 8). By this criterion, almost all compensation could be argued to be excessive in the sense that we cannot really imagine an organization without agency cost. Indeed, one can easily find many cases of what one may find as excessive compensation in non-profit organizations (for example multi-million dollar compensation for some US college presidents and quite a few professors at medical schools) as well as governmental organizations. Posner appears to use some unstated criteria to make the judgment about the compensation of American CEOs, even as he argues that one of the distinguishing hall-marks of the economics of organization is rigor and formalism.

Without addressing the issue of whether or not CEO compensation in Europe is excessive as well, Posner simply observes that the reason why American CEO compensation is greater than that in Europe is the differences in the degree of ownership dispersion, the degree of dispersion being higher in the US than in Europe. The greater degree of dispersion of ownership, Posner reasons, causes less incentive for the owners to closely monitor CEO compensation. But Posner's explanation raises more questions: has the degree of ownership dispersion in the US increased relative to Europe only recently? If so, have the consequent increases in American CEO compensation put US firms at disadvantage? It is not clear whether this is the case. If indeed the greater dispersion of ownership and the resultant excessive CEO compensation causes inefficiency, why do we see increasing dispersion, and not the opposite? If it is truly the case that the excessive American CEO compensation is inefficient and there is no private force to remedy the situation, are we to introduce regulations to encourage a greater concentration of ownership? How? Etc.

Posner's more unusual explanation for the differences in the CEO compensation between the US and Europe is envy, which presumably acts as a stronger deterrent against excessive CEO compensation in Europe than in the US. Posner posits that Europeans are more prone to be envious, which, in turn, induces the European CEOs to settle for a lesser compensation than their American counterparts in their attempt to mollify the envious. Americans, however, are envy free; Posner observes how even American CEOs try to hide the true extent of their compensation, possibly to avoid envious backlash from the public.

Envy, a powerful tendency fueled by a suspicion of injustice committed by the fortunate, can become quite destructive, as the envious will not be satisfied unless the envied are ruined, even at great costs to themselves. Where the envious can freely vent their demands for ‘justice’, where there is the corresponding fear of envy by the fortunate, the entrepreneur will naturally become more cautious and restrained. A society with less secure private property rights to protect the fortunate will frequently succumb to a mob's demand for justice to level down. Therefore, if Richard Posner is right in observing that there is less envy in the US than in Europe, resulting in greater compensation to American CEOs, it should show up as greater entrepreneurial spirit in the US.

Even as I believe that envy is an important factor in shaping politics and socio-economic outcomes, I do not find Posner's explanation of the observed differences in the compensation of CEOs, by the differences in the propensity for envy (and the fear thereof), has much to do with the economics of organization as he himself proposes it. Instead, Posner's approach seems to resemble American institutionalism.

In contrast to his judgment on the CEO compensation of the privately held American corporation, Richard Posner finds that both the US Federal judicial system and the Continental system have worked ‘reasonably well’. Commenting on the US Federal Judicial system, on the levels below the Supreme Court, Posner observes that there are many reasons why one would worry about the agency cost in the judicial system ‘designed to insulate the judges from the normal incentives and constraints that determine the behavior of rational actors’ – judges are appointed for life, with almost complete discretion, with almost complete impunity, and no meaningful chance for career advancement. Judges cannot only shirk, but they can indulge in personal whim and even sabotage the legislative intent. Yet, Posner believes that the Federal judicial system has performed relatively well.

The reason for this is, in part, the selection process of appointing judges at a relatively old age when judges’ characters and habits are well formed and not likely to change and, in part, by judges’ concern for reputation. In the case of district judges, they do not want to be known as slackers nor do they want to be reversed upon appeal. A minority of circuit judges may be constrained by the doctrine of stare decisis as well, to the extent that they want to influence the direction of the law. The most important restraints, according to Posner, are professional norms developed through the qualifying processes for judges – law school, a successful career prior to appointment to judgeship, etc. (However, there is no such saving grace for privately held business corporations, says Posner.) Despite all the potential problems arising from agency cost, Posner argues, the US federal judicial system has effectively handled the explosion of litigations in the US by means of summary judgment or settlement, effectively supplementing the sloppy legislation by judicial ‘rule making’, and by providing a cover for politicians for unpopular verdicts.

Interestingly enough, in Posner's organizational economics the organizational form seems to matter little when it comes to a well-functioning judicial system – whether it is the bureaucratic ‘career judiciary’ of Continental Europe or the lateral-entry system of US judiciary. Posner argues that both judicial systems work reasonably well. However, Posner does not offer, as with his discussion of the publicly held private corporations, any explicit criteria of judgment on the performance of a judicial system. As a sitting appeals court judge, he may be intimately familiar with the process. But the reasoning for his judgment is not open for inspection for others. Moreover, some people may observe that ‘judicial activism’ of judges is a problem, instead of a desirable attribute that Posner thinks it is. Judicial activism can be argued to be called for by sloppy legislations, but it can introduce considerable uncertainty and raise transaction costs substantially.

Posner's observations on the contrasting judicial systems leave one to wonder about the real reasons for their relative good performance, even if we agree that it is an acceptable proposition. Relying so much for the reasons why the judicial system works tolerably well on the goodness of the qualifying process of federal judges leaves much unexplained, relying on unexamined outside factors. One may wonder how either system would function if either organization were introduced to a less developed country that desires to emulate the success of the advanced countries. The new-fangled judicial system would not necessarily work so well. One has only to look at many former non-settler colonies of the West that have adopted either system. Usually one finds very corrupt judges and a great deal of dissatisfaction with the existing judicial systems. I wonder how Judge Posner would explain the performance of judicial systems in these places with his economics of organization, without resorting to the study of institutions, formal and informal, beyond organizations in question.