Service Report 18

Cooperative Theory: New Approaches

ABSTRACT

COOPERATIVE THEORY: NEW APPROACHES, edited by Jeffrey S. Royer, Cooperative

Management Division, Agricultural Cooperative Service, U.S. Department of

Agriculture.

This report contains nine papers on cooperative theory relating to operations, market behavior, 

decisionmaking, finance, and other aspects of farmer cooperation. These papers were written as 

part of an ACS project intended to stimulate research and thinking on practical aspects of 

cooperative theory. This report does not represent an exhaustive theory of cooperatives, but 

presents new approaches to thinking on several topics. In addition to answering some questions, 

these papers ask others in an attempt to encourage more thought.

Key words: cooperatives, cooperative theory, cooperative principles, operating procedures, 

methodology, structure, behavior, economic coordination, collective action, markets, 

decisionmaking, competition, finance.

ACS Service Report 18

July 1987

FOREWORD

Since Ivan Emelianoff's dissertation on the "Economic Theory of Cooperation" in 1942, a 

number of U.S. researchers have made contributions toward further developing a theory of 

cooperation. These contributions often have come in waves as concerted efforts have been made 

to strike new directions, or to formulate refinements to the evolving economic theory of 

cooperation. Notable waves of activity can be identified with Frank Robotka (1947) and Richard 

Phillips (1953) at Iowa State University; Sidney Hoos and Peter Helmberger at the University of 

California (1962); Peter Helmberger and James Youde at the University of Wisconsin (1966); 

and George Ladd and Jeffrey Royer at Iowa State University (1978). Others also have made 

individual conceptual contributions such as those by Aaron Sapiro and E. G. Nourse, which 

predate Emelianoff, and subsequent refinement by writers at various stations on a more sporadic 

basis.

As various researchers have made contributions to an evolving theory of cooperation, significant 

changes have been occurring in the size, complexity, and direction of the cooperative business 

institution itself. A number of regional cooperatives have evolved into complex, multipurpose, 

multistate industrial organizations. Theories developed for single-purpose local cooperatives are 

found wanting in conceptualizing activities of these complex organizations. At the same time, 

management schools have advanced various behavioral, game, and other theories that have 

potential application to cooperative businesses and ultimately to an extended cooperative theory.
It is with these facts in mind that a need was perceived for refocusing attention of researchers 

upon cooperative theory. The Agricultural Cooperative Service-USDA served as a catalyst to 

augment this probe through cooperative research agreements with a number of universities to 

encourage further research. The papers found herein represent the product of these theoretical 

investigations. Together they represent the latest "wave" of probings into the evolving theory of 

cooperation.

Work does not stop here but must be encouraged to continue. This proceeding represents efforts 

toward pushing the frontiers of knowledge on this business form toward new heights.

Randall E. Torgerson

Administrator

Agricultural Cooperative Service

PREFACE

The nine papers contained in this report were written as part of an ACS project intended to 

stimulate research and thinking on cooperative theory. ACS invited researchers interested in 

conducting studies on cooperative theory to submit research proposals. These papers are the 

result of research agreements between ACS and the University of Connecticut, Michigan State 

University, the University of Missouri-Columbia, and Virginia Polytechnic Institute and State 

University.

The project consists of three phases. In the first, the authors met as a group several times to 

discuss important cooperative problems and theoretical perspectives. The participants of these 

discussions wrote numerous working papers based on this interaction and input from colleagues, 

ACS researchers, and cooperative leaders. These working papers were freely exchanged for 

further discussion and criticism.

In the second phase, the authors met once again--to plan the contents of a "book of essays" on 

cooperative theory and assign themselves the topics represented in this report. The nine papers 

contained herein benefit greatly from the working papers and the cross-fertilization stimulated by 

them. After the authors wrote the papers in this report, the papers were circulated for further 

input and the authors had the opportunity for revision. Each paper was reviewed by at least two 

other authors and an ACS researcher.

In the third phase of the project, ideas from these papers and the working papers are to be 

integrated into an ACS research report useful to cooperative managers and directors. John Staatz 

of Michigan State University currently is working at this task.

We appreciate the efforts of the authors, who worked hard and thoughtfully on the papers 

contained in this report:

Andrew M. Condon, University of Vermont

 Ronald W. Cotterill, University of Connecticut

 V. James Rhodes, University of Missouri-Columbia
James D. Shaffer, Michigan State University

John M. Staatz, Michigan State University

We also extend our appreciation to these ACS reviewers for providing their valuable time: James 

R. Baarda, K. Charles Ling, Thomas H. Stafford, Donald W. Street (now with the Foreign 

Agricultural Service of USDA), and Bruce L. Swanson. These ACS employees spent time 

cleaning up the manuscripts after they were converted to our word-processing system: Deborah 

Cooper, Loraine Hill, Nellie Jones, and Greer Ross. Mary Hoke did the final formatting and 

prepared the camera-ready copy. I also would like to thank Charles Kraenzle, who reviewed 

many of the manuscripts and helped coordinate the project, and Gene Ingalsbe, who provided 

technical editing and advice. Finally, we acknowledge the efforts of Eileen van Ravenswaay of 

Michigan State University, who was an early participant in this project and contributed working 

papers and constructive reviews, and Peter Vitaliano of the National Milk Producers Federation, 

who while at Virginia Tech provided early leadership for the project and helped coordinate the 

reviews.

Jeffrey S. Royer

Editor
THE METHODOLOGY AND REQUIREMENTS OF A THEORY 'OF

MODERN COOPERATIVE ENTERPRISE

Andrew M. Condon

Methodology: The science of method or orderly arrangement; specifically,

the branch of logic concerned with the application of principles of

reasoning to scientific and philosophical inquiry. (Webster's Seventh

New Collegiate Dictionary)

Researchers and policy analysts are reexamining the role cooperatively

organized business plays in the U.S. economy. The growth in size and

importance of cooperatives in certain sectors of the economy, such as

agricultural input supply and the processing-marketing of fibers, dairy

products, grains and fresh produce, causes concern that these organizations

may be creating some of the problems they originally were intended to

mitigate. Of particular concern is the potential for the exploitation of

market power in those industries or areas where cooperatives dominate. In

addition, there is an emergent need to understand the economic nature of

cooperative enterprise to determine its appropriate role in a changing market

environment where government policy and budgetary support of agricultural

markets for the purposes of price and income stability is becoming

increasingly unpopular. To address these issues properly, economists must

have at their disposal a sound theory of cooperative enterprise to interpret

and predict the behavior of these complex organizations.

The purpose of this paper is twofold. The first part of the paper is devoted

to exposing some fundamental methodological issues related to maintaining a

research program in cooperative enterprise. I will examine the debate about

appropriate methodology in neoclassical economics in the context of the

constraints conventional interpretations impose on what is considered

researchable or scientific problems in the area of business firm

organization. The necessary components common to any economic theory will be

outlined. The nature and role of assumptions in economic theory will be

examined to demonstrate the advantages of incorporating operational reality

into the assumptions economists use to construct economic models. In the

case of economic theories of firm organization and, in particular, a theory

of cooperative organization, the inclusion of operational assumptions implies

an explicit accounting of the impacts of the system of resource property

rights to ownership and control of a firm which makes cooperative enterprise

unique from other forms of organizing economic activity.

After having laid the methodological foundation for the inclusion of

ownership and control rights into a theory of cooperative enterprise, the

second part of this paper will explore some of the new directions cooperative

research should take as a result. Note that the intended purpose is to

expose these relationships and their potential impact on the behavior of

cooperative firms in the hope of guiding future research efforts. This paper

should be considered as a first step in the process of developing a more

meaningful theory of cooperative enterprise.
Methodological Role of Property Rights

in a Theory of Economic Organizations

The primary objectives of this paper are to establish the theoretical

foundation for incorporating property rights into a theory of cooperative

behavior and to suggest how such an inclusion will change the orientation of

research into cooperative enterprise. The logical first step in the process

is to determine the conceptual role of property rights in the construction of

an economic theory. Most economic methodologists agree that all economic

theory shou d consist of a specific set of common and identifiable

components. 1 Because the property rights to ownership and control in a

firm define the limits of choice over resource use in that firm, it will be

shown that property rights fall into a category of economic assumptions that

must be empirically verifiable. Machlup calls such assumptions the "assumed

conditions" of economic theory (1978, _p. 148).

The need for realism and verification of assumptions in economic theory has

been subject to considerable debate over the years. Much of the confusion

has arisen due to a lack of recognition that a number of functional levels of

assumptions exist, .each with a specific purpose in the construction of

theory. It will be shown that the assumptions reflecting the relevant set of

property rights governing a firm fall into this category.

A Brief History of the 

Most economists will maintain that our discipline operates under an

established methodology with commonly understood and accepted rules of

Method010 7

reasoning. In particular, most would view as desirable a common set of

standards from which to construct theories and test their validity. The

concept of a universally accepted methodology of economics is comforting

because it means that all economists

book. We need not c are fully analyze

operate more 0r less from the s ame rule

each and everypiece of researc h to

identify the logic of reasoning and assure ourselves that this logic has been

employed correctly.

methodologist, logician, and philosopher conduct sound research and to read

In short, every economist need not be a practiced

and review the quality of their colleagues' work.

It will be assumed that in the discipline of agricultural economics, we

operate under the belief in a common method of reasoning and a common general

theoretical structure. It remains to decompose the components of this

theoretical structure and determine to which component the assumptions

reflecting property rights belong. A brief examination of the historical

evolution of the method of economic argument will be useful in accomplishing

this task.

The Structure of Economic Argument According to Classical Economists--The

process of reasoning and structure of theory employed by twentieth century

neoclassical economists can be understood more clearly when contrasted to the

methodology espoused by nineteenth century classical or political

economists. Classical economic arguments were made with what Blaug and

others call the "a priori" method. As is evidenced by the following quote

from Senior, general principles of human economic behavior were asserted and

2
known to be unambiguously "true" from introspection, possibly in combination

with casual observation of the world.

. . . a very few general propositions, which are the result of

observation or consciousness, and which almost every man, as soon as he

hears them, admits, as familiar to his thoughts. (Bowley, p. 43)

Such principles generally included statements of the desire to maximize

wealth, aversion to labor or sacrifice, and the pursuit of consumption.

Often more specific assertions were included, for example, that rate of

population tends to increase faster than the means of subsistence, or that

agriculture is subject to long-run diminishing marginal returns.

The key to understanding the difference between the methodological approaches

of classical and neoclassical economists is the concept of verification as

interpreted by Mill, Cairnes, and, much later, Blaug.

We cannot, therefore, too care fully endeavor to ver

comparing, in particular cases to which we have act

it would have led us to predic t, with the most trus

can obtain of those which have been actually realiz

ify

ess,

twor

ed.

our theory, by

the results which

thy accounts we

The discrep ancy

between our anticipations and the actual fact is often only circumstance

which would have drawn our attention to some important disturbing cause

which we had overlooked. (Blaug, p. 59.)

It is always regarded as the strongest confirmation of the truth of a

physical doctrine, when it is found to explain facts which start up

unexpectedly in the course of inquiry. But the ultimate principles of

Political Economy, not being established by evidence of this

circumstantial kind, but by direct appeals to our consciousness or to our

senses, cannot be affected by any phenomena which may present themselves

in the course of subsequent inquiries . . . nor, assuming the reasoning

process to be correct, can the theory which may be founded on them. We

have no alternative but to assume a disturbing cause. waug, P* 81)

Thus, in economics, as Mill had explained, we test the applications of

theories to determine whether enough of the disturbing causes have been

taken into account to explain what actually happens in the real world

after allowing, in addition, for noneconomic causes. We never test the

validity of theories behavior by virtue of these assumptions, which in

turn are true by virtue of being based on self-evident facts of human

experience. (Blaug, p. 77)

Predictions of economic behavior were derived based on these general

principles. However, empirical testing of these predictions was never

intended to prove or disprove the validity of the theory because it was

already assumed that the general principles were undeniably true. Comparison

of predictions with observations of the world was intended only to determine

under what circumstances the theory could be usefully applied.

In applications of classical theory, predictions always were said to be

subject to "disturbing causes." These disturbing causes are what we now

3
recognize as noneconomic influences and ceteris paribus conditions. If the

predictions of theory did not hold up to empirical scrutiny, classical

economists did not doubt the theory, but rather attributed the discrepancy to

the influence of uncontrolled disturbing causes.

To summarize, verificationists make predictions based on general economic

principles held to be unquestionably true. These predictions may be tested

against observed data, but only to determine when and where disturbing causes

will not interfere with the general tendencies of theory. The theory can

never be refuted by empirical data, only confirmed.

The Structure of Economic Argument According to Neoclassical Economists--Most

twentieth century economic reasoning and theory can be characterized by

Popper's concept of **falsification.*' Falsification begins with recognition

of what has been called the problem of induction. No universal statement can

be logically derived or established by singular statements, but any universal

statement can be refuted with the aid of‘deductive logic by a single

contradicting statement (Blaug, p. 12). No matter how many times the sun

rises in the morning, we cannot prove conclusively the proposition that it

always will rise in the morning by using, as evidence, observations that it

has always been so. However, with a single observation of the sun not rising

some morning, we have conclusively refuted the proposition.

Falsification requires the formation of propositions about some phenomena

that are capable of generating predictions that, in turn, are capable of

being tested against observation. These predictions must be formulated in

such a way so as to establish clearly the conditions that will demonstrate

the proposition false. The prediction must be inconsistent with some

event(s). If, upon empirical examination, the prohibited event(s) occur, we

have discredited the hypothesis. Popper defines as science the body of

propositions that can be falsified and nonscience as those propositions that

cannot be falsified (p. 43).

In Popper's view,

intent to refute it.

science is a never ending process of testing theory with

Stern warnings are issued against the use of what are

called Wnmunizing stratagems" which insulate a theory from falsifying

tests. Such stratagems include unspecified or loosely constructed "ceteris

paribus" conditions which, upon falsification, prevent the researcher from

knowing if the theory failed to predict accurately or if some vague and

unaccounted auxiliary condition influenced the result. The most extreme

interpretation of Popper envisions scientists as searching for the single,

ultimate test of falsification. If a hypothesis fails this test, the entire

theory is invalidated. More sophisticated interpretations recognize that no

such ultimate test exists, particularly in social sciences where a test of

theory necessarily includes a test of predictions conditional on auxiliary

assumptions (Blaug, p. 17). Popper, suggests that a theory is well

corroborated if it generally stands up to falsifying tests and successfully

predicts results that are not also predicted by competing theories.

The difference between *'verification" and "falsification" as approaches to

structuring and examining theories is illustrated most clearly in the context

of empirical analysis. "Verificationists" do not envision empirical evidence

4
as testing the validity of the predictions of a theory but rather its

appropriate application. Remember, the theory is already assumed to be

true. "Falsificationists" view empirical tests of predictions as tests of

theoretical validity.

The Testing of Assumptions in Economic Theory--Popper does not adequately

address the role of the assumptions that comprise a theory. He does not

specify whether the criteria of "falsification'* apply only to the hypotheses

generated from assumptions, or also to the assumptions themselves.

Hutcheson was one of the first to introduce Popper's work to English-speaking

economists. Hutcheson took the extreme or naive view of *'falsificationism,'*

attacking any form of "a priorism" or introspection. He maintained that many

of the basic assumptions employed in economic theory to that point in time

were irrefutable and therefore unscientific. Hutcheson proposed, as did

Popper, that economic inquiries be limited exclusively to statements that

were testable by empirical analysis. However, unlike Popper, Hutcheson seems

to require not only that the predictions of theory be "falsifiable," but also

the basic assumptions from which the predictions were derived.

It does not matter in principle whether the specification of the

conditions of a test of this theory is obtained 'directly' and

'independently,' or by working back 'indirectly' from specified tests of

the conclusions to the assumptions from which the conclusions are

deduced. (P* 481)

Hutcheson is saying that equally valid tests of a theory may be obtained

either from direct empirical examination of the predictions or through

empirical examination of the validity of the assumptions.

Hutcheson's attack on "a priorism" began a debate on the proper components of

economic theory that continues to the present day. Students of scientific

and economic theory such as Bridgeman, Samuelson, and Gorden argued in

support of Hutcheson by insisting that all theoretical economic statements

must be operationally meaningful. An economic proposition must imply a

"hypothesis about empirical data that could be refuted, if only under ideal

conditions" (Samuelson, p. 4). Samuelson concluded that using the criteria

of "operationalism,'* the modern theories of consumer behavior and welfare did

not represent valid economic constructs (Blaug, p. 100).

Gorden suggested that operational criteria could and should be applied to

mental operations as well as physical. As a result, introspection may be a

valid technique for generating assumptions if the assumptions meet

operational criteria. For example, we may know in our hearts that managers

of firms maximize profits, but we must be able to demonstrate this behavior

to use profit maximization as a valid economic assumption, Purely logical

statements that are generated from introspective tautologies are not

operational and cannot be used in economic theories (P . 49) .

Gorden maintains that an "operational statement implies the existence of

stable functional relationships among specified economic variables. By

5
stable is meant the ability to successfully predict changes in the dependent

variable of a function over a reasonable period of time.

As an example of the use of propositions in theory that are not operational,

Gorden offers the Law of Demand and the resultant prediction of a negative

relationship between own price and quantity. Based on operational criteria,

the following statement is without empirical content and therefore invalid:

Assuming that prices of related commodities and the tastes and incomes of

buyers are given or constant, then there is a relationship between price

and sales with a negative slope. . . . (P* 50)

The statement does not prohibit any event from occurring. It cannot be

empirically refuted. If both price and quantity should fall, then incomes,

other prices, or unobservable tastes have changed and the theory appears

equally capable of explaining both positive and negative demand responses. A

demand curve is not stable if it can account for either contradictory

occurrence. This statement could be made operational only if the relevant

ranges of the "ceteris paribus" conditions are explicitly stated and checked

for validity.

The other side of the debate has been argued most vocally by Friedman and

Machlup. Friedman counters the concept of "operationalism" with the notion

of positive science. The goal of positive science is the development of

theories that "yield valid and meaningful (i.e., not truistic) predictions

about phenomena not yet observed** (1953, p. 26). Positive theories must have

certain attributes. A theory should be simple; it should require as little

knowledge and data as possible to predict events. A theory should be precise

in prediction and yet address as wide a field of phenomena as possible. ---

Theories also must be logicallv consistent (p. 27).

A theory or hypothesis (equivalent in Friedman's usage) is valuable only

insofar as its predictions coincide with observation. For Friedman, theories

are black boxes for generating predictions and, as such, their basic

assumptions need not be realistic (read "operational"). In fact, if

assumptions are unrealistic, they may be more desirable if they are more

simple as a result. Because, in Friedman's view, theories can and should be

unrealistic, it is logical folly to interpret an empirical test of

assumptions as a direct test of the validity of the theory. Friedman's

"irrelevance-Of-assumptions** thesis has been criticized on a number of

counts, mostly stemming from what is considered by many a naive view of what

assumptions are and the role they play in theory construction. Friedman

generally treats assumptions as homogeneous elements, with little recognition

that different categories of assumptions exist, each with a distinct

theoretical role. This point will be dealt with in greater detail in the

following section on components of theory.

Another criticism leveled at Friedman arises from a confusion as to what is

meant by realism in assumptions. Assumptions may or may not be realistic in

a number of different senses. Assumptions may be abstract in that they

describe the behavior of only a subset of the variables that affect the

economic phenomena in question. An attempt is made to include only the most

6
salient influences in a model. Assumptions may be realistic in the sense

that they "ascribe motives to economic actors that we, fellow human beings

find comprehensible" (Blaug, p. 105). The pursuit of economic opportunity is

a understandable objective for a human being. However, we could not explain

profit-seeking by assuming religious adoration of money, even though both

statements might imply similar behavior. Finally, assumptions might be

unrealistic in the sense that they are patently false in the light of

observed behavior.

Friedman's does not seem to intend that assumptions should be patently false,

but rather that assumptions should be abstract:

The relevant question to ask about 'assumptions' of theory is not whether

they are descriptively 'realistic,' for they never are, but whether they

are sufficiently good approximations for the purpose at hand. (1953, p.

31)

However, he confuses the debate and sometimes leaves the impression that

factually false assumptions are acceptable if they lead to theories that

predict well:

Truly important and significant hypotheses will be found to have

'assumptions' that are widely inaccurate descriptive representations of

reality and in general, the more significant the theory, the more

unrealistic the assumptions. (1953, p. 30)

Machlup, an opponent of operationalism, interprets this concept as applying

to all economic propositions, including fundamental assumptions. He finds

that theories constructed of purely operational statements become "'low level

generalizations' or 'statements of empirical uniformities and regularities"'

(1978, p. 192). He believes that the fundamental assumptions of theory ought

to be "pure constructs" that are "a priori? in nature because:

The roughness, or degree of exactness, of empirical concepts depends upon

the technical possibilities provided by the state of the arts. The

impurities and inaccuracies inherent in most or all practicable

operations with sensory observations destroy the logical links between

different concepts. But, without logical interrelations, the

propositions containing these concepts do not afford logically necessary

conclusions. In the possibility of deducing such conclusions l'e the

sole purpose and value of a theoretical system. (1978, p. 197) $

Machlup argues that operational or empirical constructs have only two uses in

economics: "(1) when one has to decide what kind of theoretical apparatus

will be suitable for answering particular questions, and (2) when one wishes

to verify or test the theoretical apparatus" (1978, p. 201).

There is strong evidence to suggest that while most applied economists would

attest to some form of the positive school, the actual practice of economic

reasoning may be quite different. McClosky argues that the practice of

"modernism" (which he defines as a curious mixture of positive science and
operationalism) is impossible and not followed by economists no matter what

they say.

Modernism promises knowledge free from doubt, metaphysics, morals, and

personal convictions; what it delivers merely renames as Scientific

Method the scientist's and especially the economic scientist's

metaphysics, morals, and personal convictions. (Pm 488)

McClosky offers the Keynesian model as an example of a contradiction to

modernism in modern economics. Empirical formulations of Keynes'

macroeconomic ideas were not attempted until the 195Os, well after most

macroeconomists had adopted Keynesian theory as their world view. The

adoption of a theory before its predictive power has been demonstrated is

surely the positivist's equivalent of mortal sin.

McClosky recommends that we examine closely how economics actually has

progressed instead of artificially dictating how we think it ought to

progress. In addition to falsification, economists employ a host of tools to

argue that a hypothesis has merit. McClosky invites us to examine and become

aware of what he calls the rhetoric of economics,

package of techniques we use to arguFour science.

which includes the complete

Two often used, but little understood, techniques economists employ are

standards of comparison and metaphor. Economists often employ a statistical

criterion to decide whether data supports the predictions made by a

hypothesis. McClosky argues that statistical criteria alone are arbitrary

and do not reflect economic standards of judgment. One economic standard of

comparison that often is overlooked is the consequences of being wrong. When

we make predictions based on statistical criteria, we should know what

associated economic loss function is in terms of misdirected policy or poor

advice. McClosky recommends that in addition to statistical criteria,

economists must explicitly set down mutually agreed-upon economic standards

(as opposed to purely statistical standards) for accepting or rejecting a

hypothesis (pp. 496-97).

A second argumentative and communicative technique often overlooked is the

power of the literary metaphors economists use to convince. All economic

theories, hypotheses, and models are, by virtue of their abstraction,

metaphors. We are telling '*stories*' to instill a higher degree of

understanding about how the infinitely more complex real economy operates. A

metaphor is not merely an ornament to make prose or poetry more pleasing to

read. It is a device that in the words of Max Black, "has the power to bring

two separate domains into cognitive and emotional relation by using language

directly appropriate to one as a lens for seeing the other" (McClosky, p.

496). Do we really believe Gary Becker's children are "durable goods," or

through use of a carefully considered metaphor do we immediately understand

that within the household production unit (another metaphor) children play a

unique role? Does the demand for food not stretch very well if it is

"inelastic" or have we discovered something about the relationship between

price and revenue? McClosky asks us not to become upset at the realization

that economists tell stories, but rather to understand that this is part of

how we convince and that we need to explicitly recognize the metaphors we

8
use, their effectiveness in imparting the precise message we desire, and

their power to persuade in argument.

McClosky's realization that there are a number of ways to make economic

arguments may seem inconsistent with the positive economist's view of

science, but it does not really challenge the positive structure of economic

theories. Most economists still will maintain that there is no fruitful way

to directly test the fundamental assumptions of neoclassical microeconomic

theory such as rationality, consistent preference ordering, and the resultant

postulates of utility and profit maximization. They would agree with

Friedman and Machlup that any such test would have little bearing on the

validity of a economic theory because these statements are perceived to be

introspective and intended to impart ideals. However, as Machlup (but not

Friedman) and others recognize, there are multiple levels of assumptions in

economic theory, each with a specific role and each requiring a different

degree of operational realism. In the following section, these levels of

assumptions will be detailed and the role of property rights assumptions in

theory will be identified.

Components of Economic Theory

The general purpose of any economic theory is to provide a framework for the

analysis, understanding, and prediction of economic behavior. Theory gives

meaning to the events economists observe. From theory we derive hypotheses,

which, upon testing, should allow us to explain current economic behavior and

predict likely future behavior, subject to the suitability of our ancillary

conditions. Theory forms the core of what Kuhn refers to as the research

paradigm, which includes not only assumptions and hypotheses, but also the

appropriate tools of analysis and argument and the world view that defines

what are the interesting questions for economists to address.

Much of the confusion that arises from the debate over the components of

economic theory occurs as a result of a lack of mutually agreeable

nomenclature. Though labeled differently, most methodologists seem to agree

on a theory's basic components, if not their purpose and attributes. The

purpose of this section is to establish what the components of an economic

theory are and to demonstrate that certain classes of assumptions should

exhibit a degree of realism in the context of being subject to empirical

examination.

One of the most straightforward and informative descriptions of the

components of economic theory is to be found in Silberberg. Because of its

brevity, Silberberg's discussion is a good starting point from which to

examine the structure of modern microeconomic theory. Silberberg argues that

economic theory has three basic components. The first is a set of assertions

or postulates that are idealized, heuristic statements about how the actors

and constructs (i.e., consumers, firms, prices, quantities, etc.) that

comprise the economy are expected to behave. These postulates are general in

nature and are usually of the form "all X have the property P.** Examples

given of the assertions of microeconomic theory include profit and utility

maximization.

9
The second part of an economic theory is a set of test conditions, called

assumptions, whose purpose is to relate the abstract and ideal notions of

human economic behavior expressed by the assertions of theory to real world

conditions. Such conditions are necessary due the nature of the "laboratory"

in which economists must work. Because it is impossible to establish

controlled experiments of the nature found in, for example, the physical

sciences, economists must employ restrictive assumptions about the behavior

of variables over which they have no control and which could affect the

outcomes of hypothesized behavior. Examples of assumptions as defined here

are statements like "the price of bread in the theoretical assertions, in

fact corresponds to the price of bread posted at xyz supermarket on such and

such date" (p. 7) or Yeteris paribus" conditions such as "all other prices,

incomes, and tastes constant." Silberberg properly maintains that

assumptions defined in this way must be operational with respect to the

"essential aspects of the theoretical constructs" to give the theory

relevance (p. 8). This means that the assumptions of theory must adequately

and realistically describe the important economic variables treated by the

theory.

The final component of economic theory according to Silberberg is a set of

observable events that are either explained or predicted by the theory.

While this may seem a trivial point, a theory whose hypotheses explain or

predict outcomes that cannot be observed is of little practical value.

Similarly, hypotheses cannot be tested if data is required that is

unobservable, either directly or by adequate proxy. For example, suppose we

generate a hypothesis that predicts that the property rights structure

inherent to cooperatives constrains member-patron investment horizons

relative to certain other modes of organizing business, resulting in changed

patterns of investment. Such a theory is of little value if we cannot

measure a curtailed investment horizon or we cannot establish an observable

causal link between the property rights structure and the firm's investment .

behavior. In either case, the theory would be empty in content. Care must

be taken that we do not generate hypotheses that seem to explain a great deal

but are not operational and therefore cannot be tested or refuted.

Melitz provides a convincing argument for factual realism in certain classes

of assumptions. A close reading of Friedman shows that even though he argues

against factual realism in any assumption, he recognizes that some

assumptions represent fundamental statements of behavior while others are

implied statements that result from the assertions (p. 36). Melitz defines

this distinction more clearly as generative assumptions and auxiliary

assumptions. Generative assumptions are equivalent to Silberberg's

fundamental assertions and are used to derive the postulates of theory.

Auxiliary assumptions are used in conjunction with generative assumptions to

deduce operational predictions. Melitz maintains that auxiliary assumptions,

and quite possibly generative assumptions, benefit from operational validity.

Auxiliary assumptions that are either false or untested (or both) reduce the

predictive power of theories because of the increased probability of a

hypothesis being consistent with false results. Note that this probability

is not equal to one because it is possible to reach true conclusions from

10
partially false premises. The lack of empirically verifiable auxiliary

assumptions in economic theory may lead to ambiguity of prediction.

Melitz makes a strong argument for operational attributes in auxiliary

assumptions, but we still are left with a rather vague notion of what exactly

these assumptions are and what their role in theory is. Are all

nonfundamental assumptions to be tested? If so, how rigorously? We observe

the use of assumptions in economic theory that are clearly not fundamental

statements of human economic behavior (i.e, they serve as auxiliary

assumptions) but are so generally defined that definitive empirical

verification would be difficult if not impossible. Are such assumptions

valid? To answer these questions, we need a conceptual framework of

theoretical structure that is more detailed than those offered thus far.

Machlup offers the most comprehensive classification of the components of

economic theory found to date. As do most other authors, he initially

divides assumptions into two general categories, fundamental and specific.

Specific assumptions he further categorized by application, frequency of

change, and the need for rigor in testing. Figure 1 reproduces his

classification scheme.

Two additional components are proposed, assumed changes and deduced changes.

The assumed change component of a theory is a description of the economic

problem to be addressed. A proposition is made describing some change

occurring in the economic system. Such propositions usually must be

operational to have relevance (1978, pp. 148-49). The deduced change

component of a theory is the predicted result of the theory or hypothesis

that is subject to empirical test. By definition, this component must be

operational for the theory to have value. It is worth noting that the

deduced change corresponds exactly to Silberberg's concept of observable

events.

The correspondence between proposing a problem and predicting an outcome is

found in the assumptions that form the core of the theory. These assumptions

form the causal mechanism that allows us to observe economic phenomenon and

/ to deduce -predictions, which, upon successful testing, will demonstrate the

value of the theory.

The assumed type of action or fundamental postulates are the, by now,

familiar, fundamental statements of economic behavior. As explained,

fundamental postulates generally are not subject to direct empirical

verification because of their '*a priori,** ideal, or abstract nature. Machlup

does require that these fundamental statements meet a requirement of realism

in the sense that the behavior specified by a postulate, though ideal and/or

abstract in nature, must suggest behavior that humans find reasonable and

understandable (1978, p. 153).

Machlup makes his most significant contribution to understanding the role of

property right assumptions in the structure of economic theory in his

exhibition of the various classes of specific assumptions or assumed

conditions. These statements define the personal characteristics,

technological or organizational circumstances, market forms, and institutions

11
Figure l--Machlup's model of the components of economic theory

ASSUMPTIONS ON OBSERVABLE DEPENDENT

AND INDEPENDENT VARIABLES

Assumed Change:

Specific assumption

regarded as cause or

disequilibrating

variation

.

Deduced Change:

Conclusion regarded

as outcome or equilibrating variation

THE "MACHINE" OF PURE THEORY

Assumed Conditions:

A: As to type of case

*

I

1

I

I

B: As to type of

setting

\

i * +

C: As to type of

economy

J

Assumed Type

of Motivation

or Fundamental

Postulates

Source: Machlup 1978.

12
affecting the economic problem under study (1978, p. 150). Assumed

conditions are subdivided into three classes according to the type of

circumstance defined and the frequency with which it might be expected to

change.

The first class of specific assumptions refers to conditions that affect type

- - of case; i.e., circumstances that may change from problem to problem and that

have potential to influence outcomes. Examples of this kind of condition

include definitions of the goods involved, cost conditions, elasticities,

degree of competition, ease of entry, general expectations, the propensity to

consume or save, and liquidity preferences (1978, p. 150).

The second class of specific assumptions refers to conditions that affect

type of setting . These are conditions that may change from time to time, but

not in every case. Such settings might include the stage of a business cycle

or the limitations imposed by the economic policy currently in place. These

conditions are not likely to change with every new problem examined but

rather with events such as a change in government (1978, p. 151).

The final class of specific assumptions defines conditions of type of

economy. Such conditions may change from country to country or over large

periods of time but are sufficiently stable to be considered "given" at any

particular time or particular place. These conditions generally define the

legal and environmental constraints under which the economy must operate.

Included in this list of conditions are assumptions reflecting legal and

social institutions, private property, freedom of contract, corporation law,

and enforcement of contracts (1978, p. 151).

Because assumed conditions form the link between fundamental postulates of

behavior and actual economic conditions, they must exhibit some degree of

operational validity. Machlup maintains that verification of such conditions

is appropriate, but the degree of rigor need not be great. He uses terms

like "casual," and "impressionistic" to describe the nature of empirical

testing required. The justification for reduced rigor in testing of specific

assumptions lies in their varied nature (i.e., the multitude of possible

conditions), difficulty in observation, and the inherent degree of theorizing

involved in establishing the conditions. In addition, the degree of rigor

required for testing assumed conditions declines with the frequency with

which the conditions change (1978, p. 151).

In summary, a number of students of the methodology of economic inquiry have

provided us with specific set of components that all economic theories must

contain. Though different terminology is used, the function of each of these

components is the same in every case. Each author distinguishes between

assumptions that describe fundamental or ideal statements of human economic

behavior and assumptions that attempt to describe the particular social and

economic environment in which the theory is to be applied. In the latter

case, most agree that these assumptions should exhibit some degree of

operational realism if the theory is to have relevance to solving real

economic problems. In the following section, it will be shown that

assumptions reflecting property rights to ownership and control of a firm's

13
resources properly fall into the class of assumptions in economic theory that

must be operational.

The Structural and Functional Roles

of Property Rights in Economic Theory

The purpose of this section is to argue that assumptions reflecting the

property rights to ownership and control of resources in firms' organization

should be explicitly incorporated into models of organizational behavior. To

accomplish this objective, it will be necessary to define what property

rights are and to identify their specific role in the context of economic

organization. Property right assumptions can then be assigned a

methodological role in the context of Machlup's model of economic reasoning

previously presented. The determination as to whether property right

assumptions need to factually realistic can then be made.

A Definition of Property Rights--Considering the relative wealth of property

rights literature in economic journals, surprisingly few examples exist that

precisely define what property rights are or how they evolve. Generally,

property rights are defined only in terms of what they accomplish rather than

their specific nature. While terse definitions often are not very useful in

contributing to the understanding of complex social institutions such as

property rights, for the purpose of assigning a methodological role, we need

to know something about what property rights are as well as their function.

Consider the following definitions, found in important contributions to the

property rights literature:

Property rights specify the proper relationships among people with

respect to the use of things, and the penalties for violations of those

relationships. (Randall, p. 148)

In the rights of a person to a resource, we include the probability that

his decision about demarcated uses of the resource will result in that

use, in the sense that his decision dominates that of any other person.

(Alchian, p. 237)

Property rights describe the relationship of one person to another with

respect to a resource or any line of action. . . . Rights are the

instrumentality by which any society controls and orders human

interdependence and resolves the question of who gets what. (Schmid, p.

5).

All of these definitions are cloaked in terms of what property rights do

rather than what they are. The statements form a basis for determining the

probable impact of property rights, but nothing can be gleaned that can

assist in understanding how property rights change and evolve. What is the

economic incentive for instituting a particular set of property rights? With

respect to the theories of firm organization, the question might well be

put: What factors determine the organizational structure actually adopted by

a firm? The answer to this question is crucial to understanding the role of

cooperative enterprise.

14
A key to understanding how a particular set of rights comes about is to

recognize that they are social institutions that evolve to meet the interests

of a segment of society with the power to establish and enforce them. As the

needs of society change over time and are identified, so will the property

rights that govern resource use (Hite, p. 78).

The following definition synthesizes what is known about the structure and

form of property rights to ownership and control of the economic resources of

a firm, as well as their function.

Property rights are social institutions, expressed as legal restrictions,

that are devised to place constraints on how the resources available to

an economy may be used. Property rights specifically address: (1) who

may make decisions over a particular resource's use; (2) who will bear

the risk of gain or loss as a result of employing the resource in some

productive activity; (3) for how long the right may be considered valid,

(4) the circumstances under which the right can be transferred; and (5)

the penalties to be incurred for violations of the restrictions imposed

by the right.

The Nature and Function of Property Rights to the Resources of a Firm--A

neoclassical economic firm usually is defined as a single owner-operated

technical entity. Consider the following definition, variants of which can

be found in almost every advanced microeconomic textbook:

A firm is a technical unit in which commodities are produced. Its

entrepreneur (owner and manager) decides how much of and how one or more

commodities will be produced, and the gains the profit or bears the loss

which results from his decision [sic]. An entrepreneur transforms inputs

into outputs, subject to the technical rules specified by his production

function. The difference between his revenue from the sale of outputs

and the cost of his inputs is his profit, if positive, or his loss, if

negative. The entrepreneur's production function gives mathematical

expression to the relationship between the quantities of inputs he

employs and the quantities of outputs he produces. (Henderson and

Quandt, p. 52.)

The property right structure implicit in this statement implies that the

resources available to a neoclassical firm are pure private property

resources. Rights to resource use are privately held and fully allocated to

individuals. The single agent responsible for making decisions (the

entrepreneur) that determine how resources will be combined, assumes 100

percent of the risk entailed in the outcomes of those decisions. The

entrepreneur may transfer these rights to anyone else without restriction.

The firm as described by this definition represents only a subset of the

economic organizations we can observe that produce goods and services in an

economy. A complete list of such organizations would include sole

proprietorships, partnerships, investor-owned firms (IOFs), nonprofit

organizations, mutuals, labor-managed firms, and cooperatives.

15
The factor that distinguishes each of these economic organizations lies in

the nature of the set of property rights that describes ownership and control

of the resources these organizations employ. The theory of the firm, with

its implicit assumption of a single owner-manager, would appear to describe

only a single element of the economic organizations we observe. We are left

with two alternatives: (1) to develop an individual model of behavior for

each of the alternative modes for organizing economic activity or (2) to seek

an encompassing theory of economic organization within which the theory of

the firm would represent a valid subset.

Fortunately, the ground work for a theory of economic organizations based on

property rights has been established in the research of Fama; Jensen and

Meckling (1979a, 1979b); Jensen; and Fama and Jensen. We are asked to view

an economic organization not as a technical entity but as an established set

of legal relationships between all the agents who have dealings with the

organization. In the words of Jensen and Meckling, an economic organization

is the:

Nexus of contracts, written and unwritten, among owners of factors of

production and customers. These contracts or internal 'rules of the

game' specify the rights of each agent in the organization, performance

criteria on which agents are evaluated and the payoff functions they

face. (1979b, pp. 170-72)

Considering the working definition of property rights previously established

Jensen and Meckling have defined an economic organization as the sum of the

property rights of those who contribute resources to the firm and purchase

its goods and services. Fama and Jensen maintain that the rights that are of

prime importance in defining the structure of an organization are those that

specify the nature of residual claims and the allocation of the decision

process among agents (1983a, pp. 302-4).

An organization has two kinds of claims to the gross cash flow it generates.

Certain prespecified payments are contracted to agents for goods or services

supplied to the organization. Wages, repayment of debt, and taxes are

examples of such fixed claims. The residual claim is the right to the net

cash flows of the organization after all fixed obligations have been met.

Residual claimants are the riskbearers of the organization (Fama and Jensen

1983b, p. 328). The residual claims of any organization have four

identifiable characteristics: (1) ownership, (2) alienability, (3)

redeemability, and (4) ownership horizon. Any restrictions on the ownership

of a residual claim means that the role of riskbearing in the organization is

tied to some other agent role. For example, partners usually must assume

both decision management and decision control rights to hold the residual

claim. Alienability refers to the ease with which a residual claim may be

transferred from one person to another. A completely alienable claim may be

bought or sold with out restriction. Transfer of the residual c

4

aims of some

organizations may be limited to agents who meet certain criteria or

transfer may be prohibited entirely. Redeemability refers to the ability to

demand, at a specified price, return of the equity that was used to purchase

the rights to residual riskbearing in an organization. Redeemable claims are

16
a feature of financial mutuals where the entire asset base generally is

liquid. The ownership horizon refers to the length of time for which the

residual claim is valid. An unrestricted claim is valid for the life of the

organization. Restricted horizons are often associated with restricted

ownership residual claims. For example, the residual claim of a labor

production cooperative is valid only so long as the owner remains an

employee.

Fama and Jensen decompose the decision process of any organization into two

general categories: (1) decision management and (2) decision control (1983a,

p. 304). Decision management includes the right to initiate and implement

approved decisions. Decision control includes the right to ratify or choose

the decision to be implemented, the right to measure performance and the

right to set the reward of decision managers.

The reason why Fama and Jensen consider these particular property rights as

crucial in determining the organizational structure of a firm is the

existence of what are called agency costs. Agency costs arise because the

individual agents, bound together bycontract in an organization, are utility

maximizers. These individuals will seek to maximize their own interests

given the available opportunities. Agency costs include the expense of

making, monitoring, and enforcing contracts among the agents of a firm to

ensure that those with conflicting interests do not usurp the wealth of

others. In addition, agency costs include the value of wealth lost because

the cost of full enforcement of a contract will exceed its benefits (Jensen

and Meckling 1979b, p. 104).

Separation of residual rights and decision rights occurs in many types of

organization because of economies to be gained from specialization of

riskbearing (the residual claim) functions and decision functions. However,

an agency cost is created because those who make decisions are not

necessarily residual claimants and therefore may not bear the full

consequences of their decisions. The case of the IOF serves to illustrate

this process. In the IOF, residual rights and decisionmaking rights are

separated because technology and/or market conditions dictate large capital

investments and economies of scale are necessary. Residual claimants' wealth

can be increased through specialization of the riskbearing and management

roles. A potential agency cost is created because the majority of

consequences of management decisions fall on the residual claimants, i.e.,

the stockholders. Managers could be in a position to make decisions that

further their own interests4

at the expense of stockholder wealth. Fama

and Jensen hypothesize that we observe the separation of decision control

rights from decision management rights in an IOF to control this source of

agency cost. Managers have the right to initiate and implement a particular

decision, but the right of approval and evaluation is placed in the hands of

a board of directors who presumably must act in the interests of current and

future residual claimants.

According to Fama and Jensen, a given economic organization can survive only

if it, 'I. . . delivers the product demanded by customers at the lowest price

while covering costs" (1983a, p. 301). Survival means producing at the

lowest possible cost, including agency costs. The function of property

17
rights to the resources of a firm becomes clear in an economic environment of

survival. The rights to the residuals and the decision process of a firm are

structured so as to minimize total agency costs.

The nature and function of property rights to ownership and control of

resources in an economic organization can now be summarized. Property rights

have been defined in general terms as social institutions' that restrict the

ability of individuals to impose costs on others through the use of

resources. Property right systems evolve to protect the interests of

segments of society with the power to enforce them. With respect to economic

organizations, property rights assign and define the limits of the roles of

residual riskbearer, decision manager, and decision controller. 'Such rights

are manipulated in the interests of agent groups to minimize the total agency

cost involved in producing a good or service. These manipulations result in

the various kinds of economic organizations we observe. In the following

section, what has been learned about the nature and function of property

rights in the context of economic organization will be applied to the

methodological task of classifying the role of property right assumptions in

economic theory.

The Methodological Role of Property Rights in Economic Theorv-The question

to be addressed in this section is whether the assumptions reflecting the

structure of property rights in a firm need to be operational in the sense of

factual realism to construct economic theories that adequately explain and

predict the behavior of firms. From a methodological perspective, if it is

necessary to explicitly represent the property rights structure that

determines an organization's structure, then a justification has been

established for incorporating these assumptions into a theory of cooperative

enterprise.

The appropriate criterion of judgment must be whether property right

assumptions fulfill the requirements of assumed conditions as defined by

Machlup. In the last section, the function of property rights to a firm's

resources was established as defining the roles and limits of risk bearing,

decision management, and decision control. In general terms, property rights

were shown to determine a firm's organizational structure. In Machlup's

terminology, the assumptions describing the property rights to the resources

of a firm would appear to fall into one of two categories under the

subheading of assumed change: conditions that describe type of setting or

conditions that describe the type of economy in which the firm must function.

The ambiguity is due to Machlup's dual classification criteria. Assumptions

describing assumed conditions are categorized according to both purpose and

frequency of change. Property right assumptions would appear to fit into

conditions describing type of economy because this category includes "legal

and social institutions; private property; freedom of contract; . . . and

enforcement of contracts" (1978, p. 151) which is a fairly complete list of

the attributes of property rights as described in the last section. However,

Machlup also maintains that condition describing the type of economy will

vary from country to country over long periods of time and are "'settled' for

a sufficiently large number of cases to justify taking these conditions as

18
constant" (p. 151). Conditions describing type of setting are said to be

able to change over brief periods of time (p. 150).

The property right structures governing the use of the resources of a firm in

a given economy are not nearly as homogeneous as Machlup.would have us

believe. Assumptions defining these rights are properly classified as

"assumed conditions" reflecting the "type of economy,** but they cannot be

treated as constant across all organizations within a given economic system.

Models attempting to describe or predict firm-level behavior must incorporate

a realistic and verifiable set of assumptions reflecting the appropriate

rights structure governing that particular firm type.

Summary

The purpose of this section has been to demonstrate, from a methodological

perspective, that explicit treatment of property rights is appropriate in the

formation of economic theories of firm-level behavior. The ultimate intent

is to provide both a justification and a conceptual basis for incorporating

property rights into a theory of cooperative enterprise. This task has been

accomplished by carefully documenting how modern economists construct and

test theories, what the methodological components of these theories are, and

where among these components assumptions reflecting the property rights

governing firm-level resource use belong.

A brief history of the evolution of economic methodology has demonstrated

that falsification is the principal, but not exclusive method, whereby

neoclassical economists test the validity of theory. However, falsification

does not imply Friedman's "irrelevance of assumptions" thesis where accuracy

in prediction is the only requisite of economic theories and therefore the

assumptions of theory do not need to be operational.

A detailed analysis of the components of economic theory reveals that there

are two general classes of assumptions. Fundamental assertions establish

ideal and often abstract statements of human economic behavior. The other

class of assumptions defines the socio-economic environment under which a

hypothesis will be tested. Operational realism in this class of assumptions

was shown to increase the explanatory and predictive power of economic

theory.

The property rights to ownership and control of resources in a firm were

found to define the roles of residual claimant, decision manager, and

decision controller in an economic organization. The manipulation of these

property rights was shown to control the problem of agency cost. It is this

manipulation of property rights within economic organizations that determines

the different organizational structures that are observed. This concept of

economic organization will provide the foundation for incorporating the

impact of property rights into a theory of cooperative enterprise.

The final task of this section was to take what was learned about the nature

and function of the property rights to the resources of a firm and use this

information to classify the methodological role of property rights

assumptions in the context of Machlup's model of the components of economic

19
theory. Property rights define the economic environment in which

organizations must operate. As such, property right assumptions belong in

the category of "assumed conditions'* describing the "type of economy." As

was previously demonstrated, this category of assumptions must exhibit some

degree of operational realism if the resultant theory is to have relevance.

Requirements of a Theory of Cooperative Enterprise

The first section of this paper attempted to illuminate some important

methodological issues with respect to the construction of a theory of

cooperative enterprise. In the following sections, the issues such a theory

of cooperative enterprise needs to address will be discussed. The knowledge

gained about the role property right assumptions in the first section of this

paper will lead to an explicit examination of some of the important

relationships governing the structure, ownership, and control of cooperative

firms. Specifically, the motivations of the various agent groups that

comprise a cooperative will be explored.

Motivations of the Agents that Constitute Cooperative Enterprises

In the following discussion, repeated reference will be made to the concept

of an uent within the context of firms with complex organizational

structures such as IOFs or cooperatives. Usually economists refer to an

agent as one who acts on behalf of another. Because the term is used in a

slightly different context here, a clarification is in order. Neoclassical

microeconomic theory conceives of firms as exclusively entrepreneurial

units. A single agent, the entrepreneur, holds the rights to make all

production and business-related decisions and the rights to bear the residual

risk of gain or loss as a result of these decisions. Note that in this

context the term agent does not only imply one who acts for another but also

includes those who act for themselves. Employing the usual neoclassical

postulates, the entrepreneurial firm is presumed to maximize profits subject

to a budget constraint and a known level of technology. In the

nontheoretical economy, we observe firms in which the entrepreneurial rights

to make decisions (decision management), to monitor decisions (decision

control), and to bear residual risk of gain or loss (the residual claim) may

be vested in a number of different agents. To maximize profits in the sense

of the neoclassical firm, we must assume that the major agent groups, i.e.,

stockholders, management, and directors, can be without cost constrained to

act toward a single objective.

In a similar manner, our most commonly employed model of cooperative

behavior, based on the work of Helmberger and HOOS, implicitly assumes that

all agents within a cooperative are without cost constrained to behave in the

singular and homogeneous interest of members. This assumption follows from

the traditional micro view of the firm as an entrepreneurial entity where

ownership and control are vested in the same agent. In more complex

organizational forms, the assumption of a singular firm objective is a

potentially misleading simplification. A cooperatively organized enterprise

has at least three identifiable major agent groups, each of which may have

goals that complement, supplement, or conflict both among and within groups.

20
These agent groups are the member-patrons, the board of directors, and - -

management.

The purpose of this section is to demonstrate that the usual microeconomic

assumptions with respect to agent roles in a firm are inadequate for the task

of describing the complexities of cooperative enterprise. The motivations

and resulting constraints each major agent group brings to the cooperative

firm will be examined. It will be argued that explicit treatment of agent

roles and constraints within cooperatives or any other complex firm type will

provide new insights into the economic behavior of these organizations.

The Role and Motivation of Members in a Cooperative--Past theories of

cooperative enterprise have approached the issue of member motivation from

quite different perspectives. Emelianoff and Phillips viewed members as the

sole decision agents in a cooperative. Members would decide the level of

patronage to supply based on equating the sum of their own operation's

marginal cost plus an appropriate segment of the joint-plant marginal cost

function with the marginal revenue produced from the cooperative sale of

product. The appropriate segment of the cooperative plant's marginal cost

curve was argued to be that which began after all other members had made

their production decisions. Thus, in the cooperative of Emelianoff and

Phillips, members exhibit Cournot-like behavior by implicitly assuming they

can make production decisions without regard to subsequent adjustments by

other members.

Enke presented a model of consumer cooperative behavior where members may

pursue a number of alternative goals, each with different implications for

firm performance and equilibrium. Enke demonstrated that the level of

production that results in a maximization of the sum of cooperative producer

and consumer surplus is optimal from a standard welfare perspective.

However, within the context of his model, members may be more concerned with

their share of the firm's surplus (based on patronage) than the firm as a

whole (Vitaliano). Successful pursuit of individual consumer surplus would

result in a level of business where average cost is minimized. Enke's

welfare goal for the cooperative would require that price be set where

marginal cost equals average revenue. Enke admitted that the actual

equilibrium a cooperative would attain will depend on the goals and

bargaining strength of members' interests relative to management's, but he

provided no mechanism for such bargaining. While Enke's model contains a

number of serious flaws, it is the earliest attempt at a model that allows

for trade-offs among differing group objectives.

The Helmberger and Hoos model of cooperative enterprise assumes that all

members are profit-maximizers and that no single member firm is large enough

to affect the price the cooperative pays, i.e., members are price-takers with

respect to their cooperative. No other role is specified for members. This

assumption reduces member participation in the cooperative to an aggregate

supply function response. In addition, this assumption contributes to the

formation of the operating condition that cooperatives will operate to

maximize the per-unit payment price to members.

21
Historical theories of cooperative enterprise have placed a great deal of

emphasis on how members perceived the impacts of their patronage decisions on

others in the organization. Resolution of this issue is vital if member

behavior is to be modeled correctly. However, the ultimate answer is

unlikely to be found in either the awkward marginal response curves of

Phillips, the vague multiple-objective func ion of Enke, or the Helmberger

and Hoos simplistic member supply function. 5

It is not difficult to conceive of still other alternative member objectives,

consistent with rationality, that would lead to hypotheses and conclusions

quite different from these. Members may view the cooperative as providing

long-term access to input or output markets that an IOF cannot guarantee.

Such an objective would require a dynamic analysis including an understanding

of how members discount future versus current returns. Members also may view

the cooperative as an institution for reducing the unique risks faced in

production agriculture. In particular, farmers have relatively large amounts

of capital invested in undiversified, specialized-use assets such as land,

buildings, and equipment. Having all their "eggs in one basket," producers

may view the cooperative as a mechanism to avoid exploitation of their risky

positions by concentrated upstream and downstream markets. Cooperatives also

reduce short-term producer price risk through pooling. The implications of

these and other alternative member objectives cannot be adequately addressed

in the context of a static maximization model that assumes a world of perfect

certainty.

The Role of Director Boards in Cooperative Enterprise--The role of elected

directors remains an ignored issue in cooperative theory. This failure of

existing theory to explicitly examine the role of directors in cooperative

enterprise seems to imply by default that their intended purpose is to act as

representatives of the common entrepreneurial interest of members. As

previously suggested, the interests of members can differ due to reasons of

size, risk preference, and perceived discount rate of future returns. A role

that directors may play that is consistent with the traditional micro view is

the reconciliation of diverse and potentially conflicting members so the

cooperative makes decisions that contribute to the long-run benefit of the

cooperative firm.

Directors form the link between the large-group, decisionmaking process of

members and the actual decisions adopted by the cooperative. Olson has

demonstrated that small groups may be able to make decisions that large

groups cannot, even if the common interest is served. Under this view,

directors establish policy for operation of the firm, rectify major

operational decisions taken by management, and monitor management behavior to

ensure the protection of member interests however they are expressed or

perceived.

Thus far, nothing has been revealed about the role of directors of a

cooperative that conflicts with the neoclassical theory of the firm or the

Helmberger and Hoos models. However, the structure of the board of directors

encountered in cooperatives is sufficiently different from that found in the

IOF so one is compelled to ask why. The typical board found in an IOF is

made up of a combination of "inside" members who are usually representatives

22
of management or major stockholders and "outside" members who are respected

for their expertise but who have no financial interest in the firm. In

contrast, the board of most cooperatives is made up entirely of elected

member-patrons whose primary experience is related to farm management and who

typically have little prior experience in controlling the affairs of a large

and complex business enterprise. There are important exceptions to this

norm, particularly in the case of interregional agricultural cooperatives

where some board members are representatives of the management of constituent

regional cooperatives and others may be selected as "outside" directors.

The unique structure and role of the board of directors in a cooperative is

hypothesized to be a function of the unique set of property rights embedded

in cooperative enterprise. For this reason, discussion of board structure

and the impact directors may have on the performance of cooperative

associations will be left to the following section on the impact of

cooperative property rights.

The Role of Management in Cooperatives --The Helmberger and Hoos model of

cooperative behavior holds that management is constrained to operate within

the limits dictated by a firm-wide objective function (i.e., maximization of

per-unit price paid for member-supplied input) despite the fact that the

authors have maintained that organization theory allows for alternative

management behavior.

Other historical treatments of cooperative theory are worth mentioning

because of the polar manner in which they treat the role of management. Enke

was the earliest of formal cooperative theorists and the only early writer to

suggest an active role for management. He specified a number of possible

management objectives and strategies, including member-price minimization and

the avoidance of hostile behavior on the part of business rivals. He

maintained that the ultimate managerial role will depend on the voting

strength of the interest groups in a cooperative (p. 153). The possibility

of an independent managerial agenda distinct from member interests was not

considered.

Most other early writers followed Emelianoff and Phillips in specifying that

there was little or no role for management in cooperatives. These writers,

including Clark (1952a); Aizilnieks; Aresvik; and Robotka, believed that all

decision activity emanated solely from member firms. Ohm followed the

Phillips model but specified a coordinating role for management. Savage and

Trifon opposed the Phillips model and insisted that cooperatives had an

independent economic existence apart from member firms in that some decisions

were clearly made at the cooperative plant level by directors and management.

Those models that do specify an active role for management in cooperatives

relegate such activity to the operation of a well-expressed, single-purpose,

objective function. Yet, conditions may exist that would afford managers the

opportunity to pursue goals other than those that could be considered

strictly in the interest of members. Informational, institutional, or

structural constraints may be present that prevent any manager from achieving

a specified, firm-wide goal or acquiring the information necessary to do so.

In addition, constraining management to act exclusively in the interest of

23
members is not costless (Jensen and Meckling 1979b). The level of

expenditure of monitoring resources on the part of members or the board

required to ensure maximization of member interest may be excessive. The

marginal cost of monitoring and enforcement may exceed the marginal benefit

generated. Another condition that could allow managers to pursue other

objectives is the cooperative% structural inability to generate certain

information related to the quality of management performance. Because the

generation of this information is a function of the unique set of property

rights that defines a cooperative, discussion of this issue will be left to

the following section.

Economists have proposed a number of objectives a firm's manager might follow

if allowed the latitude to do so. Such objectives include the maximization

of some form of firm revenue (Baumol), firm growth rate (Marris), or

managerial amenities (Williamson). More recently, Jensen and Meckling

(1979a, 19798) and Fama and Jensen (1983a, 1983b) offered a more general

theory in which all agent groups within a firm (owners, directors, employees,

management, etc.) will pursue the objective of constrained personal utility

maximization. Managers will act so as to maximize the value of their

pecuniary and nonpecuniary reward. Pecuniary awards are based on salary and

contractual performance incentives specified by the firm. Nonpecuniary

rewards are based on the utility gained from actions that managers perceive

will increase their present and future stock of human capital and by such

personal amenities as good working conditions, large and cooperative staffs,

prestige, etc.

The behaviors implied by agent utility maximization clearly allow for

conflict with operation of a firm at maximum profit (IOF) or maximum per-unit

payment price (cooperatives). Managerial behavior can be partially

constrained by expending resources on monitoring and contractual incentives,

but this process is costly and imperfect. Models of cooperative enterprise

that are constructed without at least considering the effects of the types of

described here must leave open the possibility of biased results.

The Impact of Property Rights

on Cooperative Structure and Performance

The concept of a property right refers to the probability that an

individual's decision over the use of a particular resource will determine

that use (Alchian). This simple, yet informative definition of a property

right leads us to a discussion of what is perhaps the most important and

overlooked distinction between cooperative enterprise and other forms of

organizing business. There exists a number of definitions of what a

cooperative is, yet the essential distinction from other firm types lies in

the basic restructuring of the property rights relating to control over

resource use and the rights to the benefits or loss (residual risk) generated

by the business enterprise. In an IOF, control over how resources are used

and the rights to residuals ultimately rest in the hands of the owners of

common stock in the organization. Decision control is based on the share of

capital invested, and decisions are assumed to be judged on the merits of the

returns generated by that capital. In a cooperative, the basic property

rights governing ownership and control are structured so that decision

24
control and the rights to residuals rest solely in the hands of those who

patronize the firm as members. The possible reasons behind this alteration

of property rights, particularly in the case of agricultural cooperatives,

were discussed in the earlier section on member motivations.

The issue of how changing property rights may affect the structure and

performance of cooperatively organized firms is completely ignored in current

models of cooperative behavior that employ some variant of the

entrepreneurial theory of the firm. The theory of the firm assumes a given

and constant distribution of property rights for all types of business

organization. The Helmberger and Hoos model of cooperative enterprise merely

manipulates by assumption the standard objective function of a

profit-maximizing firm so that the firm itself earns no profit. In this way,

traditional analysis focuses on price and output determination and treats any

impact changing property rights might have on cooperative firm performance as

a nonexistent issue. The following discussion will attempt to show that

explicit treatment of the effects of property rights may reveal impacts on

the organizational structure and performance of complex firms.

As previously mentioned, the essential difference between the structure of

property rights defining a cooperative and IOF is the restriction of ultimate

decision control and the rights to firm residuals to those who patronize the

firm as purchasers of goods or users of services. Ancillary to this

restructuring of rights is the fact that cooperative firm control is

generally based on one-member/one-vote terms and not by share of capital

invested. In addition, because membership and control in such organizations

is restricted to patrons, these rights have value only as long as the member

firm or individual remains an active patron. In agricultural cooperatives,

this restriction on membership limits the term of decision control and

residual claim on the firm to the active working life span of the

member-producer.

A number of impacts on cooperative organizational structure and performance

are suggested by this change in basic property rights. The first impact

relates to the unique structure observed in the cooperative board of

directors. In an IOF, the rights to ownership and control are traded openly

on the stock market. Jensen and Meckling (1979b) and Fama and Jensen (1983a)

have maintained that if the stock market can be considered a perfect market,

then, among other things, stock prices will perfectly reflect the quality of

management decisions in a given IOF. Firms whose stock is considered

undervalued due to poor management are subject to takeover by rival firms.

It is hypothesized that this process serves as a partial constraining force

on management to act in the interests of stockholders or face loss of their

livelihoods. In a cooperative, the rights to ownership and control usually

are not transferable; thus there can be no market for these claims. No

information is generated by a secondary market for use in the evaluation and

control of management behavior in cooperatives. It can be hypothesized that

this loss of an important control mechanism is responsible for the observed

structure of the board of directors in a cooperative; i.e., that directors

are required to be member-patrons of the firm to replace the control

mechanism on management that is lost due to the effect of the property right

that prevents useful information about management performance from being

25
generated. Because they have a direct and personal interest in the

well-being of the firm, board members are less likely to condone behavior

that they perceive as not serving the general interest of members.

It has now been shown that the lack of marketability and limited life span of

the rights members hold in a cooperative firm may have bearing on the

organizational structure of these firms. It remains to be shown that

property rights also have potential to affect the performance of a

cooperative firm as compared to an IOF. Accepting the assumption of a

perfect market, the stock held in an IOF is considered to have an infinite

horizon in that stock prices should reflect investors' expectations with

regard to the present value of the returns to investments in the firm

regardless of the length of the income stream to be generated by the

investment (Fama). However, in a cooperative, there is no secondary market

for ownership and control rights and a member cannot capture the benefits

from an investment beyond the term for which he or she remains active. Upon

retirement from a cooperative, members typically are returned only the

original face value of any outstanding equity capital they have invested in

the firm (Baarda). Members can capture economic gains from the firm only

through patronage. Therefore, the member may:perceive the value of the

income stream generated by such an investment as truncated by his or her

expected term of membership. An investment would not be judged acceptable

unless the present value of returns generated by the truncated income stream

was deemed adequate.

Cooperatives whose membership behaves in this ma

relative to IOFs that perform the same function

investment portfolio may be skewed towpard shorte

case, Fama has shown that the portfoli 0 of inves

whose residual claims are limited in h.orizon wil

to firms whose claims have infinite ho rizon.

nner may e

or the dis

r-term pro

tments ado

lbe notb

ither underi

tribution of

jects. In e

pted by a fi

e optimal re

nve

t h

ith

rm

lat

st

eir

er

ive

The adverse effects of the investment horizon problem in cooperative

enterprise may be overcome, to some degree, by inclusion of certain features

into these firms' organizational structures. First, because it is the board

of directors that ultimately ratifies investment policy, a concentrated

educational effort to convince directors of the necessity of guarding the

long-term interests of their firms may help to overcome the built-in

incentive for members to maximize shorter-run interests. Secondly, it may be

possible that the horizon problem is eliminated if there exists another

mechanism whereby members can capitalize the present value of investments

whose stream of future returns extends beyond their expected term of

membership. In the case of agricultural cooperatives, it could be

hypothesized that the present value of future investments is capitalized into

the value of a member's fixed assets, e.g., the value of farmland. In the

simplest example, the farmland of a producer may become more valuable in

areas where there is access to a cooperative than in cases where there is

not, ceteris paribus. Further, farmland values may fluctuate with relative

performance of the local marketing or supply cooperative, ceteris paribus.

Unfortunately, experience with research into the constituents of farmland

value has demonstrated that is quite difficult to separate empirically and

measure the various components contributing to land prices. Finally, in

26
cases where farmers can pass cooperative membership to succeeding generations

and they perceive utility in doing so, the horizon problem may be

ameliorated.

At this point, it is reasonable to ask why it is important to know how a

changing set of property rights will affect the performance of cooperatively

organized firms, i.e., what policy implications can be drawn from the

knowledge that cooperatives may follow an investment pattern different from

an IOF performing the same function. If cooperatives invest inefficiently

relative to IOFs in industries that require longer-term commitments of

capital, then, from society's point of view, resources will be better

utilized if government does not subsidize entry into these industries. The

investment horizon problem may provide at least a partial explanation of why

cooperative organization in the U.S. economy is rarely observed outside the

agricultural sector. The marketing and supply activities of agricultural

cooperatives require investments that generally are of a short-term nature

(relative to member horizons). However, a cooperatively organized firm in

the steel industry (e.g., a labor-managed firm) may be at a disadvantage due

to the long-term nature of returns to investments in plant, equipment, and

research and development.

The effect property rights have on cooperative organizational structure and

control features also have important policy implications. If the hypothesis

that the structure of the cooperative board of directors replaces the unique

control function that is lost due to the lack of a secondary market for

residual claims proves valid, then it can be expected that this control

function will weaken as organizational hierarchies emerge that are further

removed from the member-patron and member-director agricultural experience.

The emergence of the giant interregional agricultural cooperative in such

areas as petroleum products, equipment manufacture, and international export

of commodities in recent years has led to boards of directors consisting of

agricultural producers who may have little experience in the complexities of

their cooperative's lines of business. Directors may feel incapable of

judging the quality of management decisions. In such situations, the rights

to decision control may be effectively relinquished to management. In

addition, such boards often are partially made up of management

representatives from the constituent regional organizations. Such a trend

could lead to increasing degrees of management control and possibly to

affairs such as the AGRI Industries (Waterloo) and Farmers Export (Rowen)

incidents where a large interregional cooperative apparently became

controlled by management with resultant adverse results for members.

Summary and Conclusions

The first objective of this paper was to justify, from a methodological

viewpoint, the direct examination of the impact of property right assumptions

with regard to their effect on the predictive and explanatory power of

economic theories of business organization, particularly a theory of

cooperative enterprise. Property rights were shown to fall into a class of

economic assumptions that must exhibit a degree of factual realism if the

theory is to have relevance in accurately explaining and predicting the

27
behavior of complex economic organizations. Because factual realism in

certain classes of assumptions to which property rights belong is shown to

enhance -the power of a theory, it is methodologically sound to empirically

examine the validity of property right assumptions either by direct test of

the assumption when possible or by test of the resulting hypotheses generated

by the theory.

Having established the methodological foundation for the explicit

incorporation property right assumptions into a theory of cooperative

organization, the second purpose of this paper was to present and discuss the

new issues that become relevant research questions as a result and have been

largely ignored in conceptual or applied research in the United States. As

more realistic assumptions are made regarding the incentive structure of the

various agents that constitute a cooperative firm and the nature of the

property rights that govern cooperative ownership and control, testable

hypotheses can be formed and examined that will increase our knowledge of how

cooperatives can be expected to function relative to competing firm types.

Specifically addressed are the potential implications of member, director,

and management incentives on firm performance and the impact of cooperative

property rights on organizational structure and performance.

Notes

1 . For examples, see Friedman 1968; Machlup 1978; Melitz; and Silberberg.

2 . It is important to note that after having made this definitive stateme

Machlup goes on to demonstrate that some assumptions of theory need

nt,

necessarily be operational. This will be demonstrated.

3 . For example, it may be necessary for the residual claimant to also become

a partner.

4 . For example, better working conditions, prestige, or an enhanced

perception of worth in the market for managers.

5. It should be noted that while U.S. cooperative theorists have effectively

ignored, for the most part, the issue of conflicting members, director,

and management goals, several foreign writers have made initial attempts

at dealing with the issue. For examples, see Eschenburg; Perrault; and

Pichette.

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Aresvik, Oddvar. "Comments on 'Economic Nature of the Cooperative

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Baarda, James. Personal conversation, 1984.

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Enke, Stephen. **Consumer Cooperatives and Economic Efficiency." American

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Hardie, Ian. "Shadow Prices as Member Returns for a Marketing Cooperative."

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Helmberger, Peter. '*Cooperative Enterprise as a Structural Dimension of Farm

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Helmberger, Peter, and Sidney Woos. "Cooperative Enterprise and Organization

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Henderson, James, and Richard Quandt. Microeconomic Theory, 2nd ed. New

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Hite, James. Room and Situation. Chicago: Nelson Hall, 1979.

Hutcheson, Terrence. The Significance and Basic Postulates of Economic

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Jensen, Michael. "Organization Theory and Methodology." Accounting Review

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32
THE STRUCTURAL CHARACTERISTICS OF FARMER COOPERATIVES AND

THEIR BEHAVIORAL CONSEQUENCES

John M. Staatz

To understand decisionmaking in farmer cooperative firms, it is first

necessary to understand how cooperative firms differ from other types of

businesses. This paper outlines the distinguishing structural

characteristics of farmer cooperatives and, based on those characteristics,

it develops hypotheses about how the behavior of farmer cooperatives, is

likely to differ from that of investor-owned firms (IOFs). The term

"structure," as used in the paper, is defined to include not only the

organizational components of cooperative firms but also basic operating rules

common to these firms, such as distributing net margins via patronage. The

first part of the paper briefly reviews alternative definitions of farmer

cooperatives and identifies several characteristics common to these

organizations. The second, and largest, part of the paper traces through

some of the consequences of these characteristics for the behavior of

participants in farmer cooperatives and develops hypotheses regarding how

that behavior will vary in different circumstances. The final section

briefly summarizes the major conclusions of the paper.

Defining a Farmer Cooperative

Cooperative firms frequently are defined as businesses that are owned by

their patrons and follow at least some of the Rochdale principles, which are

listed by Roy (p. 258) as:

1.

2 .

Net margins distributed according to patronage;

Democratic control --one-member/one-vote;

3 . Limited return on stock;

4 .

5 .

Limitation on the number of shares owned;

Open membership;

6 . Trading on a cash basis;

7 . Membership education in the cooperative way of doing business;

8 . Political and religious neutrality;

9 . No unusual risk assumption; and

10 . Goods sold at regular retail prices, with net margins rebated to

members, rather than discounted retail prices.

Practically no modern cooperatives follow all the Rochdale principles. The

problem of defining a cooperative as a business that follows some of these

principles is that any two cooperatives thus defined may not have any

characteristic in common. Furthermore, while some of the Rochdale principles

may be important in fundamentally defining the structure of cooperatives,

others simply represented prudent business practices at the time of the

33
Rochdale pioneers. The prohibition on credit sales, for example, may have

been appropriate during the 18th century, when the banking and credit system

was relatively undeveloped, but prohibiting present-day cooperatives from

extending credit would place them at a severe competitive disadvantage.

Certain other Rochdale principles, such as the requirements that there be *'no

unusual risk assumption" and that goods be sold at "regular retail prices,"

are so vague as to be nonoperational.

Even the more "fundamental" of the Rochdale principles are not always

followed by farmer cooperatives. Every agricultural cooperative, for

example, follows some form of closed membership, at least insofar as

membership is restricted to farmers. Many agricultural marketing

cooperatives further restrict membership because of limitations in plant

capacity, the desire to ensure product quality, or other reasons. Nor do all

farmer cooperatives follow the one-member/one-vote rule (see Ward, Schneider,

and Lopez).

Given the ambiguity of using the Rochdale principles to define a cooperative,

Schaars (cited by Roy, p. 259) argued that there were only three essential

characteristics of a cooperative:

1 . Service at cost to member-patrons;

2 . Democratic control by member-patrons (where the exact meaning of

"democratic" was left undefined); and

3 . Limited return on equity capital.

A cooperative, in Schaars' view, was a member-controlled business in which

the return to investment was distributed primarily according to patronage

rather than according to ownership of equity in the organization.

Given the variation in cooperatives' practices, it probably is impossible to

devise a concise definition of a cooperative that would be valid for every

organization that appears, on the basis of everyday observation, to act like

a cooperative (Bateman, Edwards, and LeVay). The approach taken in this

paper is similar to that of Schaars: Three characteristics common to most

farmer cooperatives are identified and used to define an "archetypical" or

*'pure" farmer cooperative. These characteristics incorporate and elaborate

on the points covered in Schaars' definition and in the first four Rochdale

principles. There undoubtedly are cooperatives that do not exhibit all of

these characteristics. As Eschenburg (pp. 84-85) pointed out, given the

diversity of these organizations, no one definition or theory of cooperatives

is likely to be comprehensive.

For the purposes of this paper, a farmer cooperative firm is defined as a

business with the following characteristics:

1 . The stockholders, who are farmers, are the major users of the firm's

services.

34
2 . The benefits a stockholder receives from committing capital to a

cooperative are tied largely to patronage. There are three reasons

for this:

(a) The business pays a strictly limited dividend on equity capital

invested in the organization.

(b) Net margins are distributed among stockholders in proportion to

their patronage with the business r ther than in proportion to

their equity ownership in the firm. B

(c) Stock of cooperative firms does not appreciate because there is a

very limited or nonexistent secondary market for it. Therefore,

capital gains are not a major bene it of stock ownership in

cooperatives, in contrast Ito IOFs. f

3 . The formal governance of the business by the stockholders is

structured *'democraticallyf in the sense that:

(a) Voting power is not proportional to equity investment. The

limitation on "voting one's equity" may be in the form of

one-member/one-vote rule, or voting may be proportional to

patronage or stock ownership but subject to some limit such as

restricting any one member from having more than 5 percent of the

total votes.

(b) There are strict limitations on the number of nonstockholders who

may serve on the board of directors.

Implications for Participant Behavior

Each of these three characteristics results in differences between the

incentives faced by participants in cooperatives and those faced by

participants in IOFs. These differences in turn may lead to differences in

the behavior of the two types of organizations.

Behavioral Differences Due to Stockholders

Being Maior Users of the Firm's Services

To the extent that stockholders influence a firm's decisions, one would

expect the decisions of a firm to be different if its stockholders were major

users of its services than if they were not. Cooperative theorists from the

1940s through the 1970s have stressed some of these differences by pointing

out how the objective function of cooperatives might differ from that of IOFs

(LeVay).

Broader Scope for Optimization- -The scope for optimization in a farmer

cooperative is potentially broader and more diffuse than in a competing IOF

that is not vertically integrated into farming. It is broader in the sense

that a profit-maximizing farmer-member would be interested not in running the

farm and the cooperative as separate profit centers but in optimizing the

35
performance of the integrated farm/cooperative system. The scope for

optimization is more diffuse because cooperative returns are distributed

according to patronage, not investment. As a result, the cooperative does

not have one locus for profit maximization but a separate locus for each

member, giving rise to a host of problems that attend collective choice.

These problems are reflected most clearly in de ates within cooperatives

about pricing, financing, and pooling policies. s

The broader scope for optimization in cooperatives may be manifested by

cooperatives taking into account their farmer-members' fixed costs when

making decisions and by differences between the pricing practices of farmer

cooperatives and those of IOFs.

Items that represent fixed costs for the stockholder-patrons may receive

greater consideration in a cooperative's decisions than they would in the

decisions of an IOF because the market transforms the fixed costs of an IOF's

customers or suppliers into variable costs for the firm. An agricultural

processing cooperative, for example, will likely give greater emphasis to

providing its supplier-members a "home" for their product than will an IOF

because the cooperative takes account of the need of its stockholders to

amortize their fixed on-farm production investments. An IOF usually does not

have to deal directly with its suppliers' fixed costs; they are transformed

via the market into the raw-product price that the IOF pays, which the IOF

processor considers as a purely variable cost.

This tendency of farmer cooperatives to give greater weight to their patrons'

fixed costs results in the capital of cooperatives being less mobile than

that of other firms. Farmer cooperatives tend to concentrate their

investments in agribusiness activities closely related to the farming

activities of the member-stockholders because the stockholders might suffer

substantial capital losses if their farming activities were not adequately

supported. These capital losses would not affect the income of stockholders

of an IOF serving these farmers; hence, there would be little pressure on IOF

management to invest in these agribusiness activities if more profitable

opportunities lay elsewhere. One would therefore expect IOFs to shift their

resources in and out of agribusiness more frequently than would cooperatives,

whose assets are tied to those of their stockholder-members.

The vertically integrated nature of a farmer cooperative may also lead to

different managerial behavior than in an IOF because the cooperative may have

to bear certain costs that it could shed onto others were it not owned by its

patrons. For example, a cooperative may be less able to drive a hard bargain

with a unionized labor force than is an IOF. The cost of a strike can be

very high to the stockholders of a farmer cooperative, as it can deny them

access to the cooperative's services at a critical time in the crop cycle.

Whereas an IOF might try to weather a strike by simply shutting down, thereby

shifting some of the cost of the strike onto its farmer-customers, a

cooperative manager who tried this strategy would likely face strong pressure

from the stockholders to settle the strike quickly. The stockholder-user

identity forces the manager to take a more integrated view of the firm's

costs and benefits.

36
Because cooperative firms are owned by their patrons, their pricing behavior

may differ from that of IOFs. Indeed, the rationale for establishing a

"competitive yardstick" cooperative is that the cooperative will price its

services differently than local IOFs, thereby forcing these firms to behave

more competitively. The pricing behavior of cooperatives also may differ

from that of IOFs because cooperative managers recognize that pricing

decisions of a cooperative affect the distribution of income among tke

stockholders. This limits the managers' latitude in setting prices.

In addition, the prices paid or charged by cooperatives have some of the

characteristics of transfer prices in a vertically integrated firm;

potentially they can be adjusted to affect the cash flow and tax liability of

the patrons. For example, patrons in high marginal tax brackets may pressure

the cooperative's management to retain net margins as unallocated equity so

that the tax liability for the earnings accrues to the cooperative, which may

be in a low marginal t

tax bratkets, who also

ax bracke

may face

t, rather than to the members. Patrons in low

cash flow difficulties, often 1.obby for net

margins to be paid to the members as cash patronage refunds. For these

patrons, the tax liability on the refund

$

.s often small compared to its

benefits in terms of increased cash flow.

The cooperative may even eliminate some of the combined member/cooperative

tax liability by converting potential earnings into nontaxable forms, such as

consumer surplus. This can be achieved by using some of the cooperative's

earnings to subsidize the price of consumer goods and services sold to

members. This suggests that cooperatives have an incentive to provide

certain amenities to their members, such as cut-rate life insurance, that are

not directly related to farm production. 6

A cooperative's ability to benefit from its broader scope for optimization

may be limited by two factors: (1) the structure of incentives facing

individual farmer-members and (2) a dearth of common interests among a highly

heterogeneous membership.

Several cooperative theorists (Kaarlehto; Eschenburg; Lopez and Spreen) have

noted that in many situations the interest of the membership of a cooperative

as a whole does not correspond with that of individual members. For a farmer

cooperative firm to take advantage of its broader scope for optimization, the

operations of the cooperative have to be coordinated with those of the

members' farm firms. If incentives exist for the members to operate their

farms in a totally independent manner (e.g., expanding production even though

all members would benefit from a mutual reduction of output), the benefits of

coordination will be lost. These situation

7

often resemble prisoner's

dilemmas and are analyzed in another paper.

Coordination of the cooperative's activities with those of its member firms

also may be reduced if the membership is highly heterogeneous. With a highly

heterogeneous membership, particular ly one in wh ich the member's pert eive

themse Ives as being in opposing camp s (e.g., butterfat producers vs. oil seed

producers), it may be difficult to get members to agree on anything other

than running the cooperative as a separate profit center. This is the

classic problem of collective choice, i.e., trying to find a pattern of

37
behavior for the collective tha

L

faithfully reflects the p

5

eferences of all

the individual members (Arrow). In game-theoretic terms, the core of

the bargaining game between stockholders may collapse to only one

solution- -independent profit maximization of the stockholders' individually

and jointly-owned firms. This does not necessarily mean the farmer-members

are poorly served by such cooperatives. The stockholders may be happy with

the cooperative's performance in the same sense investors in an IOF are happy

with their firm's performance. To the extent that the cooperative operates

as a separate profit center, however, the potential gains to the

cooperative's stockholders from the organization's broader scope for

optimization are lost.

More Diffuse Scope for Optimization: Pooling Issues and Income

Distribution- -In multiproduct or multiservice cooperatives, one of the most

important consequences of the stockholders being users of the firm's services

is that the stockholders become vitally interested in the firm's pricing of

individual goods and services, not simply in its overall financial

performance. The income that a stockholder derives from an IOF depends on

the firm's "bottom line,** but the income of a cooperative's stockholder often

depends more on the prices of the individual goods and services purchased

from the cooperative than on the organization's overall profitability. As a

result, questions of pricing, product pooling, and joint cost allocation

become issues of keen interest to the stockholders. Unlike their

counterparts in an IOF, the stockholders of a cooperative are intensely

interested in the income-distribution consequences of their firm's marketing

and cost-allocation decisions. Members' concerns about those decisions are

likely to be greatest when the members face financial difficulties and hence

cannot "afford" to cross-subsidize their co-members.

Because members of a cooperative who produce or purchase different products

will have different preferences for how the cooperative should set prices and

allocate costs, price setting and cost allocation become much more delicate

issues for management of cooperatives than they are in IOFs. Instead of

representing merely strategic questions about how best to improve the firm's

financial performance, these decisions directly affect the stockholders'

willingness to patronize and contribute financially to the organization.

This stockholder sensitivity to pricing and cost-allocation has two

implications. First, price setting and cost allocation are likely to be more

costly processes in cooperatives than in IOFs. Not only do cooperative

stockholders often demand to be involved in these decisions (e.g., via the

board of directors), but because of the diversity of stockholder interests it

may be difficult to reach a consensus about what the appropriate pricing and

cost-allocation rules should be. In contrast, in an IOF, management often

makes these decisions with no stockholder input whatsoever. Second, a

cooperative's ability to cut prices and employ cross-subsidies to gain market

share may be much more circumscribed than that with an IOF. The stockholders

who, through their patronage of particular goods and services, finance the

subsidies for the discounted items may object to carrying an Wnfair burden"

in the cooperative's quest for an expanded market share. As a result,

cooperatives may be less able than IOFs to enter new fields where gaining a

toehold in the market requires initial price-cutting. This reinforces the

38
tende

If6

y of cooperatives to have a more narrow range of activities than do

IOFs.

Limited Pool of Ecwitv CaDital--A major consequence of tying stock ownership

to patronage is that the potential pool of equity capital for cooperatives

becomes sharply circumscribed. Whereas an IOF can raise additional equity

capital by selling stock to the general public, a farmer cooperative can

increase its equity base only by convincing existing stockholders to

subscribe additional capital or by attracting new farmer-stockholders.

Existing members may be reluctant to subscribe additional capital for several

reasons. The members may operate under absolute capital rationing, requiring

them to invest mostly in their own farm enterprises just to continue

operating. Members also may perceive that the return

the cooperative is lower than in the farm enterprise. 1P

n their investment in

This may occur

because the member's perception is indeed correct, because the member

undervalues investment in the cooperative due to free riding and delays in

receiving allocated patronage refunds, or because the member overvalues

investments in the farm enterprise, such as overlarge and complex equipment.

Attracting new members may be difficult because of geographic limits on the

cooperative's scope of operations and because, in certain cooperatives, only

farmers engaged in particular types of production are admissible as members.

The difficulty in raising equity capital, combined with the "horizon problem"

(discussed later), may restrain farmer cooperatives from entering certain

highly capital-intensive areas of agribusiness, such as farm machinery

manufacture and sales, in which one would otherwise expect them to play an

important competitive yardstick role (Rhodes; Heflebower). In addition, the

difficulty of rebuilding a cooperative's equity base once it has been eroded

may make managers of cooperatives (particularly supply cooperatives)

reluctant to initiate risky activities such as price wars that might threaten

the firm's equity base. In the words of one cooperative manager, "Because

equity cannot be enticed into cooperatives, equity is more sacred: it must

be guarded more carefully** (van Nostrand, p. 86).

In certain types of marketing cooperatives, however, the common practice of

accepting all the raw product that members produce may result in managers

having to cut the price of their processed products to move their inventory.

The threat that such price cutting poses to the cooperatives' equity base has

led many marketing cooperatives to reconsider their policy of providing a

"home" for their members' products.

Risk Aversion- -Farmers invest in agricultural cooperatives as a means of

strengthening their farm businesses. The investment represents a deepening

of the farmers' financial commitment to a particular line of business rather

than a diversification of their portfolios. The tying of patronage to stock

ownership in cooperatives prevents the stockholding from being handled by

specialized agents, such as independent investors in an IOF, who are either

more risk-preferring than the patrons or who can spread their risks by

diversifying their portfolios (Carson; Condon and Vitaliano). Because the

patrons of cooperatives tend to "have all their eggs in one basket,," they may

pressure management to adopt more conservative business strategies than those

of competing IOFs. This is particularly true because farmers' investments in

39
their cooperatives are largely sunk whereas owners of an IOF can "bail out"

if the IOF's investments begin to sour. Furthermore, because of the

immobility of cooperative capital previously discussed, it is more difficult

for cooperatives than for IOFs to spread their risks by diversifying into

totally unrelated activities; hence, management itself may prefer more

conservative business strategies. Consequently, farmer cooperatives may be

more risk-averse than their IOF compe

E$_

'tors, particularly if the latter are

divisions of large diversified firms.

Better Information Flows and Product Specification--The identity of the

patron with the stockholder in cooperatives may lead to better information

flows between patrons and management and better product specification. Part

of the supply cost of a product is the cost of determining the

characteristics of the product desired by patrons. This cost may be lower in

cooperatives because they often are structured in a way that makes it easier

to collect such information. Unlike many IOFs, a cooperative usually has a

list of its patrons and may be able to collect a substantial amount of

information about their production practices and needs by asking the members

to fill out questionnaires on joining the organization and through periodic

member surveys. The members may give more truthful information to the

cooperative than they would to an IOF because as stockholders they are more

assured that the cooperative w*

lit

1 not use the information to act

opportunistically toward them. Furthermore, members of cooperatives have

more channels open to them to communicate their desires to the firm than do

customers of an IOF. In addition to the firm's management and customer

representatives, cooperative patrons have access to the firm's formal

governance structure through the board of directors. Exercising '*voice**

therefore may be cheaper for patrons in a cooperative than in an IOF

(Hirschman).

Greater Loyalty of Patrons --Because the patrons of cooperatives are

stockholders who may have substantial investment in the company, they may be

more willing than customers of an IOF to continue to patronize the same firm

even though competing firms offer goods and services on more favorable terms

in the short run. This willingness to stick with the cooperative even though

there exist short-run incentives to defect is commonly termed "cooperative

loyalty." Such loyalty is not irrational; it reflects the members' belief

that: (a) The short-run performance of the cooperative can be improved if

members stay with the organization and work to remedy the problems; and (b)

Even though there may be short-run incentives to patronize the cooperative's

competitors, in the long run the discounted net benefits from patronizing the

(improved) cooperative are greater than those available from alternative

sources. These net benefits not only include direct monetary benefits but

also the option-demand benefit of having a market alternative to IOFs and the

public-good benefits generated by the cooperative, which would be lost if

members abandoned the organization. Loyalty can help generate monetary

benefits to the members by improving the cooperative's ability to project

demand, thereby reducing inventory costs and facilitating the planning of new

facilities.

One element that strongly influences a member's view of whether there are

long-term monetary net benefits from continuing to patronize the cooperative

40
is whether the rate of return on the member's investment in the cooperative

appears to be contingent on continued patronage. This rate of return has two

components: the return of capital, that is,

investment; and the ret& on capital,

the recovery of the initial

that is, the additional net earnings

engendered by the investment (Gittinger, p. 66). In an agricultural

cooperative, the return of capital, in an undiscounted sense, depends on the

cooperative's equity redemption program. The return on capital is derived

through patronage, through limited interest payments on capital invested in

the organization, and through the cooperative's provision of public and

semipublic goods, such as lobbying. The current return gained through

patronage is represented by the difference between the cooperative's prices

(net of any patronage refund) and those of competing IOFs, appropriately

adjusted to take into account any quality differences between the goods and

services available from the cooperative and those available from the IOFs.

If the cooperative's net prices are less favorable than those of competing

IOFs, if the rate of interest paid on capital invested in the cooperative is

less than the member's opportunity cost of capital (as it usually is), and if

it is possible to act as a free rider with respect to the cooperative's

provision of public and semipublic goods, then the individual member's

short-run return on capital invested in the cooperative is negative. Even

though the competitors' prices may be as low as they are because of

competitive pressure from the cooperative, the individual cooperative member

has no incentive to take this into account if it is believed that patronage

decisions do not affect the viability of the cooperative. If the member

believes that the speed with which cooperative equities will be retired does

not depend on continued patronage, then the perceived return of capital is

unaffected by patronage decisions. Given these conditions, there is no

reason, based on current financial considerations, for the cooperative member

to be any more loyal to the firm than is the customer of an IOF. If the

member's perceived rate of return on investment in the cooperative is

negative or is not contingent on continued patronage, the member may

rationally regard the investment as a sunk cost and therefore not take it

into account in making current patronage decisions.

This situation is most likely to occur if the cooperative has an open

membership policy and if the member believes that market prices will be

unaffected by patronage decisions. Given these conditions, a member who does

not patronize the cooperative in the current year can freely patronize it in

succeeding years if the cooperative's prices or services become more

favorable, and the member believes that the patronage decision in the current

year will not affect the future prices offered by either the cooperative or

competing IOFs. The member will therefore base current patronage decisions

solely on current prices.

If, on the other hand, exit from and reentry into the cooperative is costly

or if the member believes that current patronage decision will materially

affect future prices (e.g., by weakening the cooperative's ability to enforce

workable competition or by denying the cooperative the volume it needs to

achieve economies of size), then in making patronage decisions the member has

to consider not only current prices but exDected future prices as well. Here

the role of member expectations becomes important in determining cooperative

41
lOYalty. Older members who have

were like before the cooperative

viv

exi

,id memories of what ma.rke ting conditions

S ted may be mo re loyal to the

organization than are younger members. The older members may believe that

IOFs, unencumbered by competition from a strong cooperative, would offer very

unfavorable prices to farmers; younger members may be less sanguine about

that conclusion. To the extent member relations programs and other attempts

to instill "cooperative ideology" in the membership change members' beliefs

about the importance of cooperatives as *'competitive yardsticks," they may

therefore affect member loyalty. Even so, members still may have incentives

to free ride with respect to the cooperative's competitive yardstick

activities, relying on other members' patronage to keep the cooperative

strong enough to compete effectively with IOFs.

The preceding analysis suggests that member loyalty will be greater in those

cooperatives that make a member's rate of return on investment in the

cooperative contingent on continued patronage. In cooperatives maintaining a

revolving fund for equity redemption, this could be accomplished by giving

priority among nonretired members to the revolvement of equities belonging to

those who maintain their patronage. The analysis also suggests that loyalty

will be lower where the costs of switching patronage are low. In this sense,

the Rochdale principle of completely open membership (with its attendant

implication that no penalties should exist for switching patronage back and

forth between cooperatives and IOFs) may hinder the viability of

cooperatives.

Other Pressures on Management14--implicit in the discussion of many of the

preceding issues was the notion that managers in farmer cooperatives face

different types of pressures from the stockholders than do managers of IOFs.

Because the stockholders of a cooperative are the firm's patrons, there are

pressures on cooperative managers in addition to those previously outlined.

For example, the stockholder-patrons of a cooperative are intensely

interested in technical aspects of the firm's products and services (e.g.,

the composition and quality of the fertilizers it sells) as these affect the

profitability of the members' farming operations. Shareholders therefore may

demand that their manager be fairly conversant in technical matters as

opposed to being solely a financial expert, as is often the case in IOFs.

Whereas IOF customers who are interested in the technical characteristics of

the firm's products can be referred to the firm's technical staff,

cooperative

at the top." f

kareholders may have greater power to demand to talk to "the guy

In addition, because many managerial decisions that would be considered

merely strategic in IOFs have important effects on the distribution of income

among the stockholders in a cooperative, managers of cooperatives may be

called on much more frequently than their IOF counterparts to justify these

decisions to stockholders. Because the stockholders frequently may disagree

among themselves about what the proper decision should be, the manager may

face discontented stockholders no matter what he or she decides. If

stockholder disagreements become extreme, the manager may have to play the

role of peacemaker among the stockholders to hold the firm together. All

this implies that managers in cooperatives *@are more interdependent and

interactive with user owners and execute more interpersonal and leadership

42
roles" than their IOF counterparts (Perraut, p. 94). Much of the time of

cooperative managers, particularly those of large, diversified cooperatives,

may be spent on member relations. This perhaps puts these organizations at a

competitive disadvantage because their chief executive officers have less

time than IOF managers for strategic planning and administration.

Behavioral Differences Due to the Return

on Investment Being Gained Through Patronam

As mentioned in the beginning of this paper, there are three reasons why the

benefits a stockholder receives from committing capital to a cooperative are

largely tied to patronage:

1 . The cooperative pays a strictly limited dividend on equity capital

invested in the organization.

2 . Net margins are distributed according to patronage rather than equity

ownership in the firm.

3 . Cooperative .stock does not appreciate

nonexistent secondary market for it.

This secti

of coopera

on examines

,tive partic

how these three factors c

ipants.

because of a limited or

ine to affect the behavior

Tendency to Underfinance the Cooperative --To the extent that farmers invest

in an agricultural cooperative to obtain the right to patronize the firm,

they view the value of their investment in the cooperative as instrumental,

depending not on their capital's productivity in the cooperative per se, but

on how that productivity accrues to the members through patronage. If the

cooperative pays no dividend on invested capital, that is, if members derive

benefits from the cooperative solely through patronage, then as long as it is

profitable for a farmer to patronize the cooperative, he or she can raise the

return on capital invested inlghe organization by increasing patronage

relative to their investment. If left unchecked, this incentive to

increase patronage relative to capital investment would lead to severe

underfinancing of the cooperative. Members would contribute only enough

capital to gain the right to patronize the cooperative and then expand their

patronage as long as it was profitable to do so. The rest of their capital

would then be available for investment in their farm enterprises or in other

ventures (cf. Murray 1983a, 1983b, 1983c). To prevent members from behaving

in this way, cooperatives have developed mechanisms such as capital retains,

base capital plans, substantial "up-front" entry capital contributions, and

the withholding (allocation) of patronage refunds, that attempt to force

members to align their capital contributions with their patronage.

Payment of dividends on capital also increase a member's incentive to invest

in the cooperative. However, if members differ in the amount of capital they

have invested relative to their patronage, the setting of the dividend rate

is likely to be a contentious issue. Members who are "overinvested" (i.e.,

who have contributed more capital relative to their current patronage than

the average member) benefit financially from a high dividend rate, while

43
"underinvested" members prefer a low rate (Staatz 1984, pp. 92-93). The

development of mechanisms such as base capital plans that attempt to align

capital contribution to patronage can therefore be seen as an attempt by the

cooperative to reduce conflict in the organization over payments to capital

as well as an effort to assure adequate capital retention to finance growth.

The Lack of a Secondary Market for Coonerative Stock--Although a number of

authors have discussed how the absence of a secondary market in ownership

rights affects the behavior of participants in worker-managed firms, only a

few (e.g., Condon and Vitaliano) have attempted to extend that discussion to

farmer-owned cooperatives. Secondary markets for the equity certificates of

a few cooperatives exist, but for a number of reasons such markets are not

common (see Staatz 1984, pp. 94-96). Discussions with participants in farmer

cooperatives suggest that the lack of such markets has several important

consequences.

A stock certificate of an IOF confers to the holder a residual claim on the

earnings of that firm in perpetuity. A well-functioning secondary market

will therefore value the stock in terms of the expected present value of the

firm's future net earnings. At any time, stockholders can realize- the

capitalized value of those future earnings by selling the stock. Actions

that increase the firm's future earnings potential raise the value of the

stock, allowing stockholders to capture capital gains. The access to these

capital gains via the secondary market gives stockholders a strong incentive

to be concerned about the future earnings as well as the present earnings of

the firm.

A stock certificate of a farmer cooperative, in contrast, grants to the

holder a residual claim on the earnings of the firm only so long as he or

continues patronage. Depending on the equity retirement policies of the

cooperative, the stock certificate may also confer a fixed claim to the

member's original investment in the cooperative, usually payable in nominal

terms after several years. Because there is no secondary market for the

stock, increases in the cooperative's future earnings capacity do not affect

the value of the cooperative's stock. The absence of a secondary market

prevents the stockholder from directly realizing, at any time, the full share

of the expected present value of the cooperative's future income stream.

If belonging to a cooperative increases a farmer's future on-farm earning

capacity, the farmer may, in the current period, be able to realize some of

the future value of the cooperative's activities by borrowing against future

farm earnings. This often is a poor substitute for a secondary market in the

cooperative% stock, however, because lenders base their loans to the member

not on the expected present value of the cooperative's future earnings over

the cooperative's lifetime, but only over the period during which the farmer

is expected to be an active member. If the farmer is close to retirement, he

or she may be able to tap only a small percent of accrued investment in the

cooperative through the capital market.

As a result of the illiquidity of cooperative stock, shareholders in

cooperatives are forced to obtain most of their ownership benefits via

current patronage. This may lead members to pressure the cooperative to

44
increase current earnings at the expense of future earnings. Members may be

reluctant to finance long-term investments by the cooperative if they believe

that these investments will generate most of their benefits after the current

members have retired. One would therefore expect older members, in

particular, to pressure management to increase cur

If8

nt earnings, even if this

involves liquidation of some of the firm's assets.

Observers of the labor-managed firm have identified this tendency to

emphasize current cash flow at the expense of future earnings as a major

problem in worker-owned firms, labeling it "the horizon problem" (Jensen and

Meckling; Condon and Vitaliano; Furubotn). In a farmer cooperative, the

horizon problem may be manifested by members pressuring management to:

1 . Increase the proportion of the cooperative% cash flow devoted to

current payments to members relative to investment (e.g., pressuring

the management of a marketing cooperative to have a large "cash

payout" or pressuring the management of a supply cooperative to enter

into price wars with competitors, even if such cutthroat competition

impairs the long-term viability of the cooperative).

2 . Speed up equity retirement programs and increase the dividend paid on

capital invested in the organization, both at the expense of retained

earnings. (As previously pointed out, higher dividend rates will be

favored only by members who are "overinvested" in the cooperative and

will be opposed by "underinvested" members, who prefer that most of

the cooperative's cash flow be devoted to benefits that are

distributed according to patronage.) L

3 . Liquidate the cooperative's assets, in whole or in part. Pressures

for total liquidation may be muted by provisions in most state

incorporation statutes that specify that in the case of total

liquidation a cooperative's assets must be distributed among past as

well as current patrons. Pressures

g

or a partial liquidation of the

firm's assets, however, may remain.'

Several mechanisms may partially substitute for a secondary market in

cooperative s

Es

ck, thereby attenuating the horizon problem in farmer

cooperatives. If cooperative membership can be sold with the farm, then

the expected future earnings of the cooperative will be capitalized into the

value of the farm and the horizon problem will be largely overcome. Such

effective salability of cooperative membership could be achieved if the farm

were incorporated and the corporation, rather than the farmer who owned it,

was the member of the cooperative. A change in the ownership of the

corporation, by itself, would not change the corporation's status as a member

of the cooperative (Baarda). Similarly, if production quotas or contracts of

a processing cooperative are tradeable, then the value of the cooperative

will be capitalized into their price, providing de facto salability of

membership.

Even if membership in the cooperative cannot be transferred, if the

cooperative has a completely open membership policy, then the value of the

cooperative will be fully capitalized into the value of the farm. If
membership is not fully open but the probability of gaining membership is

higher if one buys the farm of a member (e.g., if the cooperative restricts

membership to a certain geographic area), then the discounted value of the

cooperative's future earnings will be partially capitalized into the farm's

value. If the cooperative, through its competition with IOFs, leads to

higher farm product or lower farm input costs in the area, then the present

value of the cooperative's future activities also will be partial1

capitalized into the value of both members' and nonmembers' farms. !! 0

The horizon problem also may be attenuated if members derive satisfaction or

a higher retirement income from bequeathing a more viable farming operation

or structure of agriculture to their heirs or community. For example, if the

cooperative permits members to transfer membership intergenerationally within

families, older members may be willing to help finance long-term investments

in the cooperative even though these members will not directly benefit from

the investments. The older members may derive satisfaction from knowing

that their heirs will have access to a strong cooperative and may feel as

though they are repaying a debt to their predecessors who acted similarly.

Such behavior may be reinforced if the retiring members' heirs have agreed to

support the retirees in their old age. In this situation, the size of the

retirees' *'pension" is dependent on the farms' future financial performance.

To the extent that the cooperative, through various socialization processes

like member relations programs, can convince members to generalize their

"feelings of family" to the entire membership of the cooperative, the horizon

problem may be reduced even more. Such a generalization is more likely to

occur in small cooperatives where the members know each other well than in

organizations with large, diverse memberships.

The'foregoing analysis suggests that the horizon problem may be more serious

in cooperatives with the following characteristics:

1 . The per-member capital investment in the cooperative is large;

2 .

3 .

The cooperative has a closed membership;

Few of the member firms are legally incorporated;

4 . The intergenerational transfer of membership within families is

prohibited; and

5 The cooperative has a large, diverse membership. 21 .

On the other hand, in smaller cooperatives, especially those in which the

members have strong ties to one another (e.g., because of a common religion

or set of social beliefs) and in which there is a strong tradition of family

farming, the horizon problem may pose fewer difficulties.

The preceding discussion implicitly assumed that management faithfully

implemented the members' desires. To the extent that management is

interested in growth of the cooperative, however, its interests are opposed

to those of members seeking to decapitalize the firm. Ironically, if

management is successful in pursuing its own goals of growth rather than the

46
goals of the membership, the manager may act as the guardian of the

cooperative's long-term viability. If, as suggested by some authors (e.g.,

Staatz 1984; Murray 1983a, 1983b, 1983c), management has more leeway to

pursue its own goals in large, diversified cooperatives, the importance of

the horizon problems in such organizations may be reduced.

Because cooperative certificates generally are not redeemable via a secondary

market, many cooperatives in the United States have committed themselves to

retiring member equities via equity redemption programs. Such programs

partially address the problem of intergenerational transfer of ownership of

cooperatives. In addition, if a cooperative redeems its equities on a

regular schedule and members are confident that this will continue, then

equity redemption may effectively provide a retired member of the cooperative

with a pension (at least for a few years) whose payments depend on the

financial performance of the cooperative after the member retires. The

member therefore has an interest in the long-term viability of the

cooperative, which may attenuate the horizon problem.

Systematically retiring member equities places an additional demand on both

the cooperative's capital structure and its cash flow. If a stockholder in

an IOF redeems his or her ownership right in the IOF via the stock market,

the size of the firm's equity remains unchanged; only its ownership changes.

Redemption of equities by a cooperative, on the other hand, reduces the

firm's equity. As a result, a cooperative that operates a systematic equity

redemption program also must systematically acquire new capital from members

to maintain the organization% equity structure. Unlike an IOF, which can

time the issuance of new stock to coincide with favorable market conditions,

the cooperative is forced to obtain additional member capital year-in and

year-out, a task that one cooperative manager described as "an onerous

obligation.** The difficulty of attracting capital to cooperatives is

compounded by the fact that capital contributions are tied to patronage.

Therefore, a cooperative usually cannot expand its equity base by simply

issuing more stock; it must expand the patronage of current members, attract

new members, or obtain additional capital per unit of patronage from current

members.

Due to the difficulties of attracting and maintaining capital in a

cooperative, managers are under strong pressure to create some form of

permanent equity in the firm, for example, through the use of unallocated

reserves. Such permanent reserves facilitate long-run planning and give the

manager greater flexibility in allocating the firm's resources. This

flexibility becomes increasingly important as the membership of the

cooperative grows more heterogeneous and different groups within the

organization pressure management to respond to their particular interests

(Murray 1983a, 1983b).

To the extent that a cooperative systematically retires member equities,

equity redemption becomes one of several competing claimants on the firm's

cash flow, including:

1 . Payments for the firm's inputs purchased from outside the

cooperative;

47
2 . Payments for member-supplied inputs;

3 . Patronage dividends, in addition to those included in (2);

4 . Dividend payments to member capital;

5 . Retained earnings;

6 . Equity redemption; and

7 . Provision of other benefits that are distributed

a manner unrelated to patronage.

among the members in

Members who have heavily invested in the cooperative and hence have a strong

stake in equity redemption (typically older farmers) may therefore find

themselves in conflict with "underinvested" members, who prefer that cash

flow be devoted to other uses such as increasing raw product prices or

lowering input prices. If, as in many agricultural cooperatives, retired

farmers are barred from voting, the board may give equity retirement a low

priority relative to other uses of cash flow unless these "voice1 s'* members

are successful in bringing outside pressure to bear on the board. B

Neglect of equity retirement may in turn aggravate the horizon problem.

A common rule for investors in IOFs states, **If you don't like what

management is doing, sell your stock." If enough stockholders follow this

advice, the value of the stock declines, imposing capital losses on those who

bought their stock at a higher price but still hold it. In an effort to

recoup those losses or at least avoid further erosion in their asset values,

stockholders may coalesce into a bloc that attempts, via a proxy fight, to

displace the current management with one more to their liking.

Alternatively, outsiders may be tempted to take over the IOF via a tender

offer if they believe that the current management is leaving unexploited

substantial earning opportunities. In either case, it is not simply the

potential of higher future earnings for the firm that induces "renegades*' to

try to displace current management. An important added incentive is the

knowledge that if the stock market "agrees" with the renegades' analysis,

those who initiated the takeover will be rewarded with substantial capital

gains, as the market will capitalize the increase in expected future earnings

into the value of the stock (Alchian and Demsetz).

Fluctuation in the value of an IOF's stock therefore serves as an important

disciplining mechanism on management, indicating the degree of stockholder

satisfaction with current managerial policies. Many firms reinforce the

potency of this disciplining mechanism by offering stock options to top

management, which makes the earnings of these personnel contingent on the

stock's value. Tying the manager's earnings to the firm's performance, as

judged by25he stock market, may thus reduce managerial shirking (Alchian and

Demsetz).

The possibility of capturing capital gains or suffering capital losses in the

stock market also creates incentives for the development of a specialized

market in information about the managerial resources and earnings potential

48
of publicly traded IOFs. The business press, a consequence of the secondary

market for IOF stock, serves as an additional disciplining mechanism on the

management of IOFs.

The lack of a secondary market for cooperative stock denies the cooperative

these tools for influencing managerial behavior. Cooperative stockholders

have no simple indicator like a stock price by which they can evaluate how

well management has enhanced the future earnings capacity of their firm. If

they evaluate management primarily on the current prices the cooperative

charges for its services, the manager may be induced to decapitalize the firm

in an attempt to increase current earnings, simply reinforcing the horizon

problem.

Denied the stock price and the business press as concise indicators of

managerial performance, stockholders in cooperatives have to develop other

ways of monitoring managerial behavior, including requiring the board of

directors to play a more active role in the firm's affairs. Some of these

control mechanisms are discussed later in the section on "democratic

control."

The impossibility of benefiting from capital gains in a cooperative also may

reduce the incentive to found a cooperative even when the social benefits of

doing so exceed the social cost (Shaffer 1982, p. 3). Whereas entrepreneurs

who found a successful IOF are rewarded with substantial capital gains as the

net worth of the firm increases, the founders of a cooperative cannot benefit

from capital gains in the value of the cooperative firm because cooperative

stock does not appreciate. Although the creation of the cooperative may

substantially improve the profitability of the founders' farm enterprises,

these benefits generally are available to all who join the cooperative, not

just those who incur the costs of establishing the firm. Therefore, the

free-rider problem may reduce individual incentives to start a cooperative

even when ample social justification for the cooperative exists. Because of

the free-rider problem, there may be a legitimate role for governmental

subsidies to encourage the formation of cooperatives.

The Nature of Ownershin in a Cooperative --Much of the preceding analysis

suggests that the tying of equity ownership to patronage, the strict limits

on dividend payments to equity invested in the cooperative, the distribution

of net margins in proportion to patronage, and the lack of a secondary market

for cooperative stock combine to result in a fundamentally different concept

of ownership in a cooperative than in an IOF (see Shaffer 1983). Indeed, one

critic of farmer cooperatives has argued that the term 'cooperative equity

capital" is simply "an accounting misnomer for junior, subordinated revolving

debt** (Cortopassi).

The view that '*cooperative equity capital" is nothing more than revolving

debt implies that there is no true stockholder equity in the organization and

raises the question of who really f*~wns'f the cooperative. It is true that

except for unallocated reserves, cooperatives rarely have permanent equity;

consequently the ownership claim of a cooperative stockholder differs in

several ways from that of either a stockholder or a bondholder of an IOF.

49
Cooperative stock confers a residual claim on the firm's earnings, not in

perpetuity, but only as long as the member maintains patronage. It also

confers a fixed claim on the firm's cash flow (much like an IOF bond) if the

cooperative has committed itself to retiring the equities of "overinvested"

members. The residual claim on the firm's earnings usually has very limited

transferabililty and, if members are not required to keep their capital

contributions in line with patronage, the claim will not be proportionate to

investment. The fixed claim on the firm's cash flow is a much less

enforceable fixed claim than an IOF debt instrument, such as a bond, because

it is subordinate to other cooperative debt instruments and because in most

states, cooperatives' boards of directors have the discretion to decide when

and if equity certificates are to be retired and what rate of interest, if

any, they should earn in the interim (Cobia et al.).

Behavioral Differences Due to Democratic Control

Democratic control of cooperatives has two aspects: limits on voting one's

equity (or equivalently, limits on stock ownership) and restrictions on

nonmembers serving on the board of directors.

Limits on Voting on the Basis of Equity Ownership--Allocating voting power in

a cooperative on a basis other than equity ownership prevents the

concentration of nominal political control of the organization in the hands

of those who contribute the bulk of the capital. Supporters of cooperatives

usually have justified such restrictions on the grounds that they "prevent

the domination of capital in the cooperative." This diffusion of political

power, however, raises the possibility that a majority of members, who may

contribute only a small part of the patronage or capital of the organization,

may impose policies that exploit the minority of large patrons (Zusman). The

scope for such exploitation is limited by the possibility that large members

may withdraw their patronage and take their business elsewhere. Exploitation

of the minority by the majority is less feasible where potential market

competition is intense (including the possibility of disaffected members

setting up their own firms) than where the cooperative holds a secure local

monopoly.

Potentially more dangerous is the possibility that the quality of

decisionmaking by the board of directors may suffer as a result of this

diffusion of political power. If board members believe that they are

dependent for their reelection on the mass of small patrons, each of whom has

only a small stake in the cooperative's investment decisions, the board may

treat those decisions more cavalierly than if voting power were proportional

to capital contribution. Limitations on voting one's equity may put nominal

control of the cooperative in the hands of those who do not have to bear the

full consequences of their decisions, at least in the short run. Again,

potential competition limits the extent of such behavior in the long run, as

cooperatives that habitually make decisions that alienate members who

contribute the majority of patronage and capital to the firm soon lose those

members' business. In addition, large patrons may be particularly adept at

influencing the board and management through informal channels (Staatz 1984,

chap. 6; Bartlett, pp. 130-56).

50
The diffusion of political power is one reason why coalition building among

stockholders usually is much more

9x

portant in the decisionmaking process of

cooperatives than in that of IOFs. Because many of the decisions in

cooperatives affect the distribution of income among the members, cooperative

stockholders are more likely than their IOF counterparts to seek involvement

(e.g., via the board) in deciding a broad range of issues that are considered

merely strategic in an IOF. The interests of the members on these issues are

seldom homogeneous and, because voting power is not concentrated, simply

convincing a few large patrons of the correctness of one's views may be

insufficient to ensure that they will prevail.

The need to build coalitions suggests that the transaction costs of reaching

decisions may be higher in cooperatives than in IOFs. As a result,

cooperatives may be less able to react quickly to market opportunities than

are their IOF competitors. Cooperatives that delegate greater decisionmaking

authority to management thus may be better able to compete with IOFs, albeit

at the cost of less direct member involvement in decisionmaking. In

delegating decisionmaking authority to management and the board, cooperative

members have to balance the reduction of transaction costs against the risk

that management and the board may act contrary to the members' wishes. .

Because the cost of group decisionmaking is likely to increase with the size

and diversity of the group, the proportion of decisions delegated to

management and the board probably is higher in large, diverse cooperatives

than in small, homogeneous ones.

The diversity of member views and the need to build coalitions suggest that

logrolling (tying the negotiation of one issue to another) may play an

important role in cooperatives. Given divergent member preferences,

logrolling can expand the scope for agreement (Raiffa). It also reduces the

predictive power of models of cooperative behavior that assume that members

vote on each decision independently.

Limits on Nonstockholders Serving on the Board of Directors--In an effort to

ensure "member control," most farmer cooperatives prohibit or severely

restrict nonstockholders from serving on the board of directors. This is

particularly true of local cooperatives; federated regional cooperatives

sometimes permit managers of locals to serve on the board of the regional.

In addition, some state cooperative incorporation statutes provide for public

repre sentation on coop erative boards.

The board members of a farmer cooperative are users of the firm's services;

hence, they bring two sets of concerns to the board: owner concerns and user

concerns. Owner concerns revolve around the security and overall

profitability of the stockholders' investment in the cooperative. User

concerns include issues of product quality and the pricing of member

services, which affect the profitability of the cooperative to the individual

user. Because of the limitation on dividend payments and the stockholders'

inability to capture capital gains in a cooperative, user concerns are likely

to attract much of the board's attention. Unlike an IOF board, which

functions primarily as a trustee of the stockholders' investment, a

cooperative board serves as both a trustee for the investors and a

51
representative of the firm's patrons, providing an important channel by which

user concerns can be conveyed to management.

Because members of the board are users of the firm's services, they may bring

to the board some of the technical knowledge about the firm's services and

operations that "inside directors" provide in IOFs. If the cooperative's

operations are complex or extend far beyond the farm, however, it is likely

that farmer directors will lack the expertise in marketing, manufacturing, or

retailing that inside and outside directors could provide. This leads to a

dilemma in farmer cooperatives: To the extent that farmers participate in

leadership roles in the board, they may contribute to poor decisions and

hamstring management; to the extent that they do not participate, ownership

is separated from control (Helmberger, p. 1431).

Restricting board membership to stockholders limits the pool of potential

directors. If board member skills are a scarce commodity, one can well

imagine an inverted U-shaped curve relating average effective member control,

as exercised through the board, to the number of members in the cooperative.

In small cooperatives, the pool of board member talent may be so limited that

it is difficult to constitute a board that can effectively monitor managerial

behavior. Managers in these small cooperatives may therefore "run the

show." As a cooperative becomes larger, the pool of board member talent

expands,

the cooperative's decisionmaking.

allowing selection of a board that can play a more active role in

At some point, however, a cooperative may

become so large and complex that no part-time board, no matter how talented-,

can fully monitor managerial behavior. Management in these large

cooper tives may therefore have considerable scope to pursue its own

goals. 5

?

Cooperative boards of directors not only have a different structure than IOF

boards, but for several reasons they also typically play a much more active

role in their firm's decisionmaking than do IOF boards. First, as discussed

before, cooperative stockholders are intensely interested in issues such as

price setting that in an IOF would be left entirely to management. Second,

the difficulty in cooperatives of devising simple indicators of managerial

performance and automatic incentive systems (such as stock options) leads to

the need for greater direct monitoring of managerial behavior by the board.

Stockholders in a cooperative are interested in many facets of the firm's

performance beyond just net margins. A board that evaluated its manager

solely on the basis of net margins would give the manager an incentive to

raise the price of member services and run the cooperative as a separate

profit center rather than trying to coordinate the cooperative's operations

with those of its member firms. Similarly, evaluating the manager's

performance based solely on the current price of member services could

exacerbate the horizon problem and lead to member conflict over which

services should have their prices discounted the most. Rather than focus on

any one indicator of the manager's performance, the board has to balance

several aspects, which may change as the distribution of power among the

membership changes. Doing so requires the board to be more integrally

involved in the affairs of the firm than is the board of an IOF.

52
The lack of a secondary market for cooperative stock makes it difficult for

farmers who have a substantial investment in the cooperative to exit the

organization. Even if they quit patronizing the cooperative their capital is

still committed to the firm. Large patrons' limited ability to exit the

organization may lead them to pressure the board to be more directly involved

in the affairs of the firm. Because these stockholders cannot discipline the

manager by immediately withdrawing their capital from his or her control,

they are forced to rely more on member voice to convey their concerns to

management (Hirschman). In this process, the board serves as their

mouthpiece. Members who have only a small investment in the cooperative, on

the other hand, may find exit much easier, particularly if the cooperative

has several competitors. Such members may simply leave management of the

cooperative to the managers and rely mainly on exit to discipline managers

who get out of line.

Conclusions

Cooperative theorists have long debated how the behavior of farmer

cooperatives varies from that of IOFs. Much of the theoretical literature

begins by hypothesizing a particular objective function for cooperatives and

then shows how striving to maximize that function leads to behavior different

from that of a profit-maximizing IOF (LeVay). The approach taken in this

paper is more structuralist: It argues that, regardless of objective

functions, the unique structural characteristics of cooperatives may lead

them to behave differently from IOFs.

The structuralist approach is not new. Several authors (e.g.? Kravitz) have

argued that as farmer cooperatives grow into large corporations, their

behavior often becomes indistinguishable from that of IOFs. This paper has

shown, however, that structure involves more than just size. The

patron-stockholder identity, the distribution of ownership benefits through

patronage, and the democratic governance of farmer cooperatives can all lead

farmer cooperatives to behave dissimilarly from IOFs. Some of the

differences in behavior may be highly beneficial for the cooperative and its

members while others may hinder its performance. For example, the flow of

info rmation between pat*rons and the firm may be better in c ooplerat ives than

in IOFs, which can lead cooperatives to be more responsive to farmers'

needs. On the other hand, cooperative capital may be less mobile than that

of IOFs, and there may be serious problems in inducing cooperative

stockholders to act in the long-term interest of their firm. As a result of

these differences, the roles and behavior of cooperative managers and board

members may vary markedly from those of their IOF counterparts.

Not all of the hypotheses raised in this paper are mutually consistent. For

example, the paper argued that the limited ability of cooperatives and

cooperative stockholders to diversify their investments may lead cooperative

decisionmakers to be more risk-averse than decisionmakers in IOFs. On the

other hand, the horizon problems may give stockholders incentives to push

their cooperatives into reckless price wars in an effort to increase the

members' current return from the organization in the form of more favorable

short-run member prices. While the paper outlines some of the possible

53
behavioral differences between farmer cooperatives and IOFs, determining the

relative importance of these will require more empirical research.

Notes

1 . The frequently mentioned cooperative principle of *'service at cost" is

subsumed under this characteristic. How the cooperative defines its

costs and the level of those costs are obviously important in

determining what *'service at cost" really means. *'Service at cost" does

not always mean "service at minimum cost." In practice, some farmer

cooperatives also distribute net margins to nonmembers as well as to

members. The description in the text refers to an archetypical

cooperative.

2 . In this paper the term "stock" includes all forms of ownership claims on

the cooperative (e.g., retain certificates, revolving fund certificates,

and patronage refund certificates), not just common and preferred stock.

3 . Peter Vitaliano, in his review of an earlier draft of this paper,

stressed the diffuse nature of optimization in a cooperative.

4 . See the section "More Diffuse Scope for Optimization: Pooling Issues

and Income Distribution."

5. For an analysis of how cooperatives' tax status affects the income of

members in different tax brackets, see Schrader and Goldberg, pp. 34-44.

6 . Subsidizing the price of production inputs sold to members would not

reduce the members' income tax liability because the cheaper inputs

would result in higher farm profits.

7 . See Staatz, "A Game-Theoretic Analysis of Decisionmaking in Farmer

Cooperatives," in this volume.

8 . For a discussion of this problem in cooperatives, see Savage.

9 . See Staatz, "A Game-Theoretic Analysis of Decisionmaking in Farmer

Cooperatives,*' in this volume.

10 . This is not to deny that cooperatives sometimes use cross-subsidies to

gain market share. For example, many dairy cooperatives use hauling

rate subsidLes on the fringes of the cooperatives' geographical areas to

expand membership. The argument presented here is simply that the scope

for cooperatives to use cross-subsidies is much more limited than for

IOFs. For a game-theoretic analysis of the limits to

cross-subsidization in cooperatives, see Staatz, "A Game-Theoretic

Analysis of Decisionmaking in Farmer Cooperatives," in this volume.

11 . Although stockholders in a cooperative derive their financial benefits

largely through patronage, not from a direct return on investment in the

form of dividends and capital gains, it is still legitimate to speak of

54
a farmer's return on investment in a cooperative. When deciding whether

to commit capital to the cooperative, either through initially joining

it or through continuing to patronize it (which often requires

incremental purchases of cooperative equities, e.g., through per-unit

retains), the farmer compares the benefits derived from this use of

capital to the benefits derived from investing it elsewhere, such as on

the farm. The return on the investment in the cooperative is indirect,

being gained through patronage, but it is still a return on capital in

the sense that without a commitment of capital, the stockholder cannot

receive the benefit. The return on capital, however, also requires a

commitment of patronage, and in this sense is different from the return

on investment in an IOF. In those cooperatives that extend patronage

refunds to nonmembers, the return on the investment required to join the

cooperative is limited to the dividend paid on that capital and the

other benefits of membership, such as voting rights.

12 . Dunn, Ingalsbe, and Armstrong report that in general farmer cooperatives

tend to be less diversified than the IOFs with which they compete (p.

245).

V. James Rhodes, in his review of an earlier draft of this paper,

pointed out that farmers are reluctant to allow their cooperatives to

diversify into businesses unrelated to farming because the farmers'

investment in the cooperative is largely sunk. For activities unrelated

to farming, the farmers can get the same investment service from an IOF

investment firm and have far greater liquidity of investment than they

would through a cooperative. Only when the cooperative provides

services that strengthen the farming operation and that are not

available through IOFs are farmers willing to accept the illiquidity

that accompanies investment through a cooperative.

13 . Some incentives for dissembling may remain, depending on how the members

believe the costs of developing and producing new products will be

shared among the members of the cooperative. For example, consider corn

farmers who are members of a supply cooperative whose patrons include

producers of many different commodities. If the corn farmers believe

that because of the cooperative's cost-sharing practices the cost of

developing an improved corn herbicide would be borne by all the members,

the corn producers have an incentive to overstate their need for such a

product because they would have to pay only a fraction of the cost of

its development.

14 . This section draws heavily on Perraut.

15 . The smaller emphasis given to financial expertise among cooperative

managers also is due to several other factors. Raising capital in

cooperatives is not a specialized activity like in IOFs; it is a

byproduct of patronage, which requires favorable pricing, successful

member relations, etc. In addition, in many countries, cooperatives

raise debt capital through specialized agencies like the Banks for

Cooperatives, which often assume many of the financial management

functions that in IOF are normally carried out by the firm's management;

55
16 .

17.

18 .

19 .

20 l

21 .

22 .

23 .

hence, cooperatives have less need for financial expertise. In

addition, stockholders of cooperatives may put little pressure on

management to develop financial expertise because cooperative stock does

not appreciate; therefore, the stockholders cannot capture capital

gains, the magnitude of which in an IOF often depends on the

management's financial prowess.

For a proof, see Staatz 1984, p. 91.

This assumes that the members act entirely selfishly. Concern about

bequeathing a viable farming operation to one's heirs or community may

attenuate this conclusion. This is discussed later.

For example, the manager of a major agricultural processing cooperative

told the author that one board member (who had recently joined the

cooperative) had proposed selling one of the cooperative's brand names,

which had an estimated market value of $300$50 million, to an IOF. The

member reasoned that the terms of sale could specify that the

cooperative would sell its raw agricultural product to the IOF at little

reduction in the present field price, and the sale would allow current

members to capture the $30.$50 million as current income. Management

resisted the suggestion on the grounds that it was unfair to previous

members of the cooperative, who, over 65 years, had built up the value

of the cooperative's brand name but would not share in the proceeds of

the sale.

Some of the following points have been discussed by Condon and

Vitaliano, pp. 38-42.

The higher farm values will reflect only a partial accounting of the

cooperative's future activities because if the cooperative's only

benefit were to force IOFs to offer farmers more favorable prices, and

these prices were available to both members and nonmembers, nobody would

have an incentive to maintain their membership in the cooperative;

everyone would try to be a free rider. The existence of the cooperative

suggests that it offers members appropriable as well as public goods.

See the following paragraph for an important qualification to this last

statement.

For example, pressure from Congress. The increased attention that

farmer cooperatives have paid to equity redemption in recent years is

partly attributable to calls in Congress for legislation that would have

mandated certain levels of redemption if cooperatives had not improved

their performance in this area (see U.S. General Accounting Office).

Because of imperfect information, however, the stock price often

reflects the short-term performance of the firm more than its long-term

potential. Consequently, if an IOF relies heavily on the value of its

stock to reward or discipline the manager, the firm may create

incentives for the manager to emphasize the company's short-run

financial performance at the expense of long-term performance. For

56
example, managers may manipulate current income statements to

misrepresent the condition of the firm or concentrate on other strategic

actions, such as takeover bids, to increase the stock value in the short

run rather than emphasize increasing the firm's long-run productivity.

Such behavior can result in these IOFs facing their own type of horizon

problem.

24 . A possible exception is during proxy fights and tender offers in IOFs,

when coalition building among stockholders often becomes critical.

25 . The structure of the cooperative (e.g., its complexity) may be more

important than size per se in determining the degree of member control.

For details, see van Ravenswaay.

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Association.'" Journal of Farm Economics 36(1954):529-34.

Schrader, Lee F., and Ray A. Goldberg. Farmers' Cooperatives and Federal

Income Taxes. Cambridge, Mass.: Ballinger Publishing Co., 1975.

Shaffer, James D. "Notes for a More Comprehensive Theory of Farmer Owned

Cooperative System." Cooperative Theory Working Pap. 1, Dept. of

Agricultural Economics, Michigan State University, 1982.

"Notes on Firm Ownership and Control." Cooperative Theory

Working Pap.'lO, Dept. of Agricultural Economics, Michigan State University,

1983.

Staatz, John M. "The Cooperative as a Coalition: A Game-Theoretic

Approach." American Journal of Agricultural Economics 65(1983):1083-89.

Cooperatives:'

*'A Theoretical Perspective on the Behavior of Farmers'

Ph.D. dissertation, Michigan State University, 1984.

Cooperatives:'

"A Game-Theoretic Analysis of Decisionmaking in Farmer

In this volume.

U.S. General Accounting Office, Comptroller General. Family Farmers Need

Cooperatives --But Some Issues Need to Be Resolved. Washington, DC.: Rep.

to Congress CED-79406, July 26, 1979.

van Nostrand, Maurice. "Competition between Cooperatives." In Research on

Cooneratives in the 198Os, pp. 85-88. Washington, D.C.: USDA ACS Staff

Rep., 1983.

van Ravenswaay, Eileen. "Formal and Substantive Democracy in Cooperatives

(Part I)." Cooperative Theory Working Pap. 5, Dept. of Agricultural

Economics, Michigan State University, 1982.

Ward, Clement E.; Vernon E. Schneider; and Ramon Lopez. Voting Systems in

bricultural Cooperatives. Washington, D.C.: USDA ACS Coop. Res. Rep. 2,

1979.

59
Zusman, Pinhas. "Group Choice in an Agricultural Marketing Co-operative.**

Canadian Journal of Economics 15(1982):220-34.

60
THINKING ABOUT FARMERS' COOPERATIVES, CONTRACTS,

AND ECONOMIC COORDINATION

In this essay, I am interested in exploring possible roles of farmers'

James D. Shaffer*

cooperatives in dealing with the fundamental problems of coordinating

economic activity in the real world of uncertainty. In a private enterprise

economy, coordination takes place across markets and within firms, always, of

course, within a set of institutional constraints imposed by governments and

custom. Coordination across markets and within firms requires transactions.

In both cases, the transactions involve exchanges of claims to benefits and

agreements- implicit and explicit contracts. In transactions across markets,

explicit prices are central to coordination and contracts tend to be more

specific. Transactions within firms involve more general agreements,

authority relationships, and implicit prices (i.e., opportunity costs are

recognized and dealt with as implicit but contingent prices). Cooperatives

represent a third general mode of organizing coordination, combining

characteristics of markets and internal (integrated) coordination in ways

that are different from either.

The Coordination Problem

In the modern economy, the activities of thousands of people and resources

scattered over thousands of miles contribute to producing and distributing a

single product such as a loaf of bread. The contributions are made over a

period of many years, past contributions being embedded in capital goods,

knowledge, institutional structure (including firm organization), and

inventories. How to coordinate these contributions, when at each step in the

production-distribution sequence information and mechanisms of control are

imperfect, is a central economic problem. Production decisions must be made

under conditions of uncertainty as to future supplies of inputs and demands

for products. The future is inherently uncertain. If information about

future input supplies, product demands, and transformation functions were

perfect, resources were perfectly mobile and divisible, contracts were

perfectly drawn and enforceable, and no firm had power to influence its

prices, coordination would be simple. But none of these conditions exists in

the real world. Our interest is in mechanisms that effectively coordinate

economic activity under real world conditions.

The coordination problem involves at least four levels of aggregation:

1 . Coordination within firms (micro-micro coordination).

2 . Coordination between individual firms (micro coordination).

3 . Coordination of total supply with total demand for commodities or

industries at each step in the production-distribution process (macro

coordination).

*I thank my reviewers, J. Staatz, H. Riley, V. J. Rhodes, P. Vitaliano, E.

van Ravenswaay, I. Dalziell, and D. Street for helping me think about this

topic but properly accept responsibility for the paper, having stubbornly

resisted some of their suggestions.

61
4. Coordination of aggregate dem.and with aggregate

economy as a whole (macro- matro coordi.nation).

supply for the

A theory of coordination needs to address the problems and mechanisms of

coordination at each of these levels of aggregation and the

interrelationships among the levels. Decisions within firms influence the

outcomes of markets, and the prices resulting from market interaction are

part of the environment to which firms respond. Price uncertainty is created

by uncertainties about future total supplies and demand for inputs and

products which are determined by individual firm decisions based on uncertain

future prices. Mismatches of aggregate supply and demand similarly affect

prices and create price uncertainties. Addressing the economic coordination

problem involves examining governance mechanisms at all levels. Cooperatives

are one of these mechanisms of coordination.

Integration and Coordination

Before turning to the central question of the potential roles of farmers'

cooperatives and relating the roles of cooperatives to the characteristics of

markets and transactions, it will be useful to briefly discuss integration in

general. Vertical integration is defined as coordinating technically

separable activities in the vertical sequence of production and distributing

products under the control of an organization by ownership. The incentives

for vertical integration include: reducing the costs or problems involved in

transactions across markets; costs of search, negotiation, and monitoring;

and problems of uncertainty, impacted information, opportunism, and

externalities, as discussed in the previous section, and capturing economies

of scale in allocating lumpy inputs over a set of activities. Integration

also may take place to achieve growth goals of management, as an investment

by firms with accumulated funds or by mistake.

Horizontal integration involves combining within an organization multiple

production-distribution systems that are technically separable for the same

product. Examples are two processing lines or two plants to make tomato

paste. Incentives for horizontal integration include potential improvement

in the match of supply with demand (macro coordination), potential market

power, and generally improved ability to control the environment associated

with size and economies of scale.

Scope integration involves combining within one organization the

production-distribution of multiple products or services that are technically

separable. The conglomerate firm producing butter and lamp shades is an

example. Incentives for scope integration include potential of economic

power and possible economies of scale, especially in selling. Limited

coordination benefits are apparent from scope integration per se. Large

conglomerate firms may have the capacity to influence system coordination

through the exercise of political and economic power, especially by the use

of advertising and merchandising to improve the match between supply and

demand.

62
What then limits the extent of integration? Or what determines how a

subsector or economy is organized, its combination of integration and the

markets coordinating its economic activity? Given the incentives for

integration and the related problems of coordination a ross markets, why do

markets in intermediary products and services persist? E

Organizations require bureaucracies, and the larger and more diverse the

functions of the organization, the larger and more complex the bureaucracy.

Participants in an organization have their own interests and perceptions that

may not be congruent with the owners. Organizations have internal

transactions costs. Information may be impacted; behavior may be

opportunistic, etc. Valuing inputs and allocating overhead costs is

difficult and subject to internal political pressure. Organizational slack

develops. The incentive to expend effort and pay attention to details and

opportunities is generally less in large organizations than for individuals

and small firms which are more directly subject to the immediate discipline

of a market.

Substantial economies of scale exist in producing particular inputs. It may

be less expensive and less risky to acquire inputs across a market than to

produce them. A food processor, for example, would have to be very large to

achieve economies of scale from ownership of a steel plant to produce the raw

material for tin cans. And acquiring a steel plant for such purposes would

reduce flexibility and add risk associated with changing preferences and

technology for food packaging. The risks would be less for a specialized

steelmaker supplying a diverse set of firms. To achieve economies of scale

in the production of all inputs used in processing would require a huge,

diverse organization with all of the problems of a huge complex bureaucracy.

Capital constraint is an issue. Generating capital internally is a slow

process, and investors, to reduce risks, seek to diversify their

investments. Managements of very large organizations are capable of making

very large mistakes. Integrating into an unfamiliar business has significant

costs and risks. Lack of knowledge is a significant barrier to entry as the

large number of divestitures indicates. Finally, there is a political

constraint on the accumulation of market power.

Farmers' Cooperatives and Integration

A farmers' cooperative consists of an association of farmer patrons,

democratically governed, that owns one or more firms from which

member-patrons receive benefits (or incur costs) based on patronage rather

than stock ownership. The distinction between the cooperat've association

and the firms owned by the association is an important one. 3 The

cooperative appears to be horizontally integrated among members and

vertically integrated between members and the firms owned by the cooperative

association. However, this is an illusion.

The cooperative association is not a horizontal integration of its members'

firms. The member firms are independently owned, represent independent

profit centers, and act independently except as they have agreed to own a

63
firm(s) jointly or have negotiated agreements to act collectively. The

association has the potential to affect horizontal coordination, as in the

case of a bargaining cooperative, but market power requires a mechanism of

collective action to control the purchase or production decisions of

independent members.

Nor does a cooperative represent3vertical integration between member firms

and the patron-owned firm (POF). The members own the POF, but the members

remain independent. Neither the association nor the management of the POF

control the member farm firms.

Integration within a firm is very different than the relationship between

members and their cooperatives. The failure to recognize this difference

seems to be a source of confusion among some who attempt to treat a

cooperative as an integration of members' firms in applying antitrust laws or

in considering the undue price enhancement provision of the Capper-Volstead

Act. The cooperative is a third mode of organizing coordination. -----

Integration usually is defined by ownership. However, ownership through

stock ownership of an investor-owned firm (IOF) or membership in a

cooperative does not translate directly into control. The separation of

ownership and control is a topic with a large literature in economics. The

ownership of a firm by the association of members does not imply control by

individual members any more than ownership of shares of an IOF implies

control of an IOF. In this respect, integration between the member firms and

their jointly-owned firm differs from integration within a firm.

The POF is a bureaucratic organization that carries out functions under the

direction of a management appointed by a board representing the association.

As with any firm, the employees have interests and perceptions of their own

which are not completely congruent with those of the owners. And in contrast

to an IOF, where owners have a common objective of achieving profits, the

owners of a cooperative have divergent interests that reduce the

E

apacity of

the board to represent the interests of particular member-owners.

Owners of an IOF influence the firm through the board of directors and by

buying and selling stocks. The market for stocks is a major disciplinary

force for the IOF, a force that is absent for the cooperative (Staatz, pp.

368-69). The owners of a cooperative firm, in contrast, influence or

discipline management through political processes, through purchase of

stocks, through joining or exiting the cooperative, and through patronage of

the firm. This difference in disciplinary mechanisms is important in

analyzing the differences in potential performance of and cooperatives.

The relationship between members and their cooperative most resembles a

contingency contract in market coordination (Staatz, pp. 187-89).

Transaction terms are not fixed but are contingent on the patronage rebate,

which is influenced by the performance of the firm and extent of patronage.

Coordination between members and their cooperative's firm also are influenced

by the terms of the membership agreement, which in effect becomes part of the

64
contingency contract. The explicit and implicit terms of the contract are

critical to the performance of the coordination function. More about this

later.

Consider the difference between a farmers' cooperative and an IOF owning both

the cooperative's firm and the farms of the members. The coordinating

transactions would be quite different. The latter would be conducted through

bureaucratic relationships, and the former would be similar to those across

markets, but with the added potential of the patrons influencing the firm's

performance through an elected board. IOFs have integrated farming with farm

supply and product marketing, but this integration generally has been limited

to small scale. Large-scale integration of these functions has been limited

by several factors. Farming is very capital intensive. To acquire the

capital necessary for both the farms and, for example, a facility large

enough to achieve economies of scale would require a very large investment

and involve considerable more risk relative to payoff compared to alternative

investments of comparable size. While farms tend to be specialized, there

are complementary enterprises; a farmer can combine farming with nonfarm

activities. Expanding the scope of the firm to take advantage of

complementarities in farming would complicate the bureaucratic problems.

More importantly, bureaucratic coordination on a large scale is difficult in

farming because of geographic dispersion and the importance of paying

attention to details on a day-to-day basis. An employee in a large

bureaucracy is not likely to have the same incentives to attend to details

and expend effort as an independent farmer whose rewards are immediately

related to performance. Generally, a decentralized organization of farming

coordinated across markets or through cooperatives has significant advantages

over large-scale integration. An important question is the potential

advantages of ctoperative organization compared with coordination strictly

across markets.

The extent of integration of a POF is a different matter. Should a farm

supply POF vertically integrate into feed manufacturing or horizontally

integrate by acquiring multiple retail outlets? Should a marketing POF

vertically integrate into processing or retailing or horizontally integrate

by acquiring multiple processing plants? Should a POF integrate in regard to

scope by extending ownership to unrelated activities such as building

motels? The incentives and limitations of integration are similar for the

POF and for IOFs except that to the extent that the firm's objective function

is to provide benefits to members related to patronage rather than profits to

the firm and that members influence management decisions, a POF will be

different than an IOF. Cooperatives are less likely to integrate into

unrelated activities or into products that compete with products of members

and are more likely to integrate into activities that expand markets for

members' products (Staatz, pp. 70-73). Absent effective member control, the

POF might be indistinguishable from an IOF in regard to integration

propensities except that it operates under a more limited access to capital

for expansion.

Two additional modes of organizing coordination will simply be mentioned.

Joint ventures between a cooperative and an IOF are an example of

coordination across a private treaty market using a contingency contract.

65
This is similar to integration; performance depends on the detailed

provisions of the agreement.

A group of farmers may choose to organize a farm supply or product marketing

firm as an IOF, returning benefits to the owners based on some combination of

return to capital and patronage and relating voting rights to stock ownership

rather than one-member/one-vote. A comparison of such organizations with

pure cooperatives and IOFs deserves attention, but it is beyond the scope of

this brief essay, except to say that such organizations may have advantages

in particular situations.

The explanation for the evolution of the mix of modes of ,coordination is

indeed complex. Comparative performance of alternative modes does not

suffice to explain it. At least two additional factors deserve mention. A

particular mode of coordination may develop based on inaccurate

expectations. Performance of new organizations always is very uncertain.

Once a mistake is made, future options are changed. Organizations have a

tendency to persist. Similarly, legal advantages and disadvantages may favor

one of the modes. It is not valid to assume that whatever pattern of

organization evolves will provide the most effective coordination.

Also, there may be a systematic advantage in initiating IOFs compared to

cooperatives as coordinating modes because of the greater potential rewards

to the initiating entrepreneur. This advantage derives from the fact that

benefits from the successful IOF are reflected in the value and dividends of

stock that can be captured by the entrepreneur through stock ownership, while

no comparable benefits are available from establishing a cooperative. Thus,

just the fact that a cooperative is a superior method of coordinating

economic activity in terms of transactions costs, etc., does not necessarily

lead to the establishment of a cooperative. This does not address the

question of comparative transaction costs in establishing these alternatives,

which may be substantial and deserving of empirical investigation.

Some Implications of Characteristics

of Markets and Transactions

To say that transactions across markets, between members and the POF, and

within firms are alternative modes of organizing economic coordination is a

simplification. Markets, cooperatives, and IOFs come in great varieties.

They adapt to different environments, they adopt different structures and

standard operating procedures (SOPS), and these variations influence their

coordinating performance.

To think somewhat systematically about markets and cooperatives as

alternative modes of coordination, I have identified twelve characteristics

of markets, prices, or transactions that seem to me to be particularly

relevant to coordination. I briefly discuss the relationship of each to

market and cooperatively organized coordination.

It is assumed that the world is uncertain, that participants attempt to

reduce this uncertainty for themselves by controlling aspects of their

66
environment, including influencing the terms of trade, that they seek to

reduce transactions costs, and that these motives influence the mode of

coordination. I do not assume the counterfactual characteristics of the

"perfect" market or accept it as a norm against which other modes or

organization are judged. In a world meeting the conditions of the perfect

market, a comparison among markets and cooperatives would be irrelevant

because performance would be essentially the same with or without

cooperatives. However, this comparison is relevant in the real world of

uncertainty, transactions costs, bounded rationality, opportunistic behavior,

impacted information, externalities, differentiated products, endogenous

preferences, lumpy inputs, fixed assets, economies of scale and scope,

differential power, and sticky prices. Such characteristics of real world

economies complicate the problem of coordination, and they need to be taken

into account in comparing alternative coordinating institutions.

Contracts

Explicit and implicit contracts are particularly important in determining

coordination performance. Transactions involve contracts or agreements of

enormous variety and *complexity, which makes generalization about

coordinating mechanisms difficult. Williamson discusses three classes of

contracts that have relevance for coordination (Williamson, pp. 233-61). In

classical contracting, 1'. . . all relevant future contingencies pertaining to

the supply of a good or service are described and discounted with respect to

both likelihood and futurity" (p. 236). Relationships between the

transacting parties other than specified by the agreement are considered

irrelevant, and the contract is relatively easy to enforce by legal

authority. This type of contracting describes the usual relationship in spot

auction markets and is apparently assumed in the perfectly competitive market

of economic theory.

Long-term contracting under conditions of uncertainty may be impossible under

the classical scheme because complete specification of contingencies would be

prohibitively expensive or impossible. This gives rise to neoclassical

contracting, which allows some flexibility in the agreement and sets up a

process for resolving disputes and evaluating each party's performance with

respect to contract provisions. An agreed-upon procedure and third-party

arbitrator is more flexible and less expensive than litigation. Pressures to

sustain long-term relations involving many transactions has led to what

Williamson calls relational contracting, where an array of norms beyond those

centered on the exchange come into play in governing the transactions.

Contingencies unspecified by contract are settled without conflict based on a

more general code and the desire to continue the relationship.

Thinking of contracting in these terms suggests that the distinction between

transactions across markets and within firms is not clear-cut. Transactions

among employees or units within a firm are difficult to distinguish from

relational or even neoclassical contracting. Agency theory is enlightening

in this respect as it describes a firm more or less as a contract system.

Production contracting in farming as, for example, in the case of broilers,

seems closer to governance within a firm than coordination across a 'spot

market. This suggests that more attention needs to be paid to the nature of

67
contractual relations while avoiding overgeneralization about the differences

between transactions within firms and across markets.

In situations that benefit from neoclassical or relational contracting, the

owner-patron relationship that characterizes the cooperative seems to provide

the potential for advantages in coordination for cooperatives over IOFs.

Whether these potentials are realized depends on the SOPS adopted by a

cooperative. Because the transaction between an individual member and the

cooperative always is contingent on the performance of the cooperative, it is

never as simple as is implied by classical contracting. The potential for

improved coordination performance through the design of the implicit

contracts between members and their cooperatives is an important area for

analysis. Some ideas along this line are included in the discussion that

follows.

Types of Markets

In thinking about coordination across markets, I find it useful to

differentiate six general types of markets. Of major importance for

coordination effectiveness is the difference between spot markets, which deal

in goods already produced, and forward contract markets, which deal in

promises to deliver goods or services in the future. Transactions in goods

already produced or in forward contracts can be across markets characterized

as auctions, posted price, or private treaty, which yield the six types of

markets. Each of these types of markets produces different information and

incentives, involves different transactions costs, and thus influences the

effectiveness of coordinat_ion. To understand the possible roles of

cooperatives in coordination, it would be instructive to compare alternative

ways of instituting transactions between members and their POF and each of

these types of markets. I have suggested some of these comparisons in the

following discussion of characteristics of markets and transactions, but they

do not constitute the complete and systematic analysis the topic deserves.

What follows is a brief discussion of each of twelve characteristics of

markets and transactions that seem to me to be particularly important in

influencing the effectiveness of coordination along with brief comments about

the possible implications for cooperatives' roles in coordination. My

purpose in this section is the narrow one of identifying potential functions

or roles for cooperatives, responses they could make to characteristics of

markets, and transactions involving problems in coordination. It is not

intended to be a comprehensive evaluation of cooperatives' effectiveness in

these roles or a comparison between cooperatives and alternative modes of

coordination.

Twelve Characteristics:

1 The point of time in the production-distribution seuuence when terms of

t;ade are determined. Predictable terms of trade facilitate planning and

coordination. Errors in expectations result in errors in planning--too much

or too little is invested, produced, distributed, and stored. Within limits,

markets in contracts can result in predictable terms of trade, at least for

the participants. The length of the contract relative to the length of the

68
production planning is critical. For example, contracts for hogs longer than

the gestation period would reduce errors in planning the number of hogs to

breed but would not solve the problem of planning investments in confinement

housing that might have a useful life of 20 years. A 200year contract in an

otherwise uncertain world would create added planning problems and risks for

the buyer.

Most market transactions in the food system entail immediate or very

short-term delivery, thus providing little contribution to planning. Auction

markets in contracts are very rare. Most markets in contracts are private

treaty markets.

Cooperatives --Cooperatives usually do not have formal contracts specifying

future purchases from, or delivery of, products or commodities to their

patrons. However,

implicit contract. 6

SOPS of the cooperative may offer what amounts to an

For example, marketing and processing cooperatives may

offer what amounts to a negotiated contingency agreement to accept all that

members deliver with specified bonuses and discounts associated with product

characteristics and delivery dates. Most importantly, the cooperative

guarantees the existence of a market, which reduces the risk of investment

and the vulnerability to loss of asset value due to opportunistic behavior by

an investor-owned processor (Staatz, pp. 164-67). A cooperative cannot offer

a guaranteed price because the price received by a member must depend on the

performance of the cooperative, although the cooperative could offer improved

price expectations by contracting with its buyers or by hedging on the

futures market. The pooling arrangement also may affect price expectations,

reducing price variability (Staatz, pp. 189-92).

A cooperative capable of attracting members who produce a large part of the

total production of a commodity could facilitate matching supply with demand

through binding contracts with members and forward delivery contracts with

buyers. Such contracts would necessarily involve contingencies that might be

difficult to specify in detail. Here a question is whether the cooperative

could provide effective relational contracting. Such contracting would

depend on developing trust among members and buyers.

2 The flexibilitv of prices. The relative flexibility or stickiness of

prices is a critical factor in coordination and involves complex

relationships. Planning is facilitated by predictable prices and

predictability is enhanced by reduced variability. However, in an uncertain

world, plans are seldom fulfilled. Yields, competitors' production plans,

demand, etc., are not perfectly predicted. Once products are produced,

flexible prices are needed to direct these products to their best uses.

Market systems vary substantially in the way these two apparently

incompatible needs for coordination are reconciled.

Auction markets for immediate delivery with large numbers on both sides of

the market provide very flexible prices, adjusting minute to minute to

changes in supply or demand and to information about conditions. They are

excellent institutions for allocating products already produced, but their

volatile prices make planning difficult. Both posted price markets and

private treaty markets tend to result in sticky prices, which adjust slowly

69
to changing conditions. Transactions costs influence the type of market

developed at different stages in the food system. For example, posted prices

at retail reduce transactions costs, while auctions offer low transactions

cost where large quantities of standardized products are exchanged at

wholesale levels. Private treaty markets tend to develop where product

characteristics are variable and where characteristics are important to a

specified user. Contract markets tend to be private treaty, although

auctions in contracts are feasible.

A major coordination problem in the food system is created by the mix of

types of markets. Posted price markets at retail and private treaty for

labor, the largest input in the food system, create sticky prices, requiring

greater adjustment in first-handler markets for farm products, increasing the

volatility of prices in these markets, 'and thus making planning more

difficult and imposing adjustment costs on farmers.

Cooperatives --As previously stated, cooperatives have limited capacity to

guarantee forward prices. However, they have the potential to influence

production plans through providing information to members, contracting with

members, and to influence downstream participants through collective

bargaining, contracting, and promotion. As previously suggested, a

cooperative representing a large portion of production could improve the

match of aggregate production and demand, thus contributing to price

stability and coordination.

A patron-owned processor may have a competitive advantage in product markets

derived from the contingency nature of raw product transactions with its

members. An IOF offering fixed prices either on a spot or forward contract

market may assume considerable risk due to uncertain future prices. In a

cooperative, members assume this risk and the price of the raw product is

more like an internal transfer price than a transaction across a market.

Investor-owned processors sometimes attempt to shed this risk by making raw

product prices contingent on prices received for finished products. Farmers,

however, are reluctant to accept such contracts partly because of their

concern about opportunism. Whether growers benefit from the contingent

prices of the POF depends on the astuteness of management and the risk

premium built into the fixed prices of investor-owned processors. 7

3 Thinness. A thin market is characterized by a small number of

transactions or a very limited capacity to absorb variations in deliveries.

An open auction market may be thinly traded because most of the trading in

the commodity bypasses the market as private treaty transactions, which may

in turn be tied to the auction market quotation. In this case, the problem

is the representativeness of the auction market quotations. Much of the

information about supplies and demand is obscured by the private treaty

transactions, and chance variations in the quantities crossing the auction

market may result in price variations unrelated to the quantities actively

marketed. Livestock markets with large volumes of direct packer deliveries

and eggs are examples.

A second example is markets with limited capacity to absorb day-to-day

variations in quantities delivered. City markets in perishable fruits and

70
vegetables are a specific example. In such markets, two or three too many

loads of a particular commodity delivered on a particular day may result in

prices below the costs of transporting the commodity to market. Prices can

be highly volatile and unpredictable. Improved coordination involves some

mechanism for managing the day-to-day flow to market.

Cooperatives--Farmers' cooperatives have several possible roles in improving

coordination in thin markets. A cooperative could provide information about

private treaty transactions to its members, assisting them in private treaty

negotiations. This information would be useful in tying the dispersed

private treaty transactions to the auction market. Improving the information

on transactions outside the auction should make the auction price more

representative of supply-demand conditions. A cooperative would have

potential advantages in gaining reliable information compared with a

governmental agency or private firm ifit were able to generate a sense of

community among its members. An additional step would be for members to

institute an iterative process of announcing intentions with an agreement

among themselves to produce quantities consistent with their final

intentions. The iteration procedure would provide the members with

information about the aggregate intentions of the group. More effective

would be a marketing cooperative that could control the flow of members'

products to and

risks to member S

among marke ts. Apooliw gre

under some circums tanc es. t

ement could furthe r redue e the

The success of such a cooperative depends on the market share of the

cooperative; the closer to 100 percent, the more effective the cooperative.

Because the benefits would tend to accrue to all market participants, the

free-rider problem is significant. A cooperative acquiring raw products from

members where the product is traded in a thin market, with or without a large

share of he market, has a problem in assigning a value to members'

products. 5 Thus special attention to the terms of the implicit contingency

contract is required in regard to pooling and the assignment of overhead

costs.

4 Transparency The transparency of a market refers to the extent to which

the terms of all'transactions are open to observation by all potential

participants in the market. Open auction markets are transparent to those

present, but for those not present, transparency depends on the accuracy and

extent of market news reporting. Posted price markets appear to be

transparent, but appearance may be deceptive if individual deals are

negotiated and if qualities are uncertain. Also, the cost of search reduces

transparency in a dispersed market. Private treaty markets are not open to

observation without systematic market information reporting. The absence of

transparency clearly hinders coordination, increasing transaction costs,

uncertainty, and errors in resource allocations.

Cooperatives --Cooperatives may provide an information service where

transparency is lacking. Bargaining cooperatives may be used to counteract

the lack of open information in private treaty markets. Impacted information

may coexist with private treaty markets. Private treaty transactions may

involve complex contracts. A cooperative could provide not only information

on contract terms and legal advice, but also standardized contracts.

71
Improved information may be one of the most important outcomes of bargaining,

contributing to more effective coordination.

5. Specification. S_pecification coordination refers to: (1) the extent to

which characteristics of the product or service transferred across a market

are known to the parties and (2) the extent to which preferences about

characteristics and costs associated with particular characteristics are

communicated between potential participants in the market.

A product or service typically has a large number of characteristics or

attributes that add to, or reduce, the desirability of the product in a

variety of different uses. The combination of characteristics incorporated

in a product affect its cost. The number of identical products produced by a

particular producer affects cost as well; economies of scale are related to

the size of production runs. Matching characteristics produced with consumer

preferences is a horrendous problem fraught with uncertainty (Shaffer;

Hirschman).

Spot markets deal in products already produced. Producers selling in these

markets have to speculate not only about the bundle of characteristics

desired by potential buyers, but also about the products likely to be

presented by other suppliers that will affect the demand for their products.

The market feeds back information to producers in the form of prices in the

case of auction markets and the amount of sales at different prices in posted

price markets. Auction markets tend to provide more immediate and more

discriminating information than posted price markets, but in both cases the

quality of the information is very limited and uncertain. To which of the

many characteristics were buyers responding? Was the price or volume of

sales related to a particular quality characteristic or to other factors? In

spot markets, buyers can respond only to product characteristics presented.

The response does not reveal preferences for products with different bundles

of characteristics than those currently entering the market. Buyers

typically have little incentive to communicate information about more

desirable characteristics. The buyer does not know the production

possibilities for different bundles of characteristics. Some characteristics

of products cannot be observed, and buyers may base their purchases on false

expectations, thus sending false messages across the market. That is, a

purchase may be taken as an expression of preference for future products of

the same characteristics but may have no such meaning.

Research to acquire purchasers' preference information can provide valuable

information about desired characteristics, but it also involves uncertainty

in translating responses to a limited set of hypothetical questions to the

market situation. Such research is often expensive and of limited value to

the sponsor because success can be copied without incurring the cost of the

research.

The problem of communicating information about des‘ired product

characteristics, of course, is complicated in an industrial food system by

the fact that many different firms are involved in producing and distributing

a single product. The bureaucracies of processing or distribution firms may

not have the incentive or capacity to transmit needed information to their

72
suppliers. An error in the design of a container, for example, can affect

the demand for, and the price of, the product in the container.

Consumer and producer markets, of course, are quite different with respect to

scale of transactions and have different economics with respect to

transactions costs. The posted price market of the large retail store

involve very low transactions cost compared to those of a private treaty or

auction market performing the retail function. For producers' goods, private

treaty and auctio

B

markets offer feasible transaction costs and contracting

becomes feasible.

Contracting for a good prior to major production decisions that fix the

quantity or characteristics of the good offers a far different potential for

product characteristic coordination. In private treaty transactions,

contracts can specify product characteristics in detail. The nature of

private treaty transactions permits exploration of quality production

possibilities and costs. The potential for an information-rich transaction

may be restricted by the bilateral negotiating game, however, because each

party may perceive it to be in its interest to restrict or distort

information.

Contracts also may be exchanged across posted price and auction markets. A

processor may, for example, offer a standard contract to farmers on a

take-it-or-leave-it basis. The benefits of the exchange of information are

lost. Auction markets in contracts with expectation of delivery are rare.

Such contracts would necessarily be less variable in product specification

than would private treaty transactions, but with modern communications and

computers they could, through an iterative process, provide substantial

variability in specification and keep the advantages of a large number of

participants in an open market.

Cooperatives--In general, the members and management of a cooperative have

more incentive to communicate product characteristics information than is

common across markets. Members have an incentive to express their

preferences, needs, and advice about products and services. Management could

be expected to be more responsive to patron-owners than to patrons,

especially if the board is successful in establishing an ideology emphasizing

service to members as the objective of the POF. Impacted information should

be less of a problem than it is in other markets. In Hirschman's terms, the

voice option is more likely to be exercised and it is more

lf

ikely to be

effective than for an IOF patron relationship (Hirschman). Nonetheless,

costs are involved in exercising voice, members may not see or value the

improved performance of the cooperative, and the bureaucracy of the POF may

not respond to the potential benefits. Improved coordination through

improved specification communication is a potential, not a certainty.

Forward contracting may have substantial potential for improving

specification coordination. It is curious that the practice is not more

common among cooperatives. Contracts for farm inputs with highly specific

characteristics could be handled by supply cooperatives without the risk of

stocking inputs that do not meet patrons' preferences, and the search costs

to patrons could be reduced. Similarly, contracts between members and a

73
marketing cooperative coul,d, wbith in the limits of uncertain farm produe tion,

improve the match between suPP lY and demand in respect to characteri sti cs.

While an individual farmer cannot afford to do consumer preference research

related to characteristics of farm commodities, it may be feasible for a

large cooperative to do such research on behalf of its members. An

investor-owned marketing agency has little incentive to do such research

because it cannot capture the benefits which accrue to farmers. The

investor-owned processor is not interested in a particular farm commodity but

in its own products. At the same time, marketing cooperatives may be less

oriented to consumer preferences because of fixed assets and members'

preferences to continue producing commodities with specific characteristics.

6 . Contingencies and settlement. What is traded in markets are promises and*

rights to goods and services. The transaction usually involves some degree

of uncertainty. The promises (contracts) involve contingencies. Effective

coordination across markets requires the definition of contingencies and a

process for settling in case of failure to meet the terms of the promise.

Because a great many uncertainties exist, contracts usually are incomplete

and the settlement process becomes important. Aspects of contracts are

implicit or recognized by custom. Where the contingencies are complex and

uncertain and enforcement difficult and expensive, the market may be an

inappropriate coordinating mechanism.

In a spot market, the time between transaction and delivery is short and the

promise is to deliver the product as it appears to be. Of course, not all

product characteristics are observable. There is, for example, a promise

that a fertilizer or pesticide is formulated according to description. There

may be an implied warranty that if the product is not as represented, damages

may be due. But costs of settlement may be high. The classical system of

contracting prevails.

In long-distance trading, exchange is by description with contingencies

associated with failure to deliver or accept a shipment. If trading partners

behave opportunistically, that is with guile or trickery, transactions costs

increase, inhibiting market exchange. Trading may be facilitated by a

neoclassical approach to contracting, including the use of third-party

inspection and arbitration.

Additional problems arise when trading is in contractsfor goods not yet

produced. Because of uncertainties, contingencies must be included in the

contracts. The longer the contract period, the more uncertainty and the more

important the contingency clauses become. Effective coordination would be

served by specifying product characteristics, quantities, terms of trade,

timing of delivery, etc. However, many factors beyond the control of the

parties affect the ability to meet the terms of a very specific contract.

The effects of uncertainty can be mitigated by schedules of bonuses and

penalties attached to specific provisions of the contract. Contract prices

may be tied to prices in another market, or prices may be established by a

formula involving aggregate supply of, and demand for, the product and close

substitutes. Skill in contingency contracting is therefore important to

effective coordination. As the problems of settling contingencies in

74
transactions across markets increase, relational contracting, or at the least

sophisticated neoclassical contracting, may be required for effective

coordination. Bounded rationality and opportunism become more important

obstacles to transactions across markets.

Cooperatives- Trading transactions between members and their POF always are

contingent on the performance of the cooperative and the SOPS that affect

terms of trade and settlement.

SOPS

are of great importance in distributing benefits among members and in

attracting patronage, which in turn affects the performance of the

cooperative (Staatz).

The contingency nature of transactions differentiates the transactions

between members and their POF from the usual transaction across markets.l*

In a processing POF, for example, the uncertainty of future finished product

prices remains, at least in part, with the individual member, in contrast to

the risk being shifted to the buyer, as takes place in the usual auction or

posted price market. The extent to which the uncertainty remains with an

individual member or is shared by all members depends on pooling and dividend

SOPS. At the same time, the transaction differs from a transaction within a

firm.

firm, and

price plays a more important coordinating role. The transactions have the

characteristics of relational contracting. That is, a set of norms and

procedures that are not explicitly included in the transaction agreement come

to be mutually acceptable for settling contingencies. A comparison of the

cooperative with relational contracting across markets would be instructive.

The cooperative may miss opportunities to improve coordination by failing to

have more explicit contracts with its members. The cooperative's performance

may depend on the delivery or purchase of predictable quantities, for

example. A system of forward delivery contract transactions conceivably

could improve the coordination of supply and demand in agricultural

production and distribution. Settlement of contingencies would be an

important problem in such a system. Could a cooperative organize such a

system with specific supply agreements with members and relational

contracting with buyers?

7 Personal relationship and trust.

ly is the case i

indifferent and indiscriminate among customers. Th

.n spot markets for highly standardized commodities.

However, when exchange involves products with characteristics that are not

observable, contracts are incomplete, difficult to enforce, and contain

contingencies related to uncertainty. In such a situation, discrimination

among trading partners becomes important to participants and to effective

coordination. Trust greatly facilitates trade and reduces transactions

costs. Knowledge of the producers often carries information about product

as

t,

is

75
characteristics as well as information about the difficulty of settling

contract disputes and reliability of fulfilling the implicit and explicit

terms of contracts. Opportunism and fear of opportunism restrict contractual

agreements. A general lack of trust in an economy leads to more transactions

in private treaty markets, barriers to entry, and restricted exchange,

limiting the potential benefits from both specialization and scale

economies. Relational contracting, especially, relies on trust.

Cooperatives --Trust can make or break a cooperative. Because of the

contingent nature of trading transactions, a farmer must have faith that the

board and management will provide a fair and honest settlement of the

implicit agreement. Otherwise he or she will not participate. On the other

hand, where contingency contracting is important to effective coordination, a

cooperative may have an advantage over market transactions because the member

has access to political influence and information inside the organization as

well as market-like influences. Access to information about the internal

accounts is critical to contingency contracting where the contingency

involves gross margins or finished product prices, for example.

Trust in a cooperative may be related to the size of the organization because

a member may perceive that his or her political influence and access to

information would be nil in a very large cooperative. Trust may be enhanced

by successfully establishing an ideology of service to members within the

cooperative's firm and by providing information to members.

A cooperative is not immune from opportunistic behavior by members or

employees. In some instances, an IOF may be more effective in dealing with

opportunism than a cooperative because of the greater reluctance to impose

sanctions on a member-owner than on an ordinary trading partner.

8 . Frequency of transactions. Uncertainty and the potential for opportunism

increase when long-term contracting is needed to facilitate coordination. An

opportunistic participant is disciplined when he or she depends on repeated

transactions; the dissatisfied customer does not return as long as he or she

has an alternative. In the case of frequent transactions, learning takes

place and search effort can be spread over a number of transactions.

Relational contracting is fostered by repeated transactions.

Cooperatives --A cooperative may be a desirable alternative to a market for

farmers where the goods or services provided involve infrequent but repeated

transactions for a particular farmer, especially where a nonstandardized

product is involved. The cooperative would act as the farmer's agent, thus

reducing search costs and uncertainty.

Axelrod provides an interesting insight into the relationship between

repeated transactions and cooperation, defined narrowly as not defecting in a

prisoner's dilemma, which is similar to not behaving opportunistically. A

critical factor promoting cooperation is the fact that a subsequent

transaction is expected. If the current transaction is the last, defection

is likely. This suggests that cooperative policy promoting continued

patronage by members, including barriers to exit, would discourage

opportunistic behavior and facilitate contingency contracting under

76
uncertainty. It also suggests that such cooperatives might have an advantage

over markets in coordination requiring future delivery agreements.

9. Asset snecificitv. A particularly difficult coordination problem arises

when transactions involve assets that are highly specific to those

transactions. Once made, the value of the asset depends on its supplying

goods and services for a particular user, or its value may depend on the

continued availability of the supply of particular inputs. Without

alternative uses, the salvage value of the asset is low compared to its

acquisition price. The investment may be in specialized plant and equipment

or in specialized skills.

Take, for example, the case of a tree fruit useful only for processing that

can be transported only a short distance without loss of qualities desired

for processing. At the same time, processing it requires specialized

facilities that would have little value in alternative uses once they are

fixed in a particular location. Not only is the farm investment in trees

large, specialized, fixed, and long-term, but specialized equipment and

skills also are required. Before making such investments, farmers would want

an assured market at prices sufficient to provide a return on the

investment. A prospective processor, at the same time, would want an assured

supply at prices it could afford to pay based on prices it can get for the

processed product. The solution is either some form of vertical integration

or long-term contracts without which the investments are not likely to be

made. If they are not made, the economic opportunity will remain

unexploited, depriving participants of potential profits and consumers of a

desirable product. If either the growers or processor are expected to behave

opportunistically, contracting is not likely to be acceptable. The

processor, for example, may have an incentive to encourage excess capacity in

growing to assure supplies in years when output may be reduced due to

weather, etc. Thus the contract would need to deal with both price and

quantity. But guaranteeing both price and quantity makes the processor

highly vulnerable to changes in demand for its product. A means of sharing

the risk is needed. Complex contracting with trust and enforcement

mechanisms seems essential.

Now assume that either the growers have alternative markets or the processor

has alternative uses for its facilities. Contract enforcement would be more

important and difficult. By behaving opportunistically, the trading partner

with the alternatives could extract the value of the fixed assets of the

other partner (Staatz, pp. 164-70). While these may be extreme examples, a

great number of examples of transactions involving assets that are fixed and

specialized in varying degrees exist in intermediate markets in the food

system.

Cooperatives --The cooperative mode of coordination is particularly adapted to

deal with the problem of asset specificity. Because of the uncertainties and

potential for very profitable opportunism, effective coordination across

markets is difficult. In anticipation of the problems, investments in assets

highly specific to particular transactions may not be made, eliminating

potential markets for farmers and desirable products for consumers.

Integration by an IOF to solve the problem could require very large
investments in farm assets and the problems of bureaucratic management of

farms and related risks. A cooperative solves these problems. However, if

the transaction specific asset lies in the POF, and if members have'

alternatives,. long-term contracts between members and the cooperative to

assure use of the asset at levels sufficient to achieve scale economies may

be necessary or at least desirable. Otherwise a member may find it

individually advantageous to withdraw, imposing costs on other members. A

sequential process where each withdrawal increases the incentive for

subsequent withdrawals could destroy the value of the asset. The usual

membership agreement and investment, if relatively small, might not be

sufficient to protect the value of the asset.

The other side of the coin is that the cooperative may be more reluctant to

adjust to new technologies or changing market conditions than would an IOF in

an attempt to protect the value of member assets. To the extent that members

are isolated from the consequences of failure to adjust to changing

conditions, coordination of supply with demand may be impeded.

1 0 Externalities. Externalities exist when economic actions result in

benefits or costs to third parties that do not enter the private accounts of

the decisionmaking unit. The recipients of these consequences sometimes are

referred to as free or unwilling riders. What is important for our purposes

is that market transactions frequently fail to take into account important

third-party consequences, thus reducing the effectiveness of economic

coordination. The remedy, if there is one, is either a change in property

rights or integration, bringing the consequences within a firm or other

organization. Externalities are pervasiv

f3

It is neither practical nor

desirable to eliminate all externalities. Economic theorists frequently

have concluded that pecuniary externalities can be ignored. However, this is

a gross generalization and simplification. Pecuniary externalities influence

behavior, and it is difficult to identify purely pecuniary effects in the

real world.

Externalities create a significant problem in the coordination of supply with

demand in farm commodity subsectors. For example, when individual farmers

increase production of a commodity with an inelastic demand, the revenue of

other farmers is reduced. This might not be a matter of social concern if

the farmers increasing production were simply more efficient than other

farmers and, in fact, marginal revenue from the increased production exceeded

marginal costs. But what if the increased production is based on false

expectations of prices and marginal revenue turns out to be less than

marginal cost? All farmers suffer the consequences of the mistakes. Not

only that, but such behavior increases price uncertainty, which will

influence future production decisions. This is not simply a pecuniary

externality that does not matter. Forward contracting with wide

participation could reduce the problem.

Cooperatives --Cooperatives have the potential to deal with some externality

problems. They can make it possible to capture some benefits or avoid some

costs not possible in coordination across atomistic markets. Contracting in

general also has potential for reducing externalities.

78
For example, the costs of promoting a product for an individual farmer would

exceed the benefits to the farmer. The benefits, if any, would accrue to all

producers of the product. In contrast, a cooperative could initiate a

quality control, product identification, and promotion program jointly

financed by members who would collectively capture the benefits. Consumers

would benefit as well from the reliable imp

quality control and product identification. 18

ved quality made possible by the

Cooperatives with

broad-based participation also may be able to reduce the externality problem

associated with the failure to match supply with demand through the use of

member and buyer contracts.

11. Structure. Market structure refers to the size and number of firms

competing in a market, market share by largest firms, and conditions of

entry. Structure is a market characteristic that is important to

coordination performance because it is& associated with market power or the

capacity to influence terms of trade and trading relationships. Market

structure not only influences coordination, but also is influenced by the

nature of the coordination problem as firms seek to reduce or mitigate the

consequences of uncertainty.

In The New Industrial State,

sector and the market sector.

@lbraith divides the economy into the planning

The planning sector is made up of the

large firms in the economy that have market power. They have the capacity to

influence their prices. It is a sector of administered prices. The market

sector involves smaller firms that are in competitive markets and are

basically price-takers.

In the modern industrial economy, very large investments are required to take

advantage of economies of scale and scope related to technology,

distribution, merchandising, and organizing a skilled work force of

specialists including management and scientific-technical personnel. To

protect these large investments, and even to venture to make them,

managements of these firms seek to reduce uncertainty by controlling their

economic environment. They engage in long-term planning and seek to

implement the plans. First of all, they seek size and high market shares to

enhance their potential for control and influence. They seek to protect

themselves from the uncertainty of capital markets by generating capital from

earnings made possible by their ability to administer prices based on market

power. They seek to protect themselves from uncertainty of input markets

through contracts, personnel relations, and the exercise of oligopsonistic

market power. They seek to reduce uncertainty of demand for their products

through advertising, merchandising, and contracts. They seek to reduce

uncertainty of regulation and the variations in the value of money through

political influence, including the strategic location of plants in many

congressional districts.

Large firms are necessarily bureaucratic. This fact, when combined with all

their efforts to protect against uncertainty

16

leads to very sticky prices for

their products, especially on the down side. Decisionmaking involves

SOPS based on collective decisions, thus tending to reduce flexibility.

Clearly the behavior of the firms in the planning sector contributes to the

predictability of their own prices and reduces uncertainty in some of their

79
market relationships, especially through contractual arrangements. Private

treaty markets among the large firms reduce uncertainty and are rich in

coordinating information. Retail posted price markets dominated by planning

sector firms are likely to be slow to adjust to changing conditions of supply

of raw product, but at the same time to be-very risky for new entrants, even

though prices are attractive. This risk is due to the potential response of

large firms designed to protect their market share.

The planning and control efforts of large firms contribute to important

aspects of coordination, largely at the micro-micro and micro levels and to a

lesser extent at the macro level. However, these efforts exacerbate the

coordination-planning problems at the macro-macro level and within subsectors

that are coordinated across a series of markets, some of which are

atomistically structured and others dominated by planning sector firms. They

shift the burden of adjustment to industries that rely on coordination across

atomistic markets, such as those for farm products.

There is at least a hypothesis with substantial supporting evidence that

rigidities in the planning sector result in unemployed resources, most

noticeably labor, especially at low points in the business cycle. A

plausible, at least partial, explanation of the business cycle is that

individual firms overinvest, not knowing the plans of competitors and having

excessively optimistic expectations of demand. Then, in response to failure

in effective demand, they restrict output rather than adjusting prices. This

process has substantial spillover consequences for the firms outside of the

planning sector.

Similarly, in subsectors with a mix of atomistic and concentrated markets,

the adjustment to changing conditions falls much more heavily on the firms

buying and selling in atomistic markets (or at least where one side of the

market consists of a very large number of small firms). This is the case for

many subsectors that include farmers. Farm input markets are concentrated,

as are many of the markets coordinating activity of the industries supplying

firms using farm-produced inputs. This imposes added uncertainty,

volatility, and adjustment problems on the farming industries. Note the

frequent failure of posted retail prices to reflect changes in supply at the

farm level.

Conditions of entry and uncertainty affect both short-run and long-run

coordination. Uncertainty and fear of reactions by other firms inhibit

investment by prospective entrants, thus tending to protect firms in

concentrated markets. Because of uncertainty, fear, and the nature of scale

economies, niches that would otherwise be profitable to fill by investment in

plant and equipment are left empty, often to the disadvantage of firms in

subsector. For example, one processing plant might profitably serve a

farming area where two would be unprofitable due to the nature of economies

of scale. The plant may remain unbuilt because of the fear either that

another firm might by mistake enter the market or that sufficient supplies of

raw products are not assured.

Cooperatives --Cooperatives may reduce concentration in the markets of a farm

commodity subsector by entry. Even the threat of entry may change behavior

8 0
of existing firms in concentrated markets, contributing to improved

coordination (see Rhodes). The cooperative may be a creditable threat of

entry when entry by an IOF is unlikely due to the difference in benefits

available to the members of a cooperative compared to those available to

stockholders. A farmers' cooperative also may profitably influence

consumers' demand through promotion and merchandising where such efforts

would not be profitable for an individual farmer, thus contributing to

adjusting demand to existing supply. Such efforts are not profitable for

individual farmers because the benefits occur to all producers of the

commodity. The cooperative does not solve the free-rider problem but may

reduce it. A cooperative also may fill an empty niche for a processing plant

supplying a market for farm products or supplies of farm inputs by assuring a

supply or purchases through explicit or implicit contracts. This role for

cooperatives is especially important in situations involving high fixed and

specialized investments because of the potential of appropriating the value

of the fixed assets once the investment is made (Staatz, pp. 164-70).

The arguments on structure support the view of the role of cooperatives as

the "competitive yardstick" advocated by Nourse. They also suggest that the

cooperative has advantages as a coordinating mode in oligopolistic markets.

12 Elasticities. Elasticities of supply and demand are important

characteristics of markets influencing economic coordination. The neat and

simple supply and demand curves of static economic models are of a different

character in a dynamic uncertain world. The difference in short-run and

long-run elasticity of supply is well recognized. But the problems of

coordination in the real world involve constant adjustment. Assets are

neither completely fixed nor completely variable. Supply curves are not

reversible, because every change in price affects expectations and

investments that alter future supply curves. The introduction of time also

alters the concept of the demand curve, which also varies with the length of

run. In the very short run, for example, a change in price may result in

changes in inventory positions with no change in consumption while, in the

long run, a price change can result in changes in preferences altering future

demand.

Price variability can significantly affect future supply and demand.

Suppose, for example, that a price increases as a result of planning

decisions in a previous period. The higher price may result not only in

additional investments in the production of the commodity, thus shifting the

supply curve, but also may cause consumers to find substitutes, resulting in

new preferences and shifting the demand curve for the original commodity to

the left. In this case, the quantity supplied would be greater, and the

quantity demanded would be less, at the original price, and if the original

price equated marginal cost and marginal revenue, the new market clearing

price could be below average costs of production. The point is that prices

not only affect the quantity supplied and taken in the short run, but at the

same time change the longer-run supply and demand curves, affecting what will

be supplied and taken in future periods. Price elasticities are a function

of past prices, which complicates the coordination problem.

81
The farm problem sometimes is described as a chronic mismatch of supply and

demand. At least a part of the problem arises from the nature of supply and

demand elasticities as they interact in a dynamic, uncertain world. Given

these conditions, spot markets do not provide an effective mechanism for

industry-wide coordination of supply and demand.

Cooperatives --Again a market characteristic that is common for farm products

indicates the need for a coordinating institution other than a spot market to

deal with the macro coordination problem of matching supply and demand for

specific commodities. Also, as suggested before, forward contracting

provides the potential for improving macro coordination if a sufficient

market share can be included and the problems of contingency contracting can

be solved. An important question is whether farmers' cooperatives can be

effectively organized to provide this coordinating function. Would they have

advantages over a contracting system that operated across an electronic

market organized by a private firm or a governmental agency? The discussion

of market characteristics indicates the need for such a contracting system,

and the cooperative is an institution available to farmers to deal with this

problem of major importance to them. It is important to distinguish farmer

collective action through cooperatives to achieve improved macro coordination

and collective action designed to extract monopoly advantage. Without

control of production, monopoly profits are limited to those available

through possible discrimination among markets. A cooperative-managed forward

contracting system with high levels of participation could achieve improved

macro coordination without extracting monopoly profits. This fact supports

the case for a policy to facilitate the performance of this function by

cooperatives. The design of such a system is beyond the scope of this paper.

Conclusion

Micro-Micro Coordination

The POF does not seem to offer inherent advantages with respect to

coordination performance within the firm as long as the firm is operating in

highly competitive markets. The marketdisciplines all firms to seek

effective mechanisms of internal coordination. Even so, directors

representing patrons have potential access to more knowledge about the

consequences that internal coordination processes have for service to patrons

and may have more incen

ES

ve to influence these processes than directors

representing investors. The case is different for firms operating in

less than competitive markets for such firms have a surplus which may be

divided among the participants in the form of profits, compensation, or slack

performance. The POF has a unique group of participants with standing in the

firm's policymaking process--the patron-owners. They have an incentive to

press for reduction of slack to provide better prices and services to

patrons. Of course, they may or may not exercise their influence. Effective

policymaking requires dedicated directors with knowledge of bureaucratic

organization and behavior, among other things. At the same time, the absence

of a market for the stock of a POF eliminates the pressure on management to

attend to the price of the stock, including investment analysis and corporate

takeovers.

82
Groups of patron-members also may influence internal coordination to their

advantage by affecting internal transfer prices or the allocation of overhead

costs. This is a major problem to be solved, complicating the job of

management and directors and potentially creating conflict among members

(Staatz). Nonetheless, a reasonable conclusion is that cooperatives have a

role in improving the internal coordination of firms operating in markets

that permit a significant level of organizational slack.

Micro Coordination

The cooperative mode of organizing firm-to-firm transactions may be more or

less effective than coordination across a market, depending on the SOPS of

the cooperative and the characteristics of the market alternative. The

potential for more effective coordination may be unrealized. If the POF

operates to simply maximize its net revenue of the POF, its role in micro

coordination may differ little from an IOF. However, given the conditions in

the real world, the cooperative mode of organization has potential for more

effective micro coordination.

More specific forward agreements between members and the POF seem to offer

significant potential. For example, supply cooperatives could reduce

inventory and delivery costs and mistakes in ordering, as well as improve the

timely availability of exactly specified farm inputs by instituting advanced

order systems. Advanced specification of product characteristics,

quantities, and delivery schedules improves coordination for processing and

marketing. Where transaction specific assets are involved in either supply

or marketing, long-term agreements may make investments feasible that would

not be made at all without them. The more extensive use of contracts between

members and the cooperative would seem to make it possible to capture more of

the advantages of the vertically integrated firm while maintaining the

advantages of decentralized decisionmaking. Procedures for settlement of

agreements made under uncertain conditions are critical to forward

contracting systems. A combination of careful specification of contingencies

and trust are required.

Because the outcome of all transactions between members and the cooperative

is contingent on the performance of the cooperative, trust is a more

important factor in the cooperative relationship than in transactions across

a market. A critical factor in the performance of a cooperative, therefore,

is the development of an organizational ideology emphasizing mutual

responsibility and trustworthiness.

Macro Coordination

Cooperatives have a significant potential role in coordinating the total

supply of a commodity with total demand at prices reflecting costs of

production and consumers' preferences. Spot markets may efficiently allocate

commodities that already are produced among alternative uses, but they do not

provide a mechanism for effective macro coordination. Effective macro

coordination requires a mechanism to provide reliable information on future

supply, demand, and prices prior to important production decisions. A

forward delivery contract market system was suggested with cooperatives

83
managing the system and, most specifically, providing a mechanism for

enforcing and settling contingent contracts.

Marketing and bargaining cooperatives may originate with an incentive to

improve macro coordination. The policy problem is to differentiate between

macro coordination and monopolistic pricing. Open membership limits the

potential for monopolistic practice and places the emphasis of the

cooperative on macro coordination. A cooperative-managed forward contract

system addresses the problem of macro coordination and provides no threat of

monopoly pricing, even with a rule requiring participation in the system.

The roles of farmers' cooperatives in macro coordination deserves a good deal

more attention. Cooperatives may buffer the price signals associated with

changing market demand on technology, slowing the adjustments of members to

the changing conditions. Failure to adjust may be detrimental to the POF and

members alike. On the other hand, the cooperative may provide a more stable

environment for far rs, thus contributing to a more orderly and less painful

planned adjustment. T8

Macro-Macro Coordination

Volatile agricultural product supplies and prices complicate the problem of

coordinating aggregate demand and supply. Instability of the value of the

currency, interest rates, and exchange rates in turn complicate the problem

of food system coordination. For example, food prices are an important

component in the cost of living index, and many contracts and programs are

tied to this index. Improvements in macro coordination in the food system,

reducing the volatility of prices associated with mistakes in production

decisions, would contribute to improved macro-macro coordination for the

economy, which in turn would reduce the adverse effects that instability in

the aggregate economy has on the food system.

Notes

1 . See Coase for the pioneer discussion of the question.

2 . I thank Eileen van Ravenswaay for initially calling my attention to the

importance of this distinction.

3 . I will use the term POF for the firm or firms owned bv an association of

member-patrons, and cooperative to refer to the combination of

association and its firms or operating units.

. I recognize that IOF directors have some differences in objectives, such

as payment of dividends vs. stock appreciation or long-run vs. short-run

profits. I am arguing that the range of objectives for the firm is

significantly different for a POF than an IOF.

. There are, of course, examples of successful IOF integration involving

several stages of production and distribution. Cooperatives also face

problems accumulating capital.

84
6 .

7 .

8 .

9 .

10 .

11 .

12 .

13 .

14 .

15 .

16 .

17 .

18 .

Marketing and bargaining cooperatives may have formal contracts

specifying the cooperative as the sole marketing agent and setting forth

other terms, but they seldom specify quantities and terms prior to

production commitments.

Patron-owned processors frequently are said to break the product market

price because they are not committed to a raw product price. This

suggests that the commitment to market all of the members' products

along with contingent pricing may put downward pressure on prices.

It will depend on the design of the pooling agreement and the

differences in price variability among commodities in the pool. Pooling

can shift risks among members, adding to the instability of revenues for

some members.

The value of the finished product provides a guideline, of course, but

without a meaningful raw product price the problem of allocating costs

among products becomes critical.

Contracting at the consumer end of the food chain might be feasible in

terms of transactions costs through consumer cooperatives. Other

possibilities also exist.

The voice option is one of attempting to influence an organization's

performance through direct communication or political action, compared

with the exit option, which is simply to not purchase, sell, or belong

to the organization.

Note, however, that similar contingencies can be included in

transactions across markets. For example, a processor may offer to pay

on the basis of finished product prices, becoming essentially a custom

processor.

See Schmid for an elaborate treatment of this topic.

The cooperative is one of several means of dealing with this

externality/free-rider problem. Other possibilities are through

marketing orders and possibly through contracts between a group of

growers and firms marketing their products. Some type of collective

action is required.

This section uses ideas from the Calbraith analysis, but is not to be

taken as a description of his analysis.

See Okun for a comprehensive discussion of sticky prices.

This may not be true of inside directors of an IOF. There are many

examples to the contrary. The potential feedback from member to

director exists but may not be utilized.

Donald Street, in his review of this paper, suggested this to be an

important question.

85
References

Axelrod, Robert. The Evolution of Cooperation. New York: Basic ‘Books,

1981.

Coase, R. H. "The Nature of the Firm." Economica n.s. 4(1937):386-405.

Reprinted in Readings in Price Theory, ed. G. Stigler and K. Boulding, pp.

331-51. Homewood, Ill.: Richard D. Irwin, 1952.

Galbraith, J. K. The New Industrial State. Boston: Houghton Mifflin Co.,

1967.

Hirschman, Albert 0. Exit, Voice and Loyalty. Cambridge, Mass.: Harvard

University Press, 1970.

Okun, Arthur M. Prices and Quantities: A Macroeconomic Analysis.

Washington, D.C.: Brookings Institution, 1981.

Rhodes, V. James. "Cooperatives and Contestable/Substainable Markets." In

this volume.

Schmid, A. Allan. Property. Power and Public Choice. New York: Praeger,

1978.

Shaffer, James D. "Preference Articulation and Food System Performance." In

Future Frontiers in Agricultural Marketing Research, ed. P. Farris, pp.

224-45. Ames, Iowa: Iowa State University Press, 1983.

Staatz, John M. "A Theoretical Perspective on the Behavior of Farmers'

Cooperatives." Ph.D. dissertation, Michigan State University, 1984.

Williamson, Oliver F. "Transaction-Cost Economics: The Governance of

Contractual Relations." Journal of Law and Economics 22(1979):233-61.

86
FARMERS' INCENTIVES TO TARE COLLECTIVE ACTION VIA COOPERATIVES:

A TRANSACTION COST APPROACH

John M. Staatz*

This paper uses concepts from transaction cost economics to examine two

questions: (a) Under what conditions do farmers benefit from collective

action? and (b) Under what conditions is that co1 ective action likely to

take the form of a farmer-owned cooperative firm? 1 The transaction cost

approach hypothesizes that the structure that an economic enterprise develops

in a particular environment reflects the enterprise's attempt to minimize its

production and transaction costs. Organizational forms that are most

successful in reducing these costs in a given environment tend to become

dominant there (Williamson 1981). By examining the conditions under which

collective action via cooperatives offers advantages to farmers, the

transaction cost approach can therefore be used to highlight the situations

in which farmer cooperatives are most likely to arise as well as the

situations in which cooperatives may be at a competitive disadvantage

compared with investor-owned firms (IQFs).* The incentives to maintain a

cooperative once it is formed may differ from the incentives that gave rise

to its formation. This paper discusses only the incentives to form a

cooperative; for a discussion of the incentives to maintain a cooperative

once it is formed, see Staatz (1984, pp. 206-8) and LeVay.

The paper is divided into seven sections. The first briefly describes the

transaction cost approach to analyzing the structure of organizations, and

the second through fifth discuss four basic principles of that approach: the

asset fixity principle, the uncertainty principle, the externality principle,

and the hierarchical decomposition principle. The asset fixity principle

receives particular emphasis because it underlies many of the traditional

arguments for farmer cooperatives. The sixth section discusses how

cooperative action may be used to redistribute rights in farmers' favor

rather than simply to reduce transaction costs within a given set of property

rights. The seventh section summarizes the major arguments of the paper.

The Transaction Cost Approach

The transaction cost approach, as developed by Coase; Williamson; and Ouchi,

focuses on how the characteristics of a transaction affect the costs of

handling it through markets, bureaucracies, and other forms of organization.

A transaction occurs whenever "a good or service is transferred across a

technologically separable interface** (Williamson 1981, p. 1544). Transaction

costs include the costs of gathering and processing the information needed

to carry out a transaction, of reaching decisi‘ns, of negotiating contracts,

and of policing and enforcing those contracts. 3 The transaction cost

approach argues that the organizational form or "governance structure" that

minimizes the sum of production and transaction costs for a given activity

will have a competitive advantage and hence tend to dominate that activity.

*This paper has greatly benefited from the comments of J. Shaffer, E. van

Ravenswaay, P. Vitaliano, and J. Baarda, none of whom share with me

responsibility for any remaining errors.

87
A shortcoming of the transaction cost approach is its tendency to take cost

structures as given, paying little attention to the ability of different

organizational forms to change the distribution of property rights and hence

the definition of "efficiency" (Bromley; McNeil). The approach adopted here

attempts to broaden the transaction cost approach to look at the design of an

organization or association not simply in terms of optimizing within a given

set of property rights, but also in terms of the ability of different designs

to change the distribution of rights in favor of those controlling the

organization or association. Within this broadened approach, the paper

examines the traditional arguments for farmer cooperation, outlining the

conditions under which agricultural cooperatives may provide benefits to

their members that are unavailable or more costly elsewhere.

Williamson (1981) argued that four principles for efficient organizational

design determine the type of organizational structure that will tend to

dominate a particular line of economic activity (where efficiency is defined

as the ability to minimize transactions costs): the asset fixity principle,

the uncertainty principle, the externality principle, and the hierarchical

decomposition principle. As will later become apparent, most traditional

justifications for farmer cooperatives, such as the competitive yardstick

argument, can be subsumed under these four principles.

The Asset Fixitv Principle

The asset fixity principle states that as assets become more specialized or

"specific," autonomous market contracting becomes a progressively less

efficient means of allocating them (Williamson 1981, p. 1548). An asset

becomes more specific to a particular use or user as the cost of transferring

the asset to alternative uses increases. This cost may reflect technical

characteristics of the asset itself, the spatial dispersion of production, or

poorly functioning factor markets. As an asset becomes more specific, its

resale or salvage value diverges from its acquisition value. As long as the

value of the asset in use lies between the asset's acquisition and resale or

salvage value, the asset will remain fixed in its current use; the owner will

have no incentive to invest or disinvest in the asset in response to product

price changes (Johnson).

Asset Fixitv and Opportunism

The divergence between the acquisition and resale or salvage value of an

asset gives rise to rents that are potentially appropriable through market

transactions if insufficient competition in the market permits one of the

parties to the transaction to act opportunistically (Klein, Crawford, and

Alchian; Staatz 1984, chap. 2). Hence, the combination of small numbers in

the product market combined with asset fixity, which itself is often a

function of poorly functioning factor markets, can lead to situations to

which far ers

Z

are at considerable risk in their dealings with their trading

partners.

For example, consider a farmer who invests in specialized fruit production

equipment and trees to supply a processing firm that enjoys some degree of

88
local monopoly. Assume that the annual rental-equivalent price of those

assets (calculated with respect to their acquisition price) is $300,000 and

that the farmer incurs $100,000 in variable costs per year. The farmer made

these investments based on the processor's promise to pay $500,000 per year

for his or her fruit, yielding the farmer a profit of $100,000. Further

assume that the most those assets can yield in their next best alternative

use is a gross revenue of $100,000 per year. Once the farmer has invested in

the specialized assets, the processor may be tempted to renege on the

agreement and strategically lower the price because it realizes that as long

as it offers at least $200,000 it will still pay the farmer to deliver the

fruit to it, even though its action imposes a capital loss of up to $200,000

on the farmer.

Obviously, the processor cannot habitually act in this way because if it does

the farmer will be both unable and unwilling to maintain his or her

investment in fruit production. Nonetheless, if a large proportion of the

farmer's production costs are sunk at the time of the transaction, he or she

is particularly vulnerable to this sort of short-term opportunistic behavior

by his or her trading partner. Farmers may attempt to counteract this

opportunism by forming an association to: (a) bargain collectively with the

processor and threaten strikes if contract terms are ignored or (b) lobby for

government action to ensure the sanctity of contracts. In many instances,

however, even with a strong farmer association, it may be more costly for

farmers to try to enforce contracts with another firm than to internalize the

transaction by integrating forward via the creation of their own cooperative

firm. The incentives for farmers to integrate vertically via a cooperative

firm to avoid opportunistic behavior are greatest where the proportion of

sunk costs to total costs at the time of the transaction is high and the

product is highly perishable, making its transfer to alternative markets on

short notice very difficult. Fruits, certain vegetables, and dairy products

are examp les.

If an IOF is threatened by potential entry of competing firms, it may forego

short-run opportunistic behavior to maintain its market position (i.e., it

may practice limit pricing). This implies that the market share of

cooperatives would be smaller in rapidly expanding markets, where the threat

of entry of competing IOFs is greater, than in markets where demand is static

or declining. In static or declining markets, IOFs may have little to lose

by acting opportunistically. Such behavior may therefore create incentives

for farmers to integrate forward via cooperatives in these markets. This may

partly explain why U.S. farmer cooperative firms historically have expanded

their memberships and market shares during recessions, when markets for

agricultura15products have typically stagnated or shrunk (Heflebower, pp. 45,

76, and 77).

An IOF may itself face opportunistic behavior on the part of farmers,

particularly if the IOF has a large number of specialized assets at risk and

farmers have the option of reneging on their contract obligations and dealing

with other firms. Fear of such opportunistic behavior may make private

investors reluctant to undertake certain types of socially beneficial

agribusiness activities that also would be privately profitable if

opportunism were absent. Forms of vertically integrated ownership, such as

89
farmer cooperative firms, may,

B

y attenuating such opportunism, help fill

these important "empty niches.'*

Asset Fixitv and the Exercise of Market Power

Baumol, Panzar, and Willig, in their theory of contestable markets, argue

that the immobility of assets, rathe

7

than industry concentration per se,

allows the exercise of market power. They stress that for market power to

arise assets must be immobile on both sides of the market. Although the

immobility of assets in farming creates the potential for transferring rents

between farmers and their trading partners, the ability to capture these

rents depends on assets being immobile in the trading partners' businesses as

well. In other words, if barriers to exit are sufficiently high, they serve

to deter entry even where positive rents could be earned by entering the

market. This barrier to entry allows the farmers' trading partner to act

opportunistically.

Immobility of assets (including human capital) may reflect poorly functioning

factor markets, high costs of transferring resources due to other reasons

such as transport costs, and a high degree of asset specificity. This

suggests that the poorer the integration of markets and the more highly

specific the assets on both sides of the market, the greater the scope for

opportunistic appropriation of rents, and hence the greater the likelihood of

cooperatives or other forms of vertical integration by farmers. This is

another reason why agricultural cooperatives attract increased membership and

expand their activities during hard times, when alternative employment

opportunities for farmers and their assets are few and hence exit from

farming is difficult. It also partially explains the higher incidence of

cooperatives in subsectors such as dairy and fruit, in which assets on both

sides of the market tend to be highly specialized (milking parlors, orchards,

and processing plants), t an in other subsectors where assets are more

substitutable among uses. B

The analysis also suggests that as product and factor markets become less

fragmented, the asset fixity argument for the creation of farmer cooperative

firms becomes less compelling. If, however, greater market integration is

accompanied by increased asset specificity (including human capital

specificity), justification for vertical integration may still remain.

The asset fixity principle is involved in two of the most common rationales

for farmer cooperative firms and associations: the need to build

countervailing power and the need to preserve market access.

Countervailing Power

One of the most common justifications for farmer cooperation is that through

collective action farmers are able to counterbalance the market power of

their trading partners, leading to more equitable and efficient market

outcomes (Galbraith). Although this argument arises most often with respect

to cooperative associations, such as farmer bargaining associations, it

applies to farmer cooperative firms as well. Cooperative associations or

firms use their countervailingpower to raise farm incomes in two ways:

90
through redistributing existing income in the farmers' favor and through

increasing the efficiency of the economic system.

Countervailing Power and Income Distribution--Advocates of collective action

by farmers have long argued that markets in which farmers face highly

concentrated input, marketing, and processing industries generate a

fundamentally unjust distribution of income, both in terms of the income

received by farmers as a whole compared to other participants in the economy

and in terms of the inequality of incomes among farmers that results from

merchants playing one farmer off against another. By uniting in a bargaining

association, farmers may be able to redistribute income in their favor if the

association can effectively control enough of the supply to inf uence prices

and force IOFs to treat all members of the association equally. 4

Much of the potential of farmer cooperatives to use countervailing power to

redistribute income lies in the ability of these associations to limit the

appropriation of rents by farmers' trading partners. The creation of a

farmers' collective bargaining association or a farmer-owned firm may limit

the scope for such opportunistic behavior by reducing the ability of an IOF

to act as a discriminating monopsonist (through forcing the firm to treat all

farmers

f8

ually) and by increasing the actual or potential competition facing

the IOF. In addition to redistributing income in farmers' favor, the

reduction in the opportunistic appropriation of rents also may affect the

level of investment in agriculture, as discussed later.

Supporters of cooperative firms sometimes argue that in addition to

redistributing income in farmers' favor, a system that includes cooperatives

results in a more desirable regional distribution of income than a system

dominated entirely by IOFs. Large IOFs, it is argued, extract profits from

farming communities and channel them to metropolitan financial centers rather

than reinvesting locally. In contrast, say these advocates of collective

action, cooperative firms rebate net margins to patrons who invest them

locally, leading to higher local multipliers. The formation of cooperative

firms therefore may appeal to farmers not only as a means of increasing farm

income but also as a way of strengthening rural communities and

redistributing power in society.

Countervailing Power and Economic Efficiencv-The promise of increased

economic efficiency through countervailing power also may induce farmers to

form coopef

ative associations or firms and the state to support their

creation. Cooperative bargaining associations may increase efficiency by

transforming the market relationship between farmers and their trading

partners from one approaching simple monopoly or monopsony to one approaching

bilateral monopoly. (See Henderson and Quandt, pp. 244-49.) If farmers form

a cooperative marketing or supply firm to compete directly with IOFs instead

of simply bargaining collectively, such competition may improve economic

efficiency by compelling the IOFs to expand their output and increase their

X-efficiency (Leibenstein). Such competition also may reduce market

segmentation because the stockholder-customers of cooperatives may pressure

management to provide information, such as open formulas for feed and

fertilizers, that aids the customers in making buying decisions, even tho

rf

h

providing such information does not directly profit the cooperative firm.

91
Perhaps the most important way farmer cooperative firms may increase economic

efficiency is by decreasing the threat of opportunism in the face of fixed

assets, thereby encouraging investment in specialized assets in farming and

marketing facilities that can increase productivity. This advantage of

cooperatives may be particularly significant where the minimum efficient size

of operation in marketing and processing is large relative to the market and

hence the threat of monopoly or monopsony is very real.

Preservation of Market Options

The argument that agricultural cooperative firms are needed to preserve the

market options of farmers, particularly when IOFs exit a market, is

explicable largely in terms of the asset fixity principle. The prospect of

suffering large capital losses on illiquid farm assets should market access

be lost often motivates farmers to purchase investor-owned processing or

supply facilities that are closing because of poor earnings and convert these

facilities into cooperative firms. It is sometimes argued that farmers can

afford to operate marketing or farm supply facilities that IOFs have

abandoned in favor of more profitable investments elsewhere because farmers

take into account the joint profitability of farming and the marketing or

farm supply operations, not simply the profitability of marketing or input

supply alone. Whereas an IOF can exit the industry without having to take

into account the costs its departure imposes on its farmer-clients,

cooperative firms, because of their integrated nature, do take those costs

into account. Implicit in this argument is the idea that if IOFs did take

the joint profitability of farming and their marketing or farm-supply

activities into account, the IOFs would find it attractive to remain in the

industry.

This argument by itself is too facile. If the joint farming-input supply (or

marketing) operation is profitable but marketing or input supply alone is

not, why could not farmers and the IOF renegotiate their contracts,

redistributing some of the profits from farming so that the IOF could stay in

business? Indeed, if pricing of farm products is competitive, such a

redistribution of profits should take place automatically through the

market. There are several possibilities why this redistribution of profits

may not occur:

1 . If there is no collective bargaining by farmers (or if such efforts

are not effective--e.g., because of free-rider problems), if markets

for farm products are competitive, if cost structures differ among

the farms served by the IOF, and if the IOF cannot price discriminate

among its farmer customers, then competition among farmers will

redistribute rents only up to

earned by marginal producers.

lshe level of the rents previously

Inframarginal producers still may

earn rents at the competitive price, and these farmers stand to lose

those rents if the IOF exits the market.

2 . If, instead of pricing according to a competitive market, farmers

bargain collectively with the IOF, they may refuse to make price

concessions because they do not believe the IOF is in serious

financial trouble, a belief engendered by an unwillingness of the IOF

92
to open its books to the farmers. In this case, an advantage of

unified ownership of farming and marketing or input supply facilities

is an improved flow of information among system participants about

the financial health of the different operations.

3 . In collective bargaining with farmers, IOFs often have to commit

themselves to a raw product price before they know what prices they

will receive for their processed products. If agricultural

production and hence supplies and prices of products are volatile,

the IOF can incur heavy losses, yet be severely limited in its

ability to renegotiate its contracts with growers. Given highly

volatile markets, it is difficult for farmers to discern ex ante

whether an IOF asking for concessions is genuinely in trouble or is

simply attempting to act opportunistically.

4 . There may be no possible redistribution of profits between farmers

and the IOF that would simultaneously satisfy both parties'

requirements for profitability, yet the overall profitability of the

integrated operation may be acceptable to farmers but not to the

IOF. Farmers may be willing to accept a lower overall rate of return

on investment than is the IOF to capture the nonmonetary rewards of

farming, be assured secure input and output markets, or because

farmers have fewer alternative investments open to them than do TOFs

due to imperfections and transaction costs in the capital market.

5. There may be efficiencies in running input supply or marketing

facilities as cooperatives rather than as IOFs. These potential

efficiencies are discussed later.

The argument that farmers form cooperative firms to avoid capital losses that

would accrue if market access were lost suggests, as did the countervailing

power argument, that cooperatives would be more prevalent where farmers have

a large number of specialized assets at risk. This partly explains why

historically cooperative firms in the United States have been most preval nt

in those areas where farmers were highly specialized in a few activities. f 4

Development of New Farm Activities

Another consequence of the asset fixity principle is that cooperative firms

may be more likely to encourage the development of new crops and farming

techniques than are IOFs, particularly where the IOFs are restricted from

vertically integrating into farming. A marketing or processing IOF may be

reluctant to invest in teaching farmers new production techniques because the

farmers can potentially use their new skills to produce products for a

competing firm. Absent slavery, it may be very difficult for the IOF to

compel a farmer to sell exclusively to the firm for a long enough period to

amortize the firm's investment in specialized human capital in the farmer.

There is therefore an incentive to move toward unified ownership of farming

and processing to reduce this potent'al for opportunism. If permitted, IOFs

may integrate backward into farming; $ 5 alternatively, farmers may integrate

forward into processing. If forward integration takes place via a

cooperative firm and if farmers' return on their investment in the firm is

93
contingent on their continued patronage (see Staatz 1984, chap. 2), then they

may be less inclined to act opportunistically toward the cooperative firm

than they would be toward an IOF. This greater loyalty to the cooperative

would increase the cooperative's incentive to train farmers in new production

techniques. Ranade reports that in India, where land ownership ceilings

prevent multinational processing firms from integrating backward into

farming, multinationals are extremely reluctant to engage in farmer extension

work, while cooperative processors are heavily engaged in these activities.

The Uncertainty Principle

The uncertainty principle states that the greater the uncertainty surrounding

a transaction the less likely the transaction is to be efficiently mediated

by autonomous market contracting (Williamson 1979b). As uncertainty

increases, so does the cost of renegotiating contracts; as unforeseen

contingencies arise, so does the potential for opportunistic behavior. An

increase in uncertainty therefore creates incentives to shift from

institutions like the spot market to contingent contracts and vertical

integration. Because farmer cooperative firms co ine elements of both

vertical integration and contingency contracting, fB they may offer more

ways of dealing with uncertainty than either IOFs or bargaining associations.

Flexibility in Pricing

Because a farmer cooperative operates at cost, the prices it charges or pays

farmers are contingent on the firm's earnings. Typically, contingent pricing

in cooperative firms is accomplished using patronage refunds. In some lines

of business, such as fruit and vegetable processing, farmer cooperative firms

have extended contingency pricing to the point where payment for the crop may

be spread out for a year or longer following the harvest, with the amount of

the total payment contingent on the earnings of the pool in which the crop

participates.

Contingent pricing has several advantages in an uncertain environment. It

helps firms on both sides of the market avoid the costly mistakes of

committing themselves to prices that are either too high or too low in light

of changing and not fully known supply and demand conditions. It also

renders unnecessary the costly renegotiation of contracts should one party

feel it has been treated unfairly in light of the evolving market situation.

In the presence of imperfect capital markets, it also allows firms greater

flexibility in the timing of their sales. For example, Hamm (pp. 478 ff.)

describes how investor-owned processors in the canned fruit and vegetable

industry often have to offer special prices to distributors early in the

processing season to generate the cash flow necessary to pay farmers for

their crops. Cooperative processors, which are not constrained to pay

farmers immediately for their crop, have greater marketing flexibility.

In recent years, many investor-owned agricultural processing firms have moved

to contingent pricing of raw agricultural products similar to that practiced

by cooperatives (Chase-Lansdale). Nonetheless, contingency contracting is

likely to operate more smoothly in a cooperative firm. Because farmers own

94
the firm, have access to its financial accounts, and can discipline the

manager through the board of directors, they are less likely to believe that

the cooperative is using contingency contracting to act opportunistically

toward them. In contrast, unless contingency contracts between farmers and

IOFs are based on a formula (rather than a promise to "pay what we can

afford**) and permit farmers to verify the IOF's earnings,

to disputes that are costly to adjudicate.

they may give rise

Reduction of Risk Through Pooling

A commonly cited advantage of agricultural cooperatives is their ability to

reduce the variability of farmers' incomes through the pooling of grower

returns and expenses across products, time, and space. Pooling may lead to

some reduction in risk for individual farmers because fluctuations in the

returns for their commodities are counterbalanced by offsetting fluctuations

in the returns for other commodities in the pool. 17 This income

stabilization function may become increasingly important to farmers as they

specialize because in specializing they lose the income stabilization

imparted by on-farm diversification.

Although cooperative pooling may provide an income insurance function, for it

to be an incentive to establish cooperatives, this form of insurance has to

be cheaper than other ways farmers have of stabilizing their income, such as

on-farm diversification and reliance on the capital or futures markets. This

is more likely to have been true in the past than it is currently. In the

past, farmers may have preferred pooling as a means of stabilizing income for

at least three reasons. First, the uncertainties in agricultural production

and the fragmentation of rural capital markets may have caused lenders to

charge a large premium when lending to farmers. Second, pooling often

involved fewer transaction costs at the level of the individual farmer than

other forms of income insurance. Whereas gaining income stability through

the capital or futures markets requires the farmer to undertake several

transactions, such as taking out and repaying loans and buying and selling

contracts, in pooling the buying and selling decisions are centralized at the

level of the cooperative's management. This advantage of pooling probably

has been reduced as cooperatives themselves have increasingly turned to

hedging in an attempt to stabilize member returns. Third, farmers who

believed that the demand for their crop was declining may have seen pooling

as a way of transferring income to themselves from producers of more

remunerative crops. If a pool includes a broad array of products,

substantial income transfers can occur as returns from highly profitable

crops subsidize producers of low-return crops. The extent to which such

transfers can be maintained, however, is circumscribed by pressures from

producers of high-value products to limit pools to a narrow range of crops

having similar demand characteristics and to distinguish between different

qualities within a pool through a system of premiums and discounts.

Historically, many cooperatives have fluctuated between widely and narrowly

defined pools, as management has tried to balance the economies of size in

marketing permitted by broad pools against the pressures to limit income

redistribution within the cooperative through pooling. In recent years, many

95
cooperatives have moved to more narrowly defined pools (Staatz 1984,

7) .

chap.

If the income stabilization gained through pooling has served as an incentive

to form farmer cooperatives, one would expect pooling to be most prevalent in

cooperatives handling highly perishable products whose prices fluctuate

widely (and hence generate very unstable income streams) and for which there

are no organized futures markets. Cooperatives handling storable commodities

like grains or perishable products like livestock that can be traded on the

futures market might operate more on a simple buy-sell basis because their

members have the option, not open to producers of other highly perishable

products, of trying to achieve some degree of income stability through

intertemporal arbitrage of their raw product or through relying on the

futures market. This hypothesis is consistent with the experience of U.S.

agricultural marketing cooperatives: Most major fruit and vegetable

processing cooperatives operate on a pooling basis while most grain and

livestock cooperatives simply buy and resell the products of the members.

The Externality Principle

The externality principle states that a firm has an incentive to integrate

vertically when participants in adjacent market stages impose negative

externalities on the firm (Williamson 1981, pp. 1549-50).

Preservation of Product Quality

A major externality arises when participants in adjacent market stages

intentionally or unintentionally debase a firm's inputs or branded products.

For example, if a company produces a high-quality perishable product that

requires special handling in subsequent stages of the distribution system,

negligent handling of the product by distributors can damage the company's

reputation with consumers. Because it is often easier to control product

quality within the firm than across market boundaries, the company producing

the product may vertically integrate to gain tighter control over the

distribution system. For example, during the early 1900s California citrus

growers perceived that the erratic quality of their products in eastern

markets was limiting the demand for oranges and lemons. Much of the early

work of the California Fruit Growers Exchange (later Sunkist) was aimed at

improving the distribution channels for citrus, partly through vertical

integration, to ensure that citrus reaching eastern markets was of

consistently high quality (Kirkman).

On the input side, farmers also may have an incentive to integrate

vertically, particularly when new inputs, such as fertilizer, improved seeds,

and insecticides, are being introduced whose characteristics are difficult to

determine ex ante. In such situations, the scope for opportunistic behavior

is large. When such inputs are first being introduced, even ethical dealers

may not devote full attention to quality control because in the short run it

is difficult to demand a premium price for higher quality products when the

higher quality is not immediately apparent to the buyer. Concern about

building long-term business relationships tempers the tendency to shirk on

.

96
product quality; nonetheless, if the costs of entry into and exit from the

input supply business are low, incentives for fly-by-night behavior remain.

In such situations, the cheapest way for farmers to guard against such

opportunism may be to integrate vertically into the input supply business

through a grower-owned firm. For example, Southern States Cooperative, a

large supply cooperative in the southeastern United States, was formed in

1923 in response to problems tha

E

farmers had with the poor quality seed sold

by private dealers at that time. 8

Agricultural processing firms attempting to build a strong brand name may

face the same problem of assuring the quality of their inputs, particularly

their raw agricultural inputs. The problem may be most acute when the

processor is encouraging the production of a new crop, and farmers,

unfamiliar with the techniques necessary to produce a suitable product, need

close supervision. The cheapest way for the processor to assure product

quality may be to integrate vertically into farming or to use detailed

contracts to require farmers to follow specific production practices.

Contracting leads to contract enforcement costs, which may be lower for

cooperative firms than for IOFs because cooperative firms potentially have

more ways of punishing members who fail to live up to their contracts than do

IOFs. Not only can a cooperative include the same noncompliance clauses in

its contracts as does an IOF, but members who act opportunistically toward

their cooperative may face social sanctions from their fellow farmers as

well. In addition, a cooperative can make a member's return on

f!J

uity in the

organization contingent on fulfilling the terms of the contract.

Provision of Public Goods

Many of the **competitive yardstick" activities of farmer cooperative firms,

such as their leadership in introducing open formula feeds, can be viewed as

public goods. Farmers, faced with unsatisfactory performance by IOFs, may

form a cooperative firm whose purpose is to force the IOFs, through

competition, to improve their service to farmers. If successful in enforcing

competition, the cooperative generates benefits that it does not capture

itself but which accrue to the farmer-stockholders, as well as to other

farmers in the area. No independent IOF has an incentive to generate such

positive externalities (although the logic of a competitive market often

forces such behavior); it is the integrated nature of farmer co eratives

that leads to their being formed specifically for this purpose. 88

The Hierarchial Decomposition Principle

Earlier sections of this paper have argued that where asset fixity is

present, firms have an incentive to integrate vertically to avoid

opportunistic behavior by their trading partners. This section uses the

hierarchical decomposition principle to examine why such integration is more

likely to take the firm of farmers vertically integrating into other types of

agribusinesses via cooperative firms than IOFs vertically integrating into

farming.

97
Sim

of

int

cos

the

be

eff

bY

fol

.ply transf

a firm doe

ernalizati

ts, these

firm. Fo

organized

'iciently.

following

lows:

'err

s n

on

are

r v

int

Wi

the

ing a transaction fr

.ot guarantee a reduc

of the transaction e

replaced by the cos

-ertical integration

ernally in a way tha

lliamson (1981, p.15

hierarchical decomp

Internal organization shoul

quasi-independence between

(operating activities) and

should be clearly distingui

and between components so a

effectiveness.

d be

the p

low f

shed,

.s to

om the market to the internal bureaucracy

tion in transaction costs. Although

liminates previously incurred selling

ts of mediating the transaction within

to result in a net savings, the firm must

t allows it to handle the transaction

50) argues that this is best accomplished

osition principle, which he states as

designed in such a way as to effect

arts, the high frequency dynamics

'requency dynamic s (strategic planni

and ince ntives should be al igned w

promote b0th lot al and globa 1

w)

tithin

Decomposing the firm's activities into relatively independent subunits helps

prevent top management from being swamped with day-to-day operational duties,

promotes an orderly flow of information within the firm, and helps managers

within a division create an effective set of incentives for their

subordinates by making division employees primarily responsible to their

division manager, not a myriad of others, as might occur in a less

hierarchical organization.

The separation of responsibilities for daily operational decisions,

particularly at the farm level, from longer-term strategic planning and

marketing decisions would be particularly important for a firm attempting to

integrate vertically into farming, as many farm-level managerial decisions

are highly time- and site-specific. Unless environmental conditions on the

farm can be tightly controlled (as, for example, in poultry production),

vertical integration into farming may require a higher degree of farm-manager

autonomy than most IOFs are willing to delegate.

A farmer cooperative firm, on the other hand, represents a looser form of

vertical integration than a

Y?

rtically integrated IOF, resembling in many

ways a contingency contract. Stockholders in the cooperative firm agree

to eschew competition among themselves in their marketing and input supply

activities but continue to make the rest of their decisions independently.

Cooperative firms therefore allow their members to capture many of the

advantages of large-scale marketing, input production, and strategic planning

while still permitting farmers to make most of their farm-level decisions

themselves. Thus, while there are often strong reasons for vertically

integrating between farming and certain marketing and input supply

activities, the more decentralized nature of cooperatives make them a more

efficient means of carrying out that integration than an IOF.

Cooperatives as a Means of Redistributing Rights

Farmers often have acted collectively in an attempt to redistribute property

rights in society, not simply to reduce transaction costs within a given

98
distribution of rights. Such collective action usually has taken the form of

cooperative associations rather than firms. Because organizing collective

action to redistribute rights often involves free-rider problems, however, a

cooperative association may attempt to finance its political activities

through sales of appropriable goods to its members (Olson). For example,

most farm supply cooperatives in the United States were started by farmer

organizations that originally were formed for other purposes, mainly

political lobbying (Heflebower, p. 75). Farmer cooperative firms that

provide their members with goods such as farm supplies as well as lobbying

may be an effective means of organizing for political action in those

instances where farmers have a strong economic interest at stake, such as in

the design of commodity policies, and where laws concerning how these firms

spend their net earnings are lax.

Political Activity of Cooperatives

Cooperative associations attempt to redistribute rights not only through the

exercise of countervailing power but through direct involvement in the

political system as well. Particularly in those areas of agricultural

production where public involvement is large, for example because of public

health concerns, farmers may feel the need to organize politically to make

their voice heard in public decisionmaking bodies. Once organized for this

purpose, a cooperative association can be used at low cost to lobby for other

issues, such as improved terms of trade. (For example, consider U.S. dairy

cooperatives.) As direct government involvement in the agricultural economy

increases, lobbying may become the most important function of many

cooperatives. In the words of the manager of a large dairy cooperative

interviewed by the author:

We can increase returns to our members in two ways: through improving

the efficiency of our distribution system for milk and through political

action. Increasing efficiency adds pennies to our members' milk checks

while political action adds dollars. We allocate our resources

accordingly.

Cooperative associations also may be used to channel resources to farmers

after the rights to those resources have been won through political action.

For instance, tobacco and peanut cooperatives in the United States serve

largely as mechanisms to administer price support programs for these

commodities. Many dairy, fruit, and vegetable cooperatives implement the

provisions of marketing orders, some of which permit price discrimination and

other manipulations of supply. In Scandinavia, agricultural cooperatives

take on many of the functions of a public agency, helping to coordinate

government farm programs and equilibrate the supply and demand for

agricultural products (Ollila).

Cooperatives and the Democratic Ideal

Farmer cooperative associations, with their emphasis on member involvement

and voting on a basis other than capital contribution, historically have

often been formed as part of a broader attempt to promote democratic values

and wider political participation in society, particularly in situations

99
where other social organizations were highly autocratic. Early cooperative

organizers in the United States saw themselves as part of a larger social

movement aimed at redistributing power in society, and much of the early

growth of farmer cooperatives, and hence their current competitive position

in U.S. agriculture, is attributable to the strength of the populist movement

of the late 19th and early 20th centuries. Neopopulist authors such as

Kravitz continue to emphasize the importance of democratic cooperation not

only as an end in itself, but also as a way of combating the concentration of

wealth and power they see as inherent in capitalism. Many cooperative

supporters also stress the importance of cooperatives as "training grounds

for democracy,'* in which members gain skills they later use in local

governments and other organizations (see, e.g., Wills, pp. 25 and 28).

Although cooperation as a goal in itself may have been an important element

in the founding of some agricultural cooperative associations and firms, it

is unlikely by itself to sustain them, even when they have members with a

strong ideological commitment to cooperatives. This is particularly true

where the level of competition between cooperatives and IOFs is intense,

perhaps due to the previous success of the cooperatives, and where there are

alternative outlets for democratic participation, such as running for the

school board. As the manager of one cooperative firm put it, "currently

cooperative loyalty is worth about two cents per bushel."

Summary

Many of the potential benefits farmer cooperative associations and firms

offer their members derive from the fixity of assets, both physical and

human, in farming and other types of agribusiness. Asset fixity in farming

generates rents, which farmers' trading partners can potentially capture by

acting opportunistically, provided that asset fixity in the trading partners'

business creates barriers to entry or exit that permit the exercise of market

power. Asset fixity therefore underlies the arguments that cooperatives are

necessary to provide farmers with market power and to preserve their access

to markets. This suggests that farmer cooperatives are more likely to arise

and convey greater benefits to their members where: (a) Assets on both sides

of the market are highly specialized and/or (b) product and factor markets

are fragmented, leading to a divergence between the values of the asset in

its current use and its value in alternative uses. It also suggests that

cooperatives will tend to be more prominent in declining markets than in

expanding markets because in declining markets the long-term consequences to

farmers' trading partners of acting opportunistically are less severe than in

expanding markets, in which the threat of entry of competing firms is higher.

Because of asset fixity, cooperative firms may offer certain advantages over

IOFs during the early stages of agricultural specialization.

Farmer-stockholders have fewer incentives to act opportunistically toward

their own cooperative firm than they do toward an IOF (provided that their

return from the cooperative is contingent on their continued patronage);

therefore, the cooperative firm has more of an incentive than an IOF to

invest in training farmers in new production techniques.

100
The potential for opportunistic appropriation of rents from farmers is

accentuated by the riskiness inherent in agricultural markets. Cooperative

firms may offer farmers certain advantages in dealing with risk, primarily

through the firms' ability to practice contingency pricing via patronage

refunds and to offer members some degree of revenue insurance through

pooling. This suggests that pooling will be more prevalent in subsectors

like fruit and vegetables, where production and prices are more volatile and

other risk management tools such as the futures market are unavailable, than

they will be in subsectors like grain, where risk may not be as great and

there are alternative ways of managing it.

Farmers also may vertically integrate via cooperative firms to internalize

externalities imposed on them by their trading partners. On the output side,

farmers' trading partners may pay insufficient attention to maintaining the

quality of farm products, particularly highly perishable ones, as they move

through the marketing system, thereby depressing farm-level demand for these

products. On the input side, farmers may have an incentive to integrate

backward when they have no simple way of ascertaining the quality of

purchased inputs, such as by simple inspection or by relying on the sellers'

reputation. Particularly in the early stages of the industrialization of

agriculture, when purchased inputs are just becoming important in farming and

input suppliers' reputations are not well established, farmers may have a

strong incentive to integrate vertically via cooperative firms to assure

input quality.

Farmers also may have an incentive to integrate vertically to provide

themselves with goods and services that no IOF has an incentive to produce

due to their public good nature. This is particularly true of the

"competitive yardstick" services of farmer cooperative firms, the benefits of

which accrue not to the cooperative firm as such but to the farmer-members.

In their internal organization, farmer cooperative firms may offer certain

efficiencies ov

85

IOFs that help offset cooperative firms' possibly higher

decision costs. In particular, the cooperative structure allows

farmer-members to make certain location-specific farm-level decisions

individually while allowing other decisions to be made collectively.

Therefore, if there are incentives to vertically integrate farming with other

stages of production, cooperatives may be a more flexible means of achieving

that integration than IOFs, in which central management may be reluctant to

decentralize a large number of farm-level decisions.

Farmers do not form or join cooperatives simply to reduce transaction costs;

an additional motivation may be to try to redistribute rights in the farmers'

favor. Particularly where farmer-members have strong common interests, as in

single-commodity organizations, farmer cooperative associations may be an

important means by which farmers can unite to take political action. Such an

association may evolve into a firm because a cooperative firm also can

provide its members with appropriable goods and services as well as a means

of organizing political action, thereby overcoming many of the free-rider

problems inherent in political organizations (Olson).

101
Most of the cost savings outlined in this paper could accrue not only to a

farmer cooperative but also to an IOF that was involved in agribusiness and

owned primarily by farmers. In many societies, however, the ability of a

farmer organization to attract an initial membership and win concessions from

the political system may depend on its being perceived as a democratic

instrument of self help, aimed at tempering the alleged rapaciousness of

capitalism. In this sense, it may be true, as Kravitz claims, that the

process of cooperation is inseparable from the results of cooperation.

Notes

1 . van Ravenswaay discusses the need to distinguish between a cooperative

association (i.e., an organization to promote collective action by

farmers, such as a bargaining association or a lobbying group) and the

firm owned by a cooperative association.

2 . The transaction cost approach could be used to compare farmer-owned

cooperatives with other forms of economic enterprise as well, such as

worker-owned firms. Due to space limitations, this paper only presents

comparisons between farmer-owned cooperatives and IOFs.

3 . Williamson (1981) pointed out that all transaction costs derive from a

combination of bounded rationality (which reflects both imperfect

information and a limited capacity to analyze it) and opportunism, which

he defines as *'self-interest seeking with guile." Given imperfect

information about the future, all contracts are necessarily incomplete.

If people were never opportunistic, however, incomplete contracts would

not lead to contract enforcement problems; contracts would simply state

that if unforeseen contingencies arose the parties would act in a manner

acceptable to all.

4 . See Johnson and Quance for a detailed discussion of the factors that

contribute to asset fixity in agriculture.

5. Declining markets, leading to an increase in cooperatives' activities,

may result from changing consumer preferences as well as from

recessions. For example, during the 1950s and 196Os, when demand for

canned fruits and vegetables was growing, the market share of

investor-owned fruit and vegetable processors was high. With declining

demand in the 1970s and 198Os, farmer cooperatives have come to dominate

the processing market.

IOFs may have another important advantage in markets that are

expanding: the ability to respond rapidly to emerging market

opportunities. Cooperatives, with their higher costs of collective

decisionmaking, may be less adept at seizing such opportunities.

6 . See the section on the hierarchical decomposition principle for a

discussion of why vertical integration by farmers into other

agribusinesses is more likely than vertical integration by IOFs into

farming.

102
7 . For concise summaries of this argument, see Baumol (1982a, 1982b) and

Rhodes.

8 . Heflebower, in reviewing the history of farmer cooperative firms in the

9 There is strong debate over whether bargaining associations can

effectively influence supply. See, for example, Baron.

10 Implicit in the creation of a bargaining association is the threat that

the association may form a firm to compete with the IOFs if they do not

bargain in good faith. For example, the California Canning Peach

Association, a bargaining cooperative, was instrumental in founding

California Canners and Growers (Cal Can), which until 1983 was one of

the largest fruit and vegetable processing cooperatives in the United

States. Cal Can was founded in part because investor-owned processors

were cancelling the contracts of farmers who participated actively in

the bargaining association.

11 Most farmers are interested in how cooperatives affect overall economic

efficiency only to the extent that such improved efficiency results in

more favorable net farm revenues. Supporters of agricultural

cooperatives, however, have often argued that the efficiency-improving

effects of cooperatives' countervailing power justify state support of

farmer cooperation.

12 In the United States, farmer cooperatives pioneered the use of open

formula feeds and fertilizers (Heflebower, pp. 78-82). Cooperatives

may, nonetheless, have incentives to differentiate their products, both

through advertising and member relations programs, to increase member

loyalty. Indeed, cooperatives often stress their member orientation as

a distinctive quality of their service.

13 . A marginal producer is defined here as the highest cost producer among

those who collectively generate the minimum total volume of patronage

necessary for the IOF to stay in business.

United States, concluded that, "Cooperative marketing has developed most

vigorously where farmers specialize in one or a few products and have

substantial investment that cannot be diverted to other use" (pp.

72-73). For more recent evidence, see Wilkins.

14 . There is substantial evidence on this point. For dairy, grains, and

poultry, see Heflebower (pp. 44, 52, and 71). For vegetables, see Hamm

(p. 501).

15 . Around 1900, many of the large national fruit and vegetable processors

in the United States were vertically integrated into farming, in part to

assure the quality of their raw product inputs. After the human capital

to produce these products had been built up and sufficiently amortized,

the firms sold their farming operations and met their raw product needs

through contracting with farmers.

103
16 . See Shaffer, "Thinking About Farmers' Cooperatives, Contracts, and

Economic Coordination," in this volume.

17 . There is no guarantee that pooling will stabilize returns to all

18 As an alternative to forming their own firm, farmers may unite in an

association to lobby for greater direct government regulation of

investor-owned input supply firms to ensure the quality of their

products. Whether this approach is more cost effective than ensuring

product quality through creation of a farmer cooperative firm depends in

part on how open the political system is to farmers. Forxiscussion

of the historical experience in the United States, see Heflebower (pp.

78-82).

19 Staatz, "The Structural Characteristics of Farmer Cooperatives and Their

Behavioral Consequences," in this volume.

20 The public good nature of many of the activities of farmer cooperatives

leads to free-rider problems, which are analyzed in Staatz, **A

Game-Theoretic Analysis of Decisionmaking in Farmer Cooperatives," in

this volume.

21 . See Shaffer, "Thinking About Farmers' Cooperatives, Contracts, and

Economic Coordination," in this volume.

participants in the pool. Producers of "stable" crops may find their

returns destabilized by pooling.

22 . See Staatz, "The Structural Characteristics of Farmer Cooperatives and

Their Behavioral Consequences,'* in this volume.

References

Baron, P. J. "Why Cooperation in Agricultural Marketing?" Journal of

Qricultural Economics 29(1978):109-17.

Baumol, William J. "Contestable Markets, Antitrust, and Regulation."

Wharton Magazine, Fall 1982a, pp. 23-30.

*'Contestable Markets: An Uprising in the Theory of Industry

Structure.** 'American Economic Review 72(1982b):l-15.

Baumol, William J.; John C. Panzar; and Robert D. Willig. Contestable

Markets and the Theory of Industry Structure. New York: Harcourt Brace

Jovanovich, 1982.

Bromley, Daniel W. "Land and Water Problems: An Institutional Perspective."

American Journal of Agricultural Economics 64(1982):834-44.

Coase, R. H. *'The Nature of the Firm." Economica n.s. 4(1937):386-405.

Reprinted in Readings in Price Theory, ed. George G. Stigler and Kenneth-E.

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Boulding, pp. 331-51. Homewood, Ill.: Richard D. Irwin for American

Economic Association, 1952.

Chase-Lansdale, Wilson Compton. *'The Political Economy of Farmer

Bargaining: Cooperative and Proprietary Processor Responses to Farmer

Bargaining." Ph.D. dissertation, Michigan State University, 1980.

Galbraith, John Kenneth. American Capitalism: The Concept of Countervailing

Power, rev. ed. Boston: Houghton Mifflin Co., 1956.

Hamm, Larry G. "Food Distributor Procurement Practices: Their Implications

for Food System Structure and Coordination.*' Ph.D. dissertation, Michigan

State University, 1981.

Heflebower, Richard B. Cooperatives and Mutuals in the Market System.

Madison, Wis.: University of Wisconsin Press, 1980.

Henderson, James M., and Richard E. Quandt. Microeconomic Theory, 2nd ed.

New York: McGraw-Hill Book Co., 1971.

Hirschman, Albert 0. Essays in Trespassing: Economics to Politics and

Beyond. New York: Cambridge University Press, 1981.

Johnson, Glenn L. "The State of Agricultural Supply Analysis." Journal of

Farm Economics 42(1960):435-52.

Johnson, Glenn L., and C. Leroy Quance. The Overproduction Trap in United

States Agriculture. Baltimore: Johns Hopkins University Press for Resources

for the Future, 1972.

Kirkman, C. H. The Sunkist Adventure. Washington, D.C.: USDA FCS

Information 94, 1975.

Klein, Benjamin; Robert G. Crawford; and Armen A. Alchian. "Vertical

Integration, Appropriable Rents, and the Competitive Contracting Process."

Journal of Law and Economics 21(1978):297-326.

Kravitz, Linda. Who's Minding the Co-OP? A Report on Farmer Control of

Farmer Cooperatives. Washington, D.C.: Agribusiness Accountability Project,

1974.

Leibenstein, Harvey. "Allocative Efficiency vs. 'X-Efficiency."' American

Economic Review 56(1966):392-415.

LeVay, Clare. "Agricultural Co-operative Theory: A Review." Journal of

aricultural Economics 34(1983):1-44.

McNiel, Kenneth. "Understanding Organizational Power: Building on the

Weberian Legacy." Administrative Science Quarterly 23(1978):65-90.

105
Ollila, Petri. "Member Influence in Cooperatives: Contributions of

Scandinavian Studies to Research Conducted in the United States.*' Master's

Plan B paper, Michigan State University, 1983.

Olson, Mancur, Jr. The Logic of Collective Action. New York: Schocken

Books, 1968.

Ouchi, William G. "Markets, Bureaucracies, and Clans." Administrative

Science Quarterly 25(1980):129-U.

Ranade, Chandra. "Agricultural Cooperatives in India." Seminar presented at

Dept. of Agricultural Economics, Michigan State University, Oct. 26, 1983.

Rhodes, V. James. "Cooperatives and Contestable/Sustainable Markets." In

this volume.

Shaffer, James D. "Notes for a More Comprehensive Theory of Farmer Owned

Cooperative System." Cooperative Theory Working Pap. 1, Dept. of

Agricultural Economics, Michigan State University, 1982.

Coordination:*'

"Thinking About Farmers' Cooperatives, Contracts, and Economic

In this volume.

Staatz, John M. "The Cooperative as a Coalition: A Game-Theoretic

Approach." American Journal of Agricultural Economics 65(1983):1083-89.

Cooperatives:"

"A Theoretical Perspective on the Behavior of Farmers'

Ph.D. dissertation, Michigan State University, 1984.

Cooperatives:"

*'A Game-Theoretic Analysis of Decisionmaking in Farmer

In this volume.

"The Structural Characteristics of Farmer Cooperatives and

Their Behavioral Consequences." In this volume.

van Ravenswaay, Eileen 0. "Organization of Decision Making in Agricultural

Cooperatives." Unpublished paper, Dept. of Agricultural Economics, Michigan

State University, 1985.

Wilkins, Paul C. "Marketing, Farm Supply Cooperatives Serve More than Half

United States Farmers." Farmer Cooperatives, Jan. 1983, pp. 12-13.

Williamson, Oliver E. "The Vertical Integration of Production: Market

Failure Considerations." American Economic Review 61(1971):112-13.

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Markets and Hierarchies: Analysis and Antitrust

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**On the Governance of the Modern Corporation.'* Hofstra Law

Review 8(1979a):63-78.

106 .
"Transaction Cost Economics: The Governance of Contractual

Relations." *Journal of Law and Economics 22(1979b):233-61.

"The Modern Corporation: Origins, Evolution, Attributes."

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Wills, Walter J. Randolph Service Company: Its Economic Imnact.

Washington, D.C.: USDA ACS Res. Rep. 18, 1981.

107
COOPERATIVES AND CONTESTABLE/SUSTAINABLE MARKETS

V. James Rhodes*

A primary reason for the organization of cooperatives by farmers has been

perceived market failures. A conviction that the local farm supply

was exploiting a monopoly position or that the network of livestock

busine

market

ss

S

and dealers was hopelessly inefficient often has been the rationale for

establishing a cooperative. Historically there has been much acceptance of

E. G. Nourse's dictum that the goal of the cooperative is to serve as a

competitive yardstick- -a goad to investor-owned firm (IOF) competitors to

keep their costs and profits in line.

Some new developments in theory by such illustrious economists as Baumol give

new emphasis to the implications of low barriers to entry and exit (Baumol,

Panzar, and Willig). This literature argues that in certain conditions

defined as contestable markets any type of market structure yields highly

competitive results. This paper examines some of the implications of those

theoretical developments for the theory of the large cooperative and for the

application of antitrust laws to cooperatives.

A key element in the new literature is the idea of a "contestable market." A

contestable marke

"perfectly contes

disadvantages on

incumbents and (2

t is one tha

table market

either the c

) exit can b

t is

" has

ost 0

easily entered by new competitors. A

two characteristics: (1) Entrants have no

lr demand sides as compared to the

e cos tless if the entrant were to find the

market unprofitable. The implications are obvious. In markets in which

entrants can pounce on above-competitive profits or inefficient cost

structures, those types of market failures cannot persist. Degree of market

concentration does not matter if the incumbents must operate in fear of being

overrun by numerous entrants. Public policy measures then focus on promoting

ease of entry--and exit- -rather than on degree of structural concentration.

The narrow focus of this theory must be emphasized. Its market failures

arise from lack of competition. Any market failures arising from the

inherent uncertainty of future events are ignored. Shaffer argues that the

unique characteristics of cooperatives give them advantages in dealing with

certain types of real world uncertainty. Such advantages are ignored in this

analysis because the contestable markets analysis ignores them. Cooperatives

are treated here solely in terms of their usefulness as a competitive

yardstick.

Thus, in perfectly contestable markets, there is no special need or

opportunity for cooperatives. Regardless of the fewness of IOFs serving the

farm supply or marketing needs of farmers, there would be no market failures

of the type that typically have called forth cooperatives.

The potential entrants serve as well or even better than cooperatives as the

competitive yardstick. Of course, incumbent cooperatives certainly could

continue as long as they competed effectively. Why would cooperatives ever

*The author appreciates the helpful comments of Missouri colleagues Harold

Breimyer, Bruce Bullock, Charles Cramer, and Brice Ratchford and Michigan

State colleagues James Shaffer and John Staatz.

108
have entered such a market? Presumably for historical reasons. Perhaps the

market once was not contestable or was perceived that way by farmers or the

farm organization that organized the cooperative.

Given the redundancy of cooperatives in perfectly contestable markets, shall

we conclude that such markets are rare in agribusiness or that cooperatives

no longer are needed? While a full and complete answer would require much

research, it is immediately clear--and Baumol, Panzar, and Willig agree--that

the assumptions for perfect contestability are demanding indeed. The

traditional literature on entry has stressed the difficulties to an entrant

of breaking through the web of customer allegiances to the incumbents' array

of differentiated products. It appears that a perfectly contestable market

must have virtually no product differentiation. Also, in a perfectly

contestable market, the incumbents must have no cost advantage due to secret

or patented processes or sole access to scarce resources.

Large economies of scale may limit the number of potential entrants, but they

are not in themselves disadvantageous to entrants that can raise the . necessary capital. Nevertheless, generally it has been argued that any

entrant will hesitate to commit large capital resources if they cannot be

retrieved readily. Solution of the capital retrieval problem is the essence

of the costless exit assumption of perfectly contestable markets. Its

proponents argue the importance of the degree to which capital is "sunk" in a

market, i.e., the extent to which it cannot be salvaged readily through

depreciation or removal to other markets or sale (at reasonably full

recovery) to other firms. Their favorite example seems to be in the

airlines. Planes, the largest capital item in airlines, can be moved readily

from a new route (market) to other routes if that market proves to be

disappointing to the entrant. The capital costs in airlines are high but the

- - sunk costs in any given market are much lower. Consequently, airlines have

moved briskly into-- and sometimes out of--new markets in the recent era of

deregulation.

Without significant sunk costs, the entrant is freer to switch rather than

continu

f

to fight. Incumbents find it impossible to defend above-competitive

profits from the hit-and-run tactics of the completely mobile entrant. On

the other hand, if there will be important sunk costs, an entrant must assess

the risks of taking on incumbents that may choose to fight. Incumbents can

likely protect some extra profits from less mobile would-be aggressors,

because the latter realize that the post-entry environment might be so

inhospitable as to prevent the recovery of their sunk costs.

Contestable Agribusiness Markets

How well do the markets for agricultural commodities and farm supplies fit

the conditions for perfectly contestable markets? Product differentiation

does play a rather limited role in many agricultural markets because of the

homogeneous nature of farm commodities and some farm inputs. Patents and the

high costs of R and D deter entry into the manufacture of many farm chemical

pesticides and heavy farm machinery but are not important in many other farm

supplies. Fixed costs appear quite pervasive in both manufacture and

109
distribution of supplies and in commodity marketing. However, fixed costs

are not necessarily sunk, so generalizations about sunk costs should be made

cautiously. There is likely a continuum within agricultural markets with a

few markets that are quite contestable (very low barriers to entry and exit),

a few markets that have high barriers to entry and exit, and most markets

somewhere in between.

The likely least contestable markets- the manufacture of tractors and complex

equipments and pesticides --are markets that cooperatives have not been able

to enter. Ironically, the easiest markets for cooperatives to enter are the

most contestable ones- in which cooperatives have the least to offer as

competitive yardsticks. Historically, the economic accomplishments of

cooperatives have been greatest in those markets of moderate barriers--where

the rewards have been worth seeking and have not been so protected that

cooperatives could not achieve them. Some parts of agriculture are more

vulnerable to even short-run exercise of market power than are others.

Producers of highly perishable commodities are especially vulnerable to even

temporary exploitation of market power by buyers. Consequently, cooperatives

have been important in fluid milk handling for example.

Sustainable Market Structures

Baumol, Panzar, and Willig also introduce the concept of a "sustainable"

industry structure. That is the set of firms that can supply most

economically the desired industry output at a competitive price. Included

are the requirements that each firm be at equilibrium and that there exist no

incentive for entry. One begins by asking what is the minimum number of

firms that can satisfy these conditions. In some markets, one firm may be

the answer. Obviously, if one firm can supply industry demand at its minimum

average costs, then two or more firms (with access to similar production

functions) can do no better and must do worse if all the firms have the same

textbook, U-shaped average cost curves. In fact, with significant fixed

costs and a U-shaped average cost curve, one firm overloaded to some point to

the right of its minimal average costs still can supply an industry more

cheaply than can two underutilized firms. With the requisite information on

the shape of the cost functions, one can readily determine the number of

firms that provide any given output at minimum total industry costs.

Sustainability is a necessary condition for equilibrium in a perfectly

contestable market. However, in markets that are imperfectly contestable,

sustainability is not a necessary condition for equilibrium. For example, an

efficient set of firms may enjoy higher-than-competitive profits behind an

effective barrier to entry. Even an inefficient set of firms may do the

same. Obviously, there are limits to the size of the profits and/or the

degree of inefficiency that any given entry barrier can protect. While there

is no necessity for sustainability in many real-world markets in which

cooperatives may operate, the concept is useful in exploring various market

possibilities for cooperatives.

110
Imperfectly Contestable Agricultural Markets

We turn now to imperfectly contestable agricultural markets. Structure is of

little theoretical interest in perfectly contestable markets because

performance is essentially perfectly competitive regardless of structure. In

imperfectly contestable markets, structure makes a difference.

Natural Mononolv Markets

Consider first those markets in which a single firm is the most efficient

structure. Bressler's classic studies of milk distribution in the 1950s

focused professional attention on this type of natural monopoly market.

Entry is not necessarily difficult, although it could be (patents, huge

economies of scale, R and D costs, sole access to raw materials). Two or

more firms may be competing in this market for various historical reasons.

If social policy permits, a single firm eventually is likely to survive in

this market because it is the most efficient industry configuration.

Under certain conditions, a cooperative is the most desirable monopoly

(monopsony) in this type of agricultural market. By the imperfectly

contestable assumption, the incumbent is not disciplined completely by

potential entrants; it has some leeway to be inefficient and/or to enjoy

above-competitive profits. If the cooperative monopoly can match the

efficiency of the IOF, then it will benefit both consumers and farmers more

than would an IOF monopoly. The reasons are argued in another paper (Rhodes

1983). To summarize the argument: Much of above-competitive earnings of the

cooperative go to farmer-members and the latter tend to respond with larger

output, benefiting consumers. This view is opposite the pessimistic scenario

that a cooperative provides the direction that makes farmers into an

effective output-controlling cartel. That scenario assumes that the

cooperative can direct farmers and that all farmers are ready to go along

with a cartel so that it has no free riders. Neither assumption is likely to

be met.

Thus a cooperative monopoly may be socially desirable provided it is as

efficient as an IOF counterpart. If the cooperative is substantially less

efficient, the IOF may be socially more desirable.

Assuming the social desirability of the cooperative monopoly, is it likely to

exist? If the earnings of an incumbent cooperative within the oligopoly

behind the entry barrier

to the monopoly position. 4

re substantial, the cooperative gradually may grow

If there is no cooperative within the incumbent

oligopoly, or monopoly, can a cooperative enter successfully? While one

would hesitate to predict for any specific real-world case, because of all

the uncertainties of managerial decisions and rivalrous reactions, the

probabilities are on the side of the cooperative challenging the incumbent,

if the entry barrier is surmountable. This type of market failure has been

the traditional incentive for the organization of a cooperative.

The reasons already have been developed as to why sunk costs give pause to

the prudent challenger. These reasons apply more strongly to an IOF than to

a cooperative. A challenger fears being met by reduced margins--the farm

111
supply retailers start selling at lower prices and margins or the elevators

start paying farmers more for grain and suffering reduced margins. These

reactions to an entering IOF may mean substantial operating losses for an

entrant and eventually an abandonment of its sunk capital. In contrast,

these reactions to a farmer cooperative would help farmers as buyers or

sellers even more than they hurt the margins of the cooperative. Farmers can

well afford to subsidize the operations of the cooperative that has become

such an effective competitive yardstick. Thus the cooperative challenger

logically has less fear about incumbent reactions than does the IOF

challenger. It must be admitted, however, that cooperative members may take

a view more short-sighted and more self-oriented than is implied by this

scenario. Their attitude may vary by the commodity produced. Those

producers of perishables may count their vulnerability so high that they take

the long view.

Suppose that a cooperative has successfully become the only firm in this

market. It is easy to visualize some farmers organizing a second cooperative

in the name of competition **to keep the cooperative management on its toes."

Such an effort would be wasteful of resources because only one firm is

sustainable in this market. However, some members ma

3

benefit from

intercooperative competition if it can be maintained.

In sum, provided the cooperative suffers no inefficiencies because it is a

cooperative, it is socially desirable that it be the firm in natural monopoly

markets. If entry barriers are too high, a cooperative may not be able to

enter. However, a cooperative has some advantages as an entrant. If the

cooperative is one of two or more incumbents in a natural monopoly market, it

is a bit more likely to emerge as the sole survivor.

Natural Duopolv Markets

Suppose that two firms in a market are the most efficient structure.

Possible natural duopoly configurations are two IOFs, or two cooperatives, or

one of each. Farmers, for reasons enunciated earlier, would prefer one of

the latter two structures. Assuming moderate to high entry barriers, the

nature of the duopolistic interaction affects performance. The presence of a

cooperative need not necessarily pressure down earnings. Presumably,

diseconomies of scale prevent either rival from a serious attempt to grab the

entire market or even a much larger market share. Diseconomies of scale is a

limitation often not present in duopoly models, but it follows from the

assumption that two firms are more efficient than one firm in this market.

Without further assumptions, it is impossible to project the type of duopoly

rivalry and performance. To the extent that the duopoly performs like a

monopoly, the two-cooperative structure would be most preferable socially and

the two IOF configurations would be least preferable. To the extent that the

duopoly performs in a highly competitive way, there is no social preference

among the three configurations of IOFs and cooperatives.

A natural duopoly market does not automatically have precisely two firms.

One strong firm might be able to obtain monopoly control for a time. More

probably, three or more firms might try to operate in this market. By

assumption, only a duopoly structure is likely to be sustainable in a

112
long-run sense. Few things could be less useful to farmers than for them to

try to maintain three or more cooperatives in this market. Likewise, the

governing boards of two incumbent cooperatives should not permit aggressive

attempts by either cooperative's management to grow at the other

cooperative's expense. Such aggression would be costly to farmers in the

short run and carries no promise of social benefits. Of course, normal

competition between the cooperatives would be useful. The concern here is

with the aggressive, vindictive competition that sometimes occurs between

cooperatives.

Natural Three- to Nine-Firm Markets

Assuming that firms in some kinds of markets have average costs with a

flat-bottomed section, the efficient number of firms in a market is no longer

determinate. For example, three "large firms" (operating at the maximum

outputs on their flat bottoms) may produce as efficiently as nine 'small

firms" (operating at the minimum outputs on their flat bottoms). In this

case, other combinations such as one large and six small firms also would be

an efficient configuration. While these assumptions may seem contrived, it

appears quite possible that many oligopoly situations are of this type in

which various small-number structures could be equally efficient.

Particularly successful differentiation of products or services may be the

key to the firms that survive or that become "large."

As in the natural duopoly, market performance may range from competitive to

monopolistic (within the limits allowed by entry barriers). Farmers would

likely feel the need for a cooperative competitive yardstick. One or more

cooperatives of various sizes might exist. The same points made previously

apply to the type of competition useful between cooperative competitors. It

again is possible, although not as likely, that farmers would be organizing

more cooperatives to obtain more competition when the more useful approach

might be to merge small cooperative incumbents. If entry barriers are not

very high, any overly optimistic assessment of opportunities may lead to the

to farmers in the short run and carries no entry of too many firms (IOF and

cooperatives). When there are too many firms, one or more will be operazg

at an output lower than permits minimal average costs. Such firms are

motivated to "slug it out" for a larger, more efficient market share. The

outcome is an initial underutilization of resources and the eventual loss of

sunk costs for some of the contenders.

Vertically integrated processors may have economies of scale that lead to

several firms in the national processing market but that encourages

geographical monopsony in the assembly of farm raw materials. It would be

economically sensible for farmer-members to divide up the assembly areas of

their cooperatives to obtain the most efficient cooperative O f system.

course, farmers would have no means to guide the assembly of IOF competitors,

so cooperatives would likely face one or more IOFs in their assembly

territories. Such cooperative collusion would raise policy questions. It

hardly could be detrimental to consumers. The key question might be one of

impact on IOF competitors. Would the cost savings from a national

cooperative assembly plan be sufficient to drive the IOFs out of the

processing market? If so, perhaps assembly should become a monopoly of a set

113
of cooperatives that then dealt at arm's length with all processorscooperative and IOF. That alternative might be feasible for some commodities

and not others depending on the impact of vertical integration on transaction

costs.

Natural Many-Firm Markets

Agribusiness markets in which many firms compete in exactly the same market

are not common. Food service firms in larger cities is an example. Cheese

plants in the Lake States may be another.

The existence of many firms suggests low entry and exit barriers and fairly

(but not perfectly) contestable markets. Even though economies of scale are

likely not very large, the average cost curves may have a flat section so

that the most efficient number of firms is indeterminate. Both the many-firm

structure and low entry barriers suggest quite competitive market

performance. Consequently, cooperatives have no unique role as competitive

yardsticks. Cooperatives may exist and may yield modest returns and

satisfaction to their

virtually nil.

members, but their beneficial externalities are

Cooperatives and Economies of Scope

Baumol, Panzar, and Willig define economies of scope as those cost reductions

arising from simultaneous production of several products and/or services in a

firm, as compared to production of each by a separate firm. They show that

economies of scope are a necessary and sufficient condition for multiproduct

firms in perfectly contestable markets. Where economies of scope do not

exist, then a specialized entrant will take sales away from a higher-cost,

multiproduct firm. Where economies of scope do exist, the multiproduct firms

outcompete the specialized firms.

The extent of economies of scope is an empirical question. While observation

seems to elicit some obvious examples, generalizations should be made

cautiously. Economies of scope often arise from common use of an input--a

facility and/or a staff- that is used to produce one product and can produce

another as well at little or no extra cost. The combination of farm supplies

and grain marketing in local cooperatives appears an obvious example. In

contrast, livestock and milk marketing's specialized needs have kept them as

specialized activities and ordinarily in separate firms.

The nature of economies of scope at the regional level of cooperatives is

less clear. Milk marketing is generally specialized, but there are

exceptions. Most regional cooperatives perform multiple services and produce

multiple products. Some of those regionals appear to be trending toward

fewer products, but some are becoming more conglomerate. Much the same

diversity as to situation and trends is evident in the IOF competitors. In

perfectly contestable markets, we could be confident that efficiency prevails

among the various observed configurations of specialized and multiproduct

firms. In imperfectly contestable markets, efficiency may not be the only

114
determinant of firm configurations. One wonders what role that economies of

scope are playing in the organization of regional cooperatives.

Summary

Any new theory generally causes a look at economic relationships in some

slightly different perspective. The theory may be useful in causing us to

ask new questions or in leading to better answers to old questions. At the

same time, we must remember that the theory rests on extreme assumptions and

has been subjected to searching criticism (Shepherd).

Some of the new developments in the theory of contestable markets have been

used to reconsider the role of agricultural cooperatives. The conclusions

must be very tentative because empirical research has not been done to answer

the new questions as to how contestable are agribusiness markets. The

literature presumably has the most to contribute where markets are perfectly

contestable. It is doubted that many agribusiness markets are perfectly or

even highly contestable.4 Nevertheless, a study of deviations from perfect

contestability leads to some insights.

The sustainability concept focuses on low production costs as being the key

to long-term competitive success. This model has more to offer in the long

term (say 1 to 3 decades) than in the short term. Much of the previous

discussion of cooperative-IOF competition implicitly accepts the crucial role

of comparative costs. While product differentiation is fairly minor in many

areas in which agricultural cooperatives compete, it ordinarily does exist

and its influence has been understated in the previous analysis. A higher

cost firm with a superior product may out-compete its rivals. This analysis

also largely ignores the important impacts that uncertainty has on firm

behavior. For example, uncertainty often deters entry that would have been

profitable, while it also may sometimes lead to unprofitable entry. By

ignoring uncertainty, we ignore the contributions cooperatives make to

farmer-members in dealing with various kinds of uncertainty. Thus the

previous analysis possibly is biased toward a more restrictive role for

cooperatives than would result from a more realistic theoretical model. The

analysis may have more bearing on buy-sell grain marketing and farm supply

cooperatives than on those cooperatives marketing perishables or specialty

crops.

The sustainability concept also focuses attention on the configuration of

firms that can provide the desired industry output at minimum costs. This

analysis emphasizes the social wastefulness of too many competitors. It

warns farmers that, for example, more farm supply firms are not necessarily

better. To achieve the most economical farm supplies or the best market

prices for their commodities, farmers often may need to merge cooperatives

rather than encouraging competition among them. This approach focuses

attention on the need for empirical research on the shapes of cost curves.

Some of the more useful generalizations depend knowing whether the market is

a natural monopoly, a natural duopoly, or is capable of sustaining several

firms.

115
Notes

1 . Although Baumol, Panzar, and Willig do not note the possibility, even

normal competitive profits could be endangered by completely mobile

entrants that have a slightly optimistic expectation about potential

profits.

2 . That scenario is developed in Rhodes 1983.

3 . See Rhodes, 'Competition Among Cooperatives," in this volume.

4. Connor et al. argue that markets in food manufacturing are not perfectly

contestable.

References

Baumol, William J.; John C. Panzar; and Robert D. Willig. Contestable

Markets and the Theory of Industry Structure. New York: Harcourt Brace

Jovanovich, 1982.

Connor, John, et al. The Food Manufacturing Industries: Structure.

Strategies, Performance, and Policies. Lexington, Mass.: D. C. Heath and

co., 1985.

Rhodes, V. James. "The Large Agricultural Cooperative as a Competitor."

American Journal of Agricultural Economics 65(1983):1090-98.

. *Competition Among Cooperatives.** In this volume.

Shaffer, James D. "Thinking About Farmers' Cooperatives, Contracts, and

Economic Coordination." In this volume.

Shepherd, William G. "'Contestability' vs. Competition.** American Economic

Review 74(1984):572-87.

116
A GAME-THEORETIC ANALYSIS OF DECISIONMAKING IN

FARMER COOPERATIVES

John M. Staatz*

Most formal models of the economic behavior of farmer cooperatives picture

that behavior as deriving from the optimization of a single objective

function by a single agent (as in the Helmberger and Hoos (1962) model), by a

group of agents with identical goals (as in the Phillips model), or from

simple, nonstrategic majority-rule voting of the membership (as in the Zusman

model). Models incorporating voting assume that the distribution of members'

preferences is single-peaked and no logrolling (interdependent voting)

between issues takes place; therefore, no voting paradoxes arise, and the

cooperative's objective is determined by the preferences of the median

member. With few exceptions, formal models fail to address the issue of

group choice in cooperatives whose members have at least partially divergent

goals and engage in strategic behavior.

However, cooperatives face many decisions in which members' preferences

cannot be assumed to be homogeneous. Examples include the pricing of

different services to members, including the possibility of differential

pricing based on members' patronage; the choice of what products and services

to offer members; location of facilities; and the allocation of overhead

costs and pool receipts. Furthermore, the preferences of management and the

board of directors on many of these issues may differ from those of the

rank-and-file membership. Although both the cooperative management

literature and many cooperative theorists have informally discussed

cooperative decisionmaking in the context of heterogeneous preferences, there

is a need to develop models that explicitly address this issue and, in so

doing, suggest alternative ways for cooperatives to deal with group choice.

The purpose of this paper is to discuss how game theory can be used to

analyze many of the issues involving group choice in farmer cooperatives.

The aim of the paper is not to develop a comprehensive theory of the behavior

of farmer cooperatives in the market place but to focus on the relatively

neglected issues related to group choice, which have become increasingly

important as farmer cooperatives have grown and diversified in recent years.

As in any theoretical paper, the purpose is not to "prove" certain

relationships (that can only be done through empirical work) but to suggest

hypotheses regarding them that can guide future policy and research.

Game theory addresses the issue of group choice when the preferences of the

members of a group are at least partially conflicting. A major area

investigated by game theory is that of nonzero-sum games, that is, games in

which the interests of the members of a group, while usually not entirely

coincident, are not diametrically opposed. As wi 1 become evident, most

decisions in farmer cooperatives are nonzero-sum. 1

*Some of the material in this paper appeared in John M. Staatz, "The

Cooperative as a Coalition: A Game-Theoretic Approach," American Journal of

&ricultural Economics 65(1983):1084-89. It is included here by permission

of the American Agricultural Economics Association.

117
Two general types of group behavior are analyzable using the theory of

nonzero-sum games. The first occurs when, because of high communication

costs, unenforceability of contracts, lack of trust, or other reasons,

members of the group eschew joint strategies and act independently; this

behavior involves a noncooDerative game. The second arises when members of

the group can communicate and make binding commitments with one another;

these situations are analyzable using the theory of cooperative games. I n

cooperative games, there are gains from joint action by a potential coalition

of players, but the players must bargain among themselves about how the net

benefits of the joint action are to be shared. Failure to agree on an

allocation of net benefits among players prevents the coalition from forming

(Roth). Many decisions in farmer cooperatives, such as how to allocate joint

costs and pool receipts among producers of different products, can be modeled

using cooperative games. Others, such as how to ensure member loyalty in a

"competitive yardstick*' cooperative, more closely resemble noncooperative

games because in these situations cooperative participants face individual

incentives to act independently although the group as a whole would benefit

from collective action.

This paper is organized into four sections. The first section discusses the

application of the theory of cooperative games to the modeling of certain

types of decisions in farmer cooperatives, such as how to price services to a

heterogeneous membership. The second section investigates how other

situations facing farmer cooperatives, such as how to maintain member loyalty

and member discipline over management, can be analyzed using concepts from

the theory of noncooperative games, particularly the prisoner's dilemma. The

analysis in the first and second sections is based on several restrictive

assumptions inherent in game theory, and the third section analyzes how

relaxing those assumptions modifies the results derived earlier. A final

section briefly summarizes the major conclusions of the paper.

Cooperative Behavior as a Cooperative Game

Although the preferences of different participants in a farmer cooperative

are seldom strictly opposed, neither are they identical. Cooperative

participants, therefore, face two interrelated questions: (1) Can the

participants identify and agree on a set of objectives yielding benefits of

joint action? (2) And can an allocation of the benefits and costs of this

action be found that maintains the incentives of each group to participate in

the activity? "The mere existence of potential gains does not necessarily

mean that they can be realized. There is the problem of building an

organization with sufficient cohesion to withstand the disintegrating forces

arising out of conflicting interests" (Helmberger and Hoos 1965, p. 184).

The theory of cooperative games addresses the issue of group choice when the

preferences of the members of a group are at least partially conflicting.

Viewing the allocation of benefits and costs in a cooperative as a

cooperative game focuses attention on the following questions: (1) How do

the policies of a cooperative regarding the allocation of benefits and costs

among the membership affect the payoffs (both pecuniary and nonpecuniary) to

various potential coalitions within the cooperative? (2) And how do these

118
payoffs affect the willingness of various coalitions to remain active in the

cooperative, as opposed to taking their business elsewhere?

TvDes of Bargaining Issues

In farmer cooperatives, many potential bargaining situations, such as those

portrayed in the theory of cooperative games, arise. Bargaining issues

between the three main actors in farmer cooperatives (farmer-members,

management, and the board of directors) generally fall into one of five

categories: (a) selection of products and services to be handled by the

cooperative, including the choice of product quality; (b) allocation of

revenues and pricing of services; (c) joint cost allocation; (d) financing of

the cooperative; and (e) constitutional issues, which influence the

distribution20f power and decisionmaking authority within the

cooperative. For example, the pricing of goods and services to members

can be conceived of as a bargaining game between two groups of members:

those whom the cooperative can serve at relatively low per-unit costs or who

have attractive market alternatives outside of the cooperative (e.g., large

farmers) and those whom it is more costly to serve or who have few attractive

noncooperative alternatives (e.g., small farmers). The low-cost patrons

argue for differential pricing of goods and services based on the cost of

service or on *'meeting the competition," while the higher-cost patrons argue

for uniform pricing.

Similarly, the issue of what proportion of the cooperative's net earnings

should be retained rather than rebated to members can be viewed as a

bargaining game involving management and possibly the board, on the one hand,

and farmer-members on the other. Management, and perhaps the board,

interested in promoting growth of the cooperative may lobby for a high level

of retained earnings to finance that growth while farmer-members,

particularly those nearing retirement and having only a limited ability to

redeem their equity in the coop

rebated to the members as cash. s

rative, may argue that net earnings should be

Murray (1983a, 1983b, 1983c) examined

this bargaining issue in detail in the context of British cooperatives,

although not from a game-theoretic perspective.

Constitutional issues can be viewed as bargaining games that occur among

various cooperative participants at the time of the writing of the

cooperative's bylaws. In deciding how to vote on constitutional issues, the

various participants have to project how their net returns from the

cooperative will be affected by the cooperative's adoption of different

organizational structures. 4

Representing; the Gains from Joint Action:

The Characteristic Function

A basic assumption underlying the analysis in this paper is that farmers

engage in collective action via cooperatives because there are efficiencies

in certain joint, as opposed to individual, actions. These efficiencies are

represented in game-theoretic terms by a suoeradditive characteristic

function. A characteristic function shows the minimum level of payoffs that

any potential coalition of players can guarantee itself. Superadditivity of

119
the characteristic function means that a single coalition of all the players

("the grand coalition**) can always guarantee itself a higher level of payoff

than can two or more disjoint subcoalitions that in total involve all the

players. Mathematically, superadditivity of the characteristic function is

expressed as follows:

For any two disjoint sets K and L in the set N (K,L c N, K n L = 0, the

characteristic function V is superadditive if

(1) V(K) + V(L) c V(K u L),

that is, if the sum of the characteristic functions of K and L is a proper

subset of the characteristic function of their union. This means that K and

L can always gain at least as much in total by working together as they can

by working separately. This does not, however, mean that K and L will work

together. For joint action to occur, not only must the total payoff to K and

L be greater than the sum of the payoffs that would result from their

individual actions, but both K's and L's individual shares of the joint "'pie'*

must be greater than the payoffs each could achieve by acting independently.

In applying game theory to farmer cooperatives, one often can equate

suoeradditivitv of the characteristic function with subadditivity of the cost

function. In the context of farmer cooperatives, subadditivity of a cost

function means that it is cheaper to provide some service to the members of a

cooperative as whole than to provide it to them individually or in

subgroups. Subadditivity of a cost function is expressed mathematically as

follows:

For any K,L C N, K n L = 0, the cost function is subadditive if

(2) C(qk) + Wql) 2 C(qk + ql)

C(q) is the cost of producing quantity q of the service;

qk is the quantity of the service demanded by K; and

q' is the quantity of the service demanded by L.

For reasons that will become apparent later, it is important to distinguish

between a subadditive cost function and economies of scale. Economies of

scale exist when the cost function is homogeneous of degree less than one,

that is, when average cost declines monotonically throughout the range of

production. The existence of economies of scale (declining average cost) is

neither a necessary nor a sufficient condition for a cost function to be

subadditive. In particular, a subadditive cost function can exhibit

increasing average cost over a certain range of output. It is subadditivity

of the cost function rather than economies of scale that makes joint

provision of a service to a group more economical than providing the service

to individual subunits of the group. 5

120
An Example of a CooDerative Game:

Cost Allocation Among a Heterogeneous Membership

An example will illustrate how the theory of cooperative games can illuminate

some of the trade-offs facing participants making decisions in farmer

cooperatives. This example examines cost allocation (pricing of services) in

a farmer cooperative serving a heterogeneous membership and draws on a

general analytic approach outlined by Faulhaber. The example assumes that

farmers are profit maximizers and hence evaluate payoffs purely in monetary

terms. The third section of this paper relaxes this assumption.

Consider a cooperative that provides a service to a heterogeneous set of

members N = (1, 2, . . . . n). For example, the members may differ in the crops

they grow, their size of operations, or their time preference for money.

Assume:

(a) There are economies in the joint provision of the service to the

membership, i.e., the cost function for producing the service is

subadditive: for any disjoint subsets S and T in the set N (S,T

cN, SnT=0),

ws+t) 5 C(qS) + c(qt)

where C(qi) is the cost of providing the - quantity of services qi

to group i. For example, C(qs) is the total cost S would incur

providing qs of the service to itself; C(qs+t) is the total cost

at which S and T could jointly provide (qS + qt) of the service. 6

(b) Farmers in group i have only the option of purchasing qL from the

cooperative or exiting the cooperative to obtain q1 in another

way, either from an investor-owned firm (IOF) or by forming another

cooperative by themselves or with other disaffected members.

(Allowing each group to vary its patronage with the cooperative

would expand the number of strategies open to each player but would

not change the basic results of the game-theoretic analysis.)

(c) For S,T c N, S n T =

qs and qt is zero.

0, the cross-elasticity of demand between

The cost function for providing the service to each possible coalition in N,

combined with the prices at which the service can be obtained outside the

cooperative, can be used to define a characteristic function, v(q'), which

shows the minimum payoff (i.e., the minimum cost of obtaining qs) that each

group S contained in N can guarantee itself, either by acting alone or y

forming coalitions with other groups within or outside the cooperative. P

The board and management of the cooperative must decide how to allocate the

cost of producing the services among the membership. Subadditivity of the

cost function implies joint costs, and hence any allocation will be in some

sense arbitrary (Clark). This does not mean, however, that management can

allocate costs in any way it chooses; it must take into account the effect of

its allocations on members' incentives to remain in the organization. If the

121
cost allocated to group S, A(q'), is greater than v(q'), the minimum cost

that S can guarantee itself, then S has an incentive to leave the

cooperative. Hence, for a cost allocation to be stable (not induce

defection), the following condition must be met:

(3) A(q') I v(q') V S G N.

If, in addition, the cooperative is constrained to break even, returning8any

surplus above cost to members, the following condition must also be met:

(4) c A(qs) = c(qn>.

sen

Expressions (3) and (4) together define the core of the game, the set of

feasible allocations that give all participants an incentive to remain within

the organization. Hence, these expressions are called the "core

constraints.*'

More than one set of cost allocations may lie within the core, and bargaining

occurs within the cooperative over which set of cost allocations should be

imposed. In reality, the characteristic function, v(q'), that embodies

both the cooperative's cost function and the players' external market

opportunities, is likely to be known only very imprecisely so the bargaining

will take place in an atmosphere of uncertainty. Cooperative members

sometimes may try to influence the cost allocation decisions of the board and

management by issuing implicit threats and counterthreats as each group tries

to obtain the best possible allocation for itself while at the same time

ensuring that other members still have an incentive to remain in the

cooperative.

The ability of a member or group of members 9 to obtain concessions from

other members of the cooperative depends on two factors: the costs the

member could impose on other members if he or she were to exit the

cooperative (this determines the bargaining threat to others in the

organization) and the other players' perception of the costs the member would

impose on himself or herself if he or she were to leave (this determines how

seriously the threat is taken).

The potential harm, ho, member S can impose on others in the cooperative

can be measured by how much the remaining members' cost of obtaining the

cooperatively produced service would increase if S were to leave the

organization:

(5) ho = [C(q”-S)/qn-S - c(qn>/qnl qngsm

With S in the organization, the remaining n-s members can hope to obtain

their qnos units of service at a unit cost of C(qn)/qn, the average

cost of production for the grand coalition. (As will become apparent later,

this hope is not always realized even if the grand coalition does form.)

This unit cost would rise to C(qnos)/qnos if S were to leave the

organization.

122
Similarly, the harm S would impose on himself or herself by exiting, h,,

can be measured by how S's cost of obtaining the service would increase if

they left the organization:

(6) h, = v(clS) - Ec(qn)/qnl QS*

Equation (5) states that, ceteris paribus, the more strongly subadditive the

cooperative's cost function is with respect to a member's output, the

stronger that member's bargaining position. Large members in cooperatives

with strongly subadditive cost functions have substantial bargaining powfti

;

small members in cooperatives with constant costs have practically none.

This suggests that cooperatives composed of a few large members may face more

disruptive, threat-filled bargaining over allocation of costs and benefits

than cooperatives with many small members. Cooperatives with a few large

members face an allocation problem similar to the problem of allocating costs

and benefits in a cartel (Kuhn).

Equation (6) suggests that a member's threat of exit will be taken more

seriously, the smaller the perceived cost to the member of leaving the

cooperative. For example, a member's ability to extract concessions from the

cooperative would be lower if he or she faced stiff penalties for defection

(e.g.9 forfeiture of accrued retains) than if not.

In the bargaining process, a member may argue that he or she should bear only

the incremental cost of providing services to them, i.e., for S c - N,

(7) A(q') = C(qn) - C(qn-S) V S G No

Paying according to incremental costs may appear fair and is the rule that

would result from a linear programming approach to pricing cooperative

services (see Hardie). Unfortunately, such an allocation scheme may not

always be stable.

Assume that the cooperative is composed of four groups of members, B, S, G,

and P. For example, the cooperative might provide processing and marketing

services to producers of Beans, Spinach, Grapes, and Peaches. Assume that

the cooperative has the following subadditive cost function (zeros can be

added to the figures to lend more realism):

(8) C(qb) = C(qS> = c(qg) = C(qP) = $300

(9) C(qb+y = c(qg+p) = $410

(10) qqb+g) = qqb+p) = c(qs+g) - c(qs+p) = $500

(11) C(qb+s+g) = $600

(12) qqb+s+P) = c(qb+g+P) = qqs+g+q = $650

(13) C(qb+s+g+p) = $810.

123
A cost function like this might arise in the following way. If each group of

producers built its own processing plant, each could process its product at a

cost of $300. If the vegetable growers (B and S) jointly processed their

products they could do so at a total cost of $410, as could the fruit growers

(G and P) if they processed jointly. There also would be some savings if one

group of vegetable growers (e.g., B) combined with one group of fruit growers

(e.g.9 G) for joint processing. Their total cost of production, $500, would

be higher than that of the joint fruit or the joint vegetable operations,

however, due to their inability to share certain costs that are joint in

those operations (e.g., the cost of syrup in an integrated fruit canning

operation). Assume that if three products are processed jointly, the

cooperative has to expand its warehouse. Suppose that this can be done on

land immediately behind the current plant that would otherwise be used for

burying or burning peach pits. If peaches are not processed by the

cooperative, this poses no problem, and the combined cost of processing and

marketing beans, spinach, and grapes becomes $600. If, however, peaches are

processed, the pits have to be hauled away, raising the price of processing

any three-product combination including peaches to $650. Finally, assume

that even with hauling away the peach pits, all four products can be jointly

processed in a single plant for $810.

Because of the subadditivity of the cost function, there are potential joint

benefits from processing all four products in a single plant. The board and

management are faced with determining a set of cost allocations, A(qi),

that will cover the $810 total cost of producing the service for all members

while still giving all members an incentive to remain in the organization.

Note that charging all members the same cost for the service is infeasible;

if each were charged the average cost of $202.50, B, S, and G would have an

incentive to form their own cooperative and produce the service for a total

cost of $600, or an average cost of $200. Some sort of differential pricing

is required to hold the coalition together, in w ich P is forced to pay more

than the average cost and B, S, and G pay less. 1hL

Will pricing according to incremental cost work? The incremental-cost

pricing rule (7) and the break-even constraint (4) imply that:

(14) A(qb) + A(qs) + A(qg> + A(qp> = $810

(15) Ad> 2 $110 V i

(16) A(sb> + A($) 1 $300

(17) A(qg) + A(qP) I $350.

Applying the incremental cost rule A(qi) 1 $110 may not lead to a

stable coalition. For example, the allocations A(qb) - A(q') - $120 and

A(qg) = A(qp) = $285 satisfy both (14) and (15), yet under this set of

allocations G and P have a clear incentive to break away from the cooperative

because they could jointly produce the service for $410, an average cost to

them of $205. The existence of costs that are joint among a proper subset of

players (rather than being purely attributable or joint among all players)

124
implies the need to tes t whether that

PlaYe rs, are paying the ir full incremental

t, as well as the individual

cost (Faulhaber).

In certain instances where the average cost of producing the service first

decreases then rises, there may be no stable allocation of costs (the core

may be empty). For example, if equations (11) and (12) are replaced with

(lla> C(qb+S+g) - C(qb+s+P) - C(qb+g+P) - C(q'+g+P) - $600

(that is, if peach pits can be disposed of at no cost in the three-product

plant) 9 then the binding core constraints become:

(18) A(qb> + A@> + A(sg) I $600

(19) A(qb) + A(qs) + A(qp) s $600

(20) A(qb> + A(qg) + A(qp) s $600

(21) A(qs> + A(qg) + A(qp) I $600 and

(14) A(qb) + A(qs> + A(qg) + A(qp) = $8100

Adding (18) through (21) yields

3[A(qb) + A(q') + A(qg> + A( 4 $2,400,

or

(22) A(qb) + A(q’) + A(qg) + A(qp) 5 $800

which contradicts (14). Hence, although there are economies in the joint

provision of the service to all participants, given this cost function, the

core constraints are such that there is no possible cost allocation that does

not give someone the incentive to leave the cooperative.

This model illustrates the following points:

(1) In certain circumstances, differential pricing of services to members is

necessary to preserve the stability of the cooperative. The differential

pricing must reflect both how a member's patronage affects the cooperative's

cost function (this is just an extension of the service at cost principle)

and the member's trategic opportunities for obtaining the service outside

the cooperative. 15 This suggests that large members in cooperatives with

strongly subadditive cost functions may be particularly successful in

extracting price concessions from the cooperative. However, small members

may oppose granting price concessions to larger members for fear the

concessions will simply reinforce the competitive advantages of larger

operations. In addition, income tax provisions (e.g., section 521) may limit

the degree to which cooperatives can price discriminate among their members.

(2) Even if a cooperative does decide to price discriminate among members, if

there are costs that are joint among a proper subset of members, the

125
cooperative cannot simply adopt an incremental cost rule for setting prices

as this can give some members incentives to leave the organization. Thus

setting their own cooperative and produce the service for a total cost

allocations can be a complex process, and it is problematic whether a

feasible allocation could be determined on a simple one-member/one-vote

basis.

(3) Although differential pricing of services to members may be necessary to

preserve the stability of cooperatives that have highly heterogeneous

memberships, instituting such pricing usually requires a vote of the board,

which, if elected on a one-member/one-vote basis, may be controlled by

smaller-volume patrons. If small patrons steadfastly oppose differential

pricing, large members may exit the cooperative unless voting rules are

changed to increase the political power of the larger patrons. Caves and

Petersen (appendix A, p. 1) report some evidence that such a reallocation of

political power has occurred in cooperatives with heterogeneous memberships,

noting that the one-member/one-vote rule prevails in only 71 percent of

large, predominately federated cooperatives (whose members are likely to be

diverse) compared with 92 percent of local cooperatives.

(4) In situations where a cooperative's average cost of providing a joint

service first decreases then increases, there may be no allocation of costs

that gives everyone an i-..centive to stay in the organization. This suggests

that cooperatives need to be very careful in deciding when to expand their

membership and/or their mix of activities, expanding only when there are

clear synergies that allow the organization to hold down its average costs.

The impossibility of finding a stable allocation of costs among a

heterogeneous membership may prevent cooperatives from "doing all things for

all people."

(5) If the core of the game is not empty, there may be more than one feasible

allocation of costs, and the management and the board must somehow choose a

fair allocation. The model presented here simply states that the final

allocation must lie within the core; it does not specify where within the

core the optimal allocation lies. In other words, although game-theoretic

considerations establish a feasible region within which prices must be set,

costs allocated, or product mix determined, exactly where within that region

the final decision falls may depend on factors such as the internal politics

of the cooperative or the board's conception of what a "faiu" solution should

be. Game theorists have proposed alternative solution concepts for choosing

among different allocations within a core, with each solution concept

embodying a different concept of fairness (see Staatz 1984, appendix C). For

instance, the Shapley va

'fs

e approach, which allocates to each coalition its

"average marginal cost," would in the this example lead to the following

cost allocation:

Mb> - Am - mlgl = $198.33, and

A(clp> - $215.00.

Examination of these solution concepts may be useful in helping to determine . equitable cost allocations.

126
(6) Failure to choose an allocation that lies within the core can lead

members to exit the cooperative. Game-theoretic analysis could help

management predict which allocations would induce defection and which would

not. In determining the cost functions facing cooperative participants

(which in turn largely determine their characteristic functions), economic

engineering approaches may be particularly useful (see French).

(7) The model suggests that if dissatisfied members do not leave the

cooperative, bargaining over allocations of costs and benefits can be intense

and bruising. Reality, however, may not be so harsh. Participants are

likely to know only very imprecisely the costs (payoffs) of the alternatives

open to them, and the board and management may be able to influence their

estimates of those costs (e.g., through member relations programs). In this

sense, uncertainty about what is in one's best interest may reduce conflict

in the cooperative. To the extent that-members receive nonpecuniary benefits

from remaining in the cooperative, bargaining over the allocation of monetary

benefits and costs in the organization may also be muted. These

possibilities are examined in the third section of this paper.

(8) Another important way in which management and the board can facilitate

agreement on allocation of costs and benefits is through devising ways to

convert apparent zero-sum games among the membership into nonzero-sum games,

thus expanding the potential core of the game. For example, allocation of

receipts from a marketing pool among producers of different commodities (say,

X, Y, and 2) may appear to be a zero-sum game if viewed in the context of a

single year; whatever is gained by producers of X is lost to the producers of

Y and 2. However, if the producers can be convinced to take a multiyear

perspective, the game becomes nonzero-sum. Unless management or the board

has strict control over potential supplies, allocating excessive returns to X

may lead (via the supply response for X) to excessive inventories of X in

coming years, reducing the net returns available for distribution among all

producers in subsequent years. A more "balanced" allocation in the current

year may lead to improved profit possibilities for all producers in

subsequent years, implying joint gains from a coordinated allocation

strategy. Documenting the possible consequences of adopting extreme

bargaining positions may be an important way in which management can

facilitate agreement. Another way of converting zero-sum games to

nonzero-sum games is by *tlogrolling*l --tying the negotiation of one issue to

another, so that the scope for trade-offs, given divergent member

preferences, is expanded (Raiffa; Buchanan and Tullock, chaps. 10-11).

Cooperative Behavior as a Noncooperative Game:

Prisoner's Dilemmas in Farmer Cooperatives

In certain circumstances, participant behavior in a farmer cooperative more

nearly r

fB

embles a noncooperative game, particularly a prisoner's

dilemma. In a prisoner's dilemma, the "rational" pursuit of individual

self-interest leads to a Pareto-inferior outcome.

Formally, a prisoner's dilemma is defined as a game that has a payoff matrix

of the form shown in figure l(a). Each player has two possible strategies,

127
Figure l--Payoff matrices for a prisoner's dilemma

Player B

C

Player A

D

where a21 > all > a22 > al2 and b21 > bll > b22 > $2

(a) Generalized form of the game, with payoffs in expected utility

Player B

A B

Player A

t *

c uv) (4 9 lo>

D (l(W) (596)

(b) Numerical example, with payoffs in expected utility

128
cooperating wi k the other player (C) or defecting (D) and acting

independently. E Although the payoffs to each player are higher if they

both cooperate (strategy pair C,C) than if they both defect (strategy pair

D,DL the incentives facing the players are such that each has an individual

incentive to defect althou& each knows that their opponent is acting

similarly. For example, in the prisoner's dilemma illustrated in figure

l(b), the payoff to player A always is higher if he or she defects, no matter

which strategy player B selects. If B chooses to cooperate, A's payoff

increases from 8 to 10 if he or she defects rather than cooperates. If B

chooses to defect, A's payoff increases from 4 to 5 if he or she also

defects. B faces a similar set of incentives. If both players defect,

however, they are both worse off than they would have been if

Ef:

ey had both

cooperated, as they receive payoffs of (5,6) instead of (8,8).

Two characteristics of a prisoner's dilemma lead to this Pareto-inferior

result. First, the players are unable to communicate with one another and

make binding commitments regarding mutually advantageous joint strategies.

Second, the prisoner's dilemma usually is pictured as an isolated game,

played only once by the participants. The behavior of the players in this

game is in no way linked to their behavior in other games--the players have

no concerns about developing or preserving their reputations as reliable

partners, etc. However, if players face recurrent prisoner's dilemmas,

patterns of cooperation among the players may evolve. This has been own

both experimentally and theoretically (Raiffa, pp. 123-26; Schotter). aP

A wide variety of situations in farmer cooperatives, ranging from pricing and

output decisions to problems of inducing members to participate adequately in

the governance of the cooperative, appear at times to resemble prisoner's

dilemmas. For example, given an inelastic demand for its product, a

cooperative's revenues would increase if the cooperative restricted output;

yet because the organization's net earnings are rebated to its members in

proportion to their individual production, each member has an incentive to

expand output, thereby undercutting the cooperative's attempt to restrict

supply. Provision of certain public goods by cooperatives--more competitive

input and output markets, lobbying,

dilemma (see Staatz 1984, chap. 4). 18

nd so on-- also may resemble a prisoner's

As with all public goods, a

free-rider problem exists: An individual need not join or patronize the

cooperative to enjoy all these benefits. However, failure to patronize the

cooperative may lead to a long-term decline in the organization's ability to

provide these goods, Rhodes (1978) also has suggested that farmer-members

often may fail to oversee and discipline cooperative management adequately

due to a free-rider problem:

Seldom does any cooperative member have an economic self-interest for

trying to discipline management. His potential costs exceed his

potential benefits. While all members together may have an economic

incentive, the rational choice is for each individual to hope the others

make the effort while he reaps the benefits. (P. 223)

However, the usefulne

cooperative loyalty,

ss of the S tat.ic prisoner's di

the output dec isions of farmer

1 emma mod.el to analyze

cooperat ives, and

problems of disciplining management is problematic because the standard

129
prisoner's dilemma is pictured as a one-time game in which players are given

the choice of cooperating or defecting and in which there are clear

individual incentives to defect. Because they play the game only once,

players are not concerned with maintaining their reputations as reliable

partners; even if they defect they will not face retribution from their

partners in subsequent periods. In reality, farmers do not face a one-time

decision of whether to join and support a cooperative (or to support its

decisions); that choice is continually before them. Reputations clearly &

matter; cooperatives may expel habitually "noncooperative" members even if

doing so imposes some short-term cost on the remaining members.

If a single-period game (called a constituent game) is infinitely iterated, a

new game is defined (called a supergame), in which the payoffs are the net

present values of the stream of payoffs from the constituent games. Several

authors (e.g., Taylor; Schotter; Axelrod and Hamilton) have shown that even

if

Et;

e constituent game is a prisoner's dilemma, the supergame need not

be . The result depends critically on five elements:

1 . The length of the supergame (the supergame must be of infinite

duration or at least of a duration unknown in advance to the

players);

2 .

3 .

4 .

5.

the reaction of the players to a defection by one of their number;

the rates of time preference by the players;

the relative size of the

constituent game; and

payoffs for defection and cooperation in the

the number of players in the game.

A supergame of known duration composed of constitu

prisoner's dilemmas itself a prisoner's dilemma. SF

t games that are

Similarly, the

supergame will be a prisoner's dilemma if players who do not defect fail to

punish in subsequent iterations of the game those who. do; unconditional

cooperati

8

in a prisoner's dilemma supergame is never an equilibrium

strategy. In addition, even if there u punishment for defection, the

supergame still may be a prisoner's dilemma if players have sufficiently high

discount rates; given a high discount rate, the gain to a player in the

current period from defection may be greater than the discounted value of the

punishments consequently inflicted. Related to this are the relative size of

the payoffs for cooperation and defection in the constituent game. The

higher the return to defection relative to cooperation in the constituent

game 9 ceteris paribus, the more likely the supergame is to be a prisoner's

dilemma. Finally, the larger the number of players, the more likely it is

that a supergame composed of prisoner's dilemma constituent games will itself

be a prisoner's dilemma. For conditional cooperation to be a rational

behavior in an n-person prisoner's dilemma supergame, each player must know

how many other players cooperated in the previous iteration of the game and

each cooperating player's discount rate must lie below a certain level

(Taylor, chap. 3 and pp. 92-93). Both conditions are more likely to prevail

in a small group than in a large one.

130
If the problem of maintaining loyalty to a farmer cooperative (or to its

price and output decisions) is truly a prisoner's dilemma supergame, then the

previous analysis suggests the following hypotheses:

(1) Cooperative loyalty is greater among those who will b.e farming for an

indefinite period compared to those who are close to leaving farming,

provided there is no way for the individual leaving farming to continue to

benefit from the existence of the cooperative (e.g., through capitalization

of the value of the cooperative into the value of the member's land, through

a "pension" provided by the retirement of the member's accrued equity in the

organization, or through utility derived from supporting a cooperative with

which one has had a long associat'

$8

n or from passing on a viable farming

operation to the member's heirs). If those leaving farming will have no

further payoffs from the cooperative once they leave, they have no incentive

to remain loyal to it as they near their retirement; in the short run,

defection is always the dominant strategy.

(2) Cooperative loyalty increases as the penalties for disloyalty are

increased. Although this is hardly a surprising hypothesis, it is sometimes

ignored by cooperative-practitioners. If cooperatives do indeed provide

public goods, then theory suggests that it may be too easy for members to

leave cooperatives. Although managers of cooperatives sometimes express

astonishment that members who have substantial investments in a cooperative

are not more loyal to the organization, in many instances the me er's return

on investment is only weakly conditional on continued patronage. 9%

Cooperative members may rationally regard their investment in the

organization as a sunk cost and therefore not take it into account in making

current decisions. This implies that cooperative loyalty might be increased

by making the return on past investment more conditional on current

patronage. Doing so also might increase the use of member voice relative to

exit in disciplining management (Hirschman).

(3) A farmer's cooperative loyalty decreases as he or she becomes more

leveraged. Highly leveraged farmers are likely at times to face severe

cash-flow difficulties and therefore have a high discount rate. As

agriculture relies increasingly on purchased inputs and, as a consequence,

farm borrowing increases, one would therefore expect a secular decline in

cooperative loyalty. In addition, the widespread notion that young farmers

as a group display less cooperative loyalty than older farmers may in part be

attributable to younger farmers being more highly leveraged than their older

counterparts. In a cash flow bind, many young farmers may not be able to

*afford cooperative 1

5Z

alty if more favorable prices or credit terms are

available elsewhere.

(4) Cooperative loyalty is greater in small cooperatives than in large ones.

It is more likely that members of a cooperative will develop concerns for the

welfare of their co-members if the group is small and they get to know each

other intimately. Developing a degree of altruism regarding the payoffs to

the other players in a game can transform it from a prisoner's dilemma to a

game that does not have a Pareto-inferior outcome.

131
Some Oualifications to the Game-Theoretic Analysis:

The Roles of Transaction Costs and Ideology

Although game-theoretic analyses generate many intriguing hypotheses

regarding farmer cooperatives, such analyses are built on several restrictive

assumptions. Game theory assumes that all players know: (a) the rules of

the game, (b) all the other players' preferences, and (c) the relationship

between all the players' actions and the outcomes of the game (or at least a

probability distribution for those outcomes). Knowledge of the relationship

between actions and consequences implies that players have perfect foresight

(at least up to a probability distribution) and that in cooperative games

players can instantly and effortlessly evaluate the payoffs from joining all

possible coalitions and engaging in all possible strategies open to them.

Game theory further assumes that players face no other transaction costs in

carrying out their strategies, such as the costs of building coalitions and

enforcing agreements, and that the preferences of all players are immutable.

These assumptions are patently unrealistic. This section analyzes how

substituting more realistic assumptions regarding information costs, actors'

knowledge and computational abilities, other transaction costs, and the

possibility of changing players' preferences through the inculcation of a

"cooperative ideology" modifies the game-theoretic analysis presented in the

first two sections. The first part of this section discusses how imperfect

knowledge and transaction costs affect the conclusions drawn from the theory

of cooperative games while the second part examines how the conclusions

derived from the theory of noncooperative games (especially the prisoner's

dilemma) are modified once one takes into account the efforts of farmer

cooperatives to influence the preferences of their members.

Limitations of the Perfect Knowledge Assumption

Shubik has shown that the costs of gathering, storing, and processing

information and negotiating an agreement in an n-person cooperative game all

increase in proportion to a number raised to the nth power. For example, in

a two-person cooperative game in which each pl

4

yer has 10 alternative

strategies, each player must evaluate 100 (-10 ) possible outcomes of the

game. If the number of players increases to 10, the numbe of possible

outcomes to be evaluated increases to 100,000,000,000 (-10 O). iE Even if a

player could gather, without cost, information on all these possible

alternatives, evaluate them, and store the results, he or she also would have

to negotiate potential agreements with all possible coalitions, the number of

which also increases as a power of n. The costs of doing all this seriously

draw into question whether bargaining situations involving more than two

players really resemble the scenarios portrayed by the theory of cooperative

games. In Shubik's words, **By attaching even slight costs to the acts of

storing, gathering, and processing information, any firm can compute that

cost of getting anything like complete information will be astronomical" (pp.

148-49).

Shubik concluded that because of these information costs, players often act

noncooperatively, eschewing negotiation with one another over joint

strategies in favor of the informationally more efficient strategy of acting

132
independently. Cooperative games, he argued, are thus replaced by the

noncooperative games that underlie them.

Whereas Shubik argued that information costs reduced the scope for agreement

in cooperative games from that predicted by theory, Schotter and Schwodiauer

(P . 509) hold just the opposite view. Because of transaction costs, they

argue, it is unlikely that all possible coalitions that might block an

imputation will form; hence the core (the zone of agreement) will be larger

than theory suggests.

In farmer cooperatives, both the outcome predicted by Shubik and that

predicted by Schotter and Schwodiauer appear to occur depending on the

circumstances. In many instances (e.g., pricing of products), members do not

vote on every alternative open to them; rather the cooperative establishes a

rule (e.g., that fertilizer will sell for $x per ton subject to a possible

price adjustment via a patronage refund) that provides each member with a

low-cost set of expectations regarding the outcome of the cooperative's

actions. Given this set of expectations, the members can then each act

independently as they would in a competitive market. They act, in other

words, as they would in a noncooperative game in which the price of

fertilizer was given exogenously.

In other circumstances, particularly those concerning major decisions for the

cooperative such as whether to merge with another cooperative, the members do

negotiate with one another and vote. However, they do not consider all the

alternatives open to the cooperative, however, only a select few. Although

the game still is cooperative, it is a much simpler game than that predicted

by theory.

Determining who establishes the rules in these noncooperative games and wh

selects the alternatives to be considered in the (simplified) coope rative

.O

games is important to understanding the behavior of farmer cooperatives. The

rules determine what the "independent" actors in a noncooperative game have

to take into account in planning their behavior and hence how they interact

with one another. Similarly, the agenda that is established in a bargaining

(cooperative game) situation largely conditions the outcome of that

bargaining.

Because of information costs and other transaction costs, the highly

elaborated bargaining game predicted by the theory discussed in the first

section is replaced by two interlinked games. The first, a cooperative

(bargaining) game, can be called a constitutional game. In it, the rules of

the cooperative are established, including pricing rules, rules that

determine who sets the agenda for subsequent bargaining issues among the

members, and so on. Even in the constitutional game, not all alternatives

are considered; limits imposed by the external environment (competition in

the industry, laws governing the structure of farmer cooperatives, and so on)

and the knowledge and imagination of the members determine the alternatives

considered. The second, or consequent game, consists of the noncooperative

game or the simplified cooperative game already discussed. In this game, the

cooperative members either act independently, taking the rules or prices

determined earlier as given (as in the fertilizer example) or bargain over a

133
restricted set of alternatives that was delimited in the preceding

constitutional game.

Stating that the fully elaborated game predicted by theory is replaced by a

constitutional game and a consequent game is simply another way of saying

that in the presence of transaction costs there are economies in moving from

decisionmaking based on direct democracy (the fully elaborated game) to a

system of representative governance (the two subgames) (Staatz 1984, pp.

147-48; Buchanan and Tullock, p. 6). In such a system, the outcome of the

constitutional game largely conditions the outcome of the consequent game.

Therefore, understanding the behavior of a particular farmer cooperative

requires an understanding of its rules for making rules and how these

influence who participates in the governance of the cooperative.

It is reasonable to assume that members decide whether to participate in a

cooperative's governance based on their perceptions of the costs and benefits

to them of participating. The existence of transaction costs implies that

participation will be concentrated among members having an intense interest

in particular issues decided by the cooperative while those having a more

diffuse interest will abstain, even if in aggregate they could gain a great

deal from participation. The reason for this is that the transaction cost of

participating in the cooperative's governance is likely to exceed an

individual's potential gain from participating if he or she has only a

diffuse interest in the issues being decided by the cooperative. Such

individuals therefore do not become involved in the cooperative's governance

although in aggregate they may represent a majority of the members.

For example, consider a cooperative that is deciding among three options: to

expand its current plant at site 1, to build a new plant at site 2, or to

keep its current plant at site 1 with no expansion. Expansion requires an

additional subscription of capital from the members; therefore, the board

will not undertake the expansion unless members express strong support for

such action. Furthermore, assume that the projected net revenues from

expanding the plant at the two alternative sites are comparable so that there

is no clear-cut financial advantage to expanding in one site relative to the

other. Therefore, the board decides that if the members are willing to

finance the expansion, the board will choose the plant location based

primarily on the input it receives from members. The membership consists of

two groups. One group, C, has a concentrated interest in keeping or

expanding the plant at site 1 while a second group, D, has a slight

(diffused) preference for building a new plant at site 2. If the board hears

only from members of C, it will expand the plant at site 1; if it hears only

from members of D, it will build a new plant at site 2; if it hears from

neither group, it will keep the current plant at site 1 unmodified; and if it

hears from both groups, it will decide on the plant location through a

process that gives each group a 50 percent chance of getting its most

prefer'red alternative.

Members of C and D must decide whether to lobby for their preferred

alternatives. Let the expected payoffs to individual members of C and D in

the absence of transaction costs be those shown in figure 2(a). In this

situation, the dominant strategy for each member is to lobby; no matter what

134
Figure 2--Payoffs for political action in-the cooperative--concentrated and

diffused interests

Member D

Not Lobby Lobby

Not Lobby (1095) (397)

Member C

Lobby (1595) (W)

(a) Payoffs without transaction costs

Member D

Not Lobby Lobby

?

Not Lobby (1095) (394)

Member C

Lobby (1285) (63)

(b) Payoffs after deducting transaction costs

135
the opponent does, the member's payoff is always higher if he or she

lobbies. The equilibrium outcome therefore is lobbying by both C and D, with

C's expected payoff equal to 9 and D's expected payoff equal to 6.

Now suppose that the cost of lobbying for each -group is 3. Deducting this

cost from the payoffs involving lobbying yields the payoff matrix shown in

figure 2(b). In this situation, lobbying is still the dominant strategy for

C-no matter what D does, C's payoff is always higher if he or she lobbies.

However, D's dominant strategy now becomes not lobbying. As a result of

transaction costs, the equilibrium outcome now involves only C's lobbying;

hence C's most preferred outcome (expansion of the plant on site 1) occurs.

Thus the existence of transaction costs reinforces the tendency f members

with concentrated interests to dominate cooperative governance. 28

This tendency is further reinforced by the value of the information generated

by the cooperative during its operations. Information about developments in

a subsector is valuable to farmers in that subsector and often is costly to

obtain. When such information is costly, one motivation to participate in

the governance of a cooperative is the prospect of gaining access to

information on the subsector

the course of its operations. 58

nerated by the cooperative's management during

The value of this information to an

individual is greater the larger is his or her investment in the subsector

and the poorer are his or her alternative sources of information. Large

farmers, therefore, may have a C and D in the greater incentive to run for

the board, to serve on cooperative committees, and so on, than do small

farmers, particularly if information on developments in the subsector are not

readily available from other sources.

Another consequence of transaction costs is a tendency for decisions in a

cooperative, once made, to be relatively stable. Whereas game theory

predicts that bargainers will recontract in an eyewink should any of them

perceive the least advantage in some new course of action, in reality

decisions are unlikely to be revised unless the gains from revising them

clearly outweigh the transaction costs of organizing to do so. Therefore,

the existence of transactions costs protects the utility of those who have

the initial right to decide an issue in the organization.

Cooperative Ideology and the Modification of Member Preferences

Game theory assumes that each player has an unchanging set of preferences.

However, much of the activity in farmer cooperatives is aimed precisely at

changing the preferences of the participants in the organization to modify

their behavior. One of the main ways in which this is done is through

attempting to inculcate a "cooperative ideology" into farmer-members, members

of the board, and members of management.

In many instances, the incentives facing individual participants in farmer

cooperatives may induce them to behave in a way that is inconsistent with the

welfare of the cooperative as a whole. Individual farmers may expand

production when farmer-members as a group would benefit if output were

restricted; farmers may act as free riders with respect to the cooperative's

competitive yardstick activities, leading to a long-term decline in the

136
cooperative's ability to carry out those activities; managers may attempt to

conceal their activities from the board through manipulation of information;

and individual board members may attempt to use their positions to

25

eather

their own nests rather than to improve the welfare of the members. Such

a divergence between individual and group incentives is not unique to

cooperatives; it is faced to some degree by all organizations. As an

adaptive response to this problem, most organizations attempt to inculcate an

organizational ideology- a set of shared norms and beliefs--that tend to

reduce the divergence between individual and group goals (Roberts).

In terms of the game-theoretic model, the function of cooperative ideology is

twofold. First, it aims at altering players' perceptions of the payoffs of

the constituent games that they play. (Game theory assumes that players

evaluate these payoffs in terms of utility, not just money.) Specifically,

cooperative ideology, which is fostered both through formal programs, such as

member relations activities and board and management training sessions, and

informal socialization processes, attempts to:

(1) Change farmer-members' expectations regarding the pecuniary payoffs that

would be available to them with and without the cooperative. Member

relations programs often stress the importance of cooperatives in enforcing

competition and suggest that if they are not supported farmers will be much

worse off in the future.

(2) Influence participants' marginal rates of substitution between the

pecuniary and nonpecuniary benefits they derive from membership in the

cooperative. Cooperative ideology often stresses cooperation as a goal in

and of itself, being as worthy of a person's efforts as striving for material

advantage. At the same time, this ideology tries to reduce the marginal

utility that members of the organization receive from pecuniary benefits they

receive "unethically"--for example, from using their position of authority in

the cooperative to benefit themselves financially at the expense of others in

the organization.

(3) Induce a degree of altruism in players' evaluation of the payoffs from

the constituent games, that is, broaden a player's evaluation of the outcome

of a game to include not only how well he or she fares personally but also

how well his or her cohorts make out. Cultivating concern for others in the

cooperative may help overcome potential prisoner's dilemmas. This can

perhaps be seen best through an example. Suppose that initially the payoff

matrix facing two typical cooperative members is that shown in figure 3(a),

which represents a prisoner's dilemma. Both player 1 and player 2 can choose

between cooperating (C) and defecting (D), and each has a clear incentive to

defect. However, when both defect, the outcome (1,l) is mutually less

preferred than the outcome (5,4) that would have been obtained had they both

cooperated. Now suppose that through the inculcation of a new ideology each

player develops a degree of altruism, viewing his or her payoffs in utility

as the average payoff in the original game to both himself or herself and his

or her cohort. This results in a transformed game having the payoff matrix

shown in figure 3(b). In this game, mutual cooperation is the equilibrium

outcome. That is, through the introduction of a sufficient degree of

137
Figure 3-oTransformation of a prisoner's dilemma through introduction of a

degree of altruism

Player 2

A B

C

Player 1

D

(a) Original game

(5 94) ULV

(7 90) (191)

Player 2

A B

Player 1

~~~

(4.5,4.5) (3.5,3.5)

(3.5,3.5) (191)

(b) Transformed game

138
altruism, the game is transformed from

98

prisoner's dilemma into a game in

which cooperation spontaneously occurs.

The second major aim of cooperative ideology is to decrease the discount rate

members use to compare the payoffs from sequential constituent games in

supergames. As mentioned before, the higher the discount rate the more

likely it is that a supergame composed of constituent games that are

prisoner's dilemmas will itself be a prisoner's dilemma. For example,

members with high discount rates often are "unable to afford cooperative

loyalty" --therefore much of the socialization process in cooperatives aims at

trying to get farmer-members and board members to take a long view of the

cooperative's activities. By reducing the member's discount rate,

cooperative ideology discourages short-term opportunistic behavior in favor

of long-term support for mutual cooperation.

If ideology is an adaptive response by an organization to the problems it

faces, then that ideology needs to evolve as the problems change. An

ideology that is incongruent with the problems faced by an organization is

ultimately maladaptive. But because ideology that has been incorporated into

an individual's set of values seems so "natural" and self apparent, the need

for its change often is perceived only gradually and therefore the ideology

is likely to change very slowly. Attempts to change elements of an

organization's ideology rapidly may meet bitter resistance from certain

participants, as has occurred in some cooperatives when differential pricing

of services to members was proposed, although, as demonstrated in the first

section, such pricing is sometimes necessary to preserve the viability of the

cooperative.

Summary and Conclusions

Game theory, with its emphasis on decisionmaking under conditions of mutual

interdependence and on the allocations of costs and benefits from joint

activity, is particularly suited to examining the behavior of participants in

farmer cooperatives. Many decisions in these cooperatives resemble the

bargaining situations analyzed by the theory of cooperative games, where

joint action yields mutual benefits but where players must agree on how to

share those benefits before the joint action can be undertaken. Other

decisions facing participants in farmer cooperatives, particularly those in

which agreements among the participants are difficult to enforce, more

closely resemble noncooperative games, especially the prisoner's dilemma

supergame. Although the examples in this paper have focused mainly on the

pricing decisions of cooperatives, game theory offers insights into a broad

array of issues involving collective choice in cooperatives, ranging from the

financing practices of the firm to member control over management (see Staatz

1984, chap. 5).

The game-theoretic approach developed in this paper stresses that farmer

cooperatives cannot always singlemindedly pursue the simple objectives

posited in earlier models of cooperative behavior, such as maximization of

total member profits or maximization of per-unit cooperative surplus, because

doing so may result in a distribution of member benefits that creates

139
incentives for certain members to leave the organization. For a similar

reason, a cooperative may not be able to serve everyone; tensions over

cross-subsidies among a highly diverse membership may prove too disruptive.

Rules such as "equal treatment for all" may in certain circumstances result

in no service for anyone as they precipitate the disintegration of the

organization.

The game-theoretic approach also emphasizes that apparently irrational

behavior by cooperatives may result from individual participants rationally

pursuing their own self-interest. For example, consider intercooperative

competition. Farmer cooperatives often fiercely compete with one another,

even when they are owned by the same farmers (Ratchford; Swank). Although

greater collaboration would seem to be in the long-term interest of the

farmer stockholders, competition persists because individual incentives push

managers, board members, and stockholders to encourage it. Although managers

and board members may desire some reduction in intercooperative competition,

they are likely to oppose taking collaboration to its logical extreme,

merger, unless they are assured that they will retain positions of authority

in the new organization. Farmer-members may prefer intercooperative

competition for several reasons. If competing cooperatives cross-subsidize

certain services (particularly if different cooperatives subsidize different

services), then members can act as "cherry pickers," buying from each

cooperative its subsidized services and purchasing the other services (those

that provide the subsidies) somewhere else. Second, if the cooperatives'

equities are not freely redeemable, then members, particularly those nearing

retirement, may have no way in the short run of gaining access to their

accrued investment in the cooperative except through pressuring management to

liquidate some of the cooperati

distributed to current patrons. y8

's assets, the proceeds from which would be

One way of liquidating a cooperative is

to push it into ruinous price wars, which generate short-term gains to the

members in the form of more favorable prices at the expense of the long-term

viability of the organization. Third, members who feel distant from the

board and management, particularly in large cooperatives, may feel that

intercooperative competition is the only way in which the board and

management can be effectively disciplined. These members might prefer better

direct member control of the board and management to ensure the firm's

efficiency (but then again they might not, given the individual costs of

monitoring the organization), but lacking direct member control,

intercooperative competition may be seen as the only way to keep the people

at the top on their toes. The game-theoretic approach stresses that if

"wasteful" intercooperative competition is to be reduced, the incentives

facing individual participants in the cooperatives must be changed.

Introducing transaction costs and the possibility that participants'

preferences can be changed through the inculcation of "cooperative ideology**

modifies some of the conclusions of the game-theoretic analysis and stresses

the need to understand the rules for making rules in farmer cooperatives. It

also stresses the important role that socialization processes and member

relations programs may play in successful farmer cooperatives. However, many

of the major conclusions of the game-theoretic analysis remain valid. The

concept of the core continues to be particularly important: To prevent a

proposed allocation of costs and benefits in a farmer cooperative from

140
inducing defection,

36

areful attention has to be given to the

individual members.

payoffs facing

Furthermore, the game-theoretic approach emphasizes that in certain

circumstances what is good for the individual cooperative participant

(farmer-member, board member, or manager) may not be good for the

organization as a whole; this often is due to the free-rider problem inherent

in many of the activities undertaken by cooperatives. Therefore, if

cooperatives are to succeed in fulfilling what is often an important social

role, there may be a need to develop rules that limit individual choice

within the organization to prevent it from being undermined. This is a

delicate task because if taken to an extreme it would eliminate member exit

as a means of disciplining the board and management. Nonetheless, this

analysis shows that unfettered individualism in cooperatives may leave all

members worse off than if defecting from the cooperative were more costly in

the short run.

1 .

2 .

3 .

4 .

5 .

6 .

Notes

For formal definitions of the game-theoretic terms used in this paper,

see Lute and Raiffa; Bacharach; Taylor; or Staatz 1984, appendix C.

For a compilation of these bargaining issues, see Staatz 1984, pp.

226-32.

If, however, retained earnings are used to retire member equities

rather than to finance growth of the cooperative, older members may

prefer a high level of retained earnings.

The best-known application of game theory to analyzing the choice of

constitutional issues is Buchanan and Tullock's The Calculus of Consent,

especially chaps. 11 and 12. There is a fundamental difference between

the type of game analyzed by Buchanan and Tullock and those discussed

here. Buchanan and Tullock analyzed constitutional choice in a

democratic entity from which exit was essentially impossible; therefore,

the criterion for group choice in their model was maioritv rule. Exit

is possible from farmer cooperatives; farmer-members who strongly

disagree with some collective action taken by the organization (e.g.,

its pricing practices) are free to leave the organization. The

criterion for group choice in these games, like that in all "classicaV*

bargaining games (Roth), is therefore unanimity; if all members of a

potential coalition are not at least as well off as they could be in

some other arrangement, the coalition will not form.

For a detailed discussion of the relationship between subadditivity of a

cost function and economies of scale, see Baumol, Panzar, and Willig,

chap. 7.

The cost functions presented in this section represent the cost to a

given group (coalition) of farm firms of obtaining a particular

service. Hence, the cost function represents the cooperative's cost of

141
7 .

8

9

10

11

producing the service plus any additional costs incurred by the member

firms in gaining access to the service.

Because the cost function is subadditive, the model applies only to

situations where reducing the size of the cooperative or its range of

services would result in an increase in costs for the remaining members

or for providing the remaining services. The model does not apply to

situations where a cooperative's elimination of unprofitable lines of

activities leaves the remaining patrons better off. In that situation,

the dilemmas outlined here do not arise; pressure both from the patrons

who generate positive net margins for the cooperative and from the

competitive environment may lead management to eliminate the

unprofitable activities.

Payoffs usually are pictured in game-theoretic models as payments to

players while here they are payments bv players. Formally, the

correspondence to standard theory can be made by changing signs (i.e.,

payoffs become negative revenues) and thereby reversing the direction of

all inequalities.

In farmer cooperatives, the entire surplus above cost is not returned to

the members as cash; some is kept as operating reserves. The decision

on how much of the surplus to pay out as cash is itself a bargaining

issue that can be analyzed using a game-theoretic model (see Staatz

1984, pp. 253-63).

In the following paragraphs, the term "member" should be interpreted as

signifying either a single member of a group or members acting as a

coalition.

This conclusion is strengthened even further if we assume that small

farmers are more risk-averse than large farmers. If large farmers are

less risk-averse, they would be more willing to gamble in the bargaining

process than would small farmers and would therefore drive a harder

bargain, particularly if (as game theory assumes) the larger farmers are

aware of the small farmers' utility functions, including their risk

preferences (see Harsanyi).

Here is where the distinction made earlier between economies of scale

and a subadditive cost function becomes important. Because the cost

function is subadditive, it is cheaper to process all four products in a

single plant, but because the average cost of processing does not

decline monotonically throughout the range of production, farmer-members

cannot simply be charged the firm's average cost.

12 . In this example, external market opportunities were not analyzed; the

cooperative's cost function alone defined the characteristic function.

Including external market opportunities in the analysis would have

shrunk the core (reduced the scope for agreement within the

cooperative).

142
13 . The Shapley value for an individual coalition (player) i is defined as

+(Q _K;Iln-kJ;;k-l)! [v(K) - VW-(WI

.

where

n= number of players in the game,

k - number of players in coalition K,

v(K) is the characteristic function for coalition K, and

v(K-(i)) is the characteristic function for the coalition made up of

all members of K who are not also members of i.

The expression [v(K) - v(K-(i))] represents the marginal contribution of

player i to coalition K. The expression

(n-k)!(k-l)!

n!

represents the probability that in a random build-up of the grand

coalition of n players, player i will join in the coalition in the kth

position. Summing the product of these expressions over all K yields

the average of player i's possible marginal contributions. For further

details, see Schotter and Schwodiauer or Lute and Raiffa, pp. 245-52.

14 . In certain other situations, the behavior of participants resembles

another type of noncooperative game, the *'coordination problem." For

details and an example, see Staatz 1984, pp. 270-75.

15 . Figure 1 illustrates a two-player prisoner's dilemma. Prisoner's

dilemmas can also be defined for more than two players (see Taylor).

16 . When there is one strategy in a game (such as defection in the

prisoner's dilemma) that gives a player a higher payoff no matter what

the other players do, that strategy is said to be dominant.

17 . See the discussion of "supergames" later.

18 . For a review of the arguments that the provision of public goods in

general represents a prisoner's dilemma, see Taylor, chap. 1.

19 . For a mathematical demonstration, see Staatz 1984, pp. 407-14.

20 . If a player knew in advance that the nth iteration was the last, he or

she would have a clear incentive to defect in that iteration because in

any single-constituent game defection is the dominant strategy. The

(n-1)th iteration would then become in effect the last game, but here

again the same argument for defection would apply, and so on, all the

way back to the first iteration.

143
21 .

22 .

23 .

24 .

25 .

26 .

27 .

28 .

29 .

30 .

Unconditional cooperation in a prisoner's dilemma supergame is defined

as cooperating no matter how the other players have behaved in previous

iterations of the game. Conditional cooperation is defined as

cooperating only as long as the other players, or some critical number

of them, continue to cooperate; if they defect, the other player defects

(for some period) in subsequent iterations of the game.

For details, see Staatz, "The Structural Characteristics of Farmer

Cooperatives and Their Behavioral Consequences,'* in this volume.

See Staatz, "The Structural Characteristics of Farmer Cooperatives and

Their Behavioral Consequences," in this volume.

When the author suggested this hypothesis to a cooperative manager, he

replied, "But in the long run they can't afford cooperative

dislovaltv." His reply neatly illustrates the prisoner's dilemma. Some

evidence of the importance of cash flow considerations in determining

cooperative loyalty emerged from interviews with farmers. Several fruit

and vegetable farmers reported selling crops produced on their own land

to their cooperatives and crops produced on rented land to IOFs. In the

presence of imperfect capital markets, the farmers needed the immediate

payment for the crop provided by the IOFs to pay their land rent; for

crops produced on their own land, they could afford to accept the

deferred payment typical of fruit and vegetable processing cooperatives.

If the cost of lobbying for each group rose above 6, it would no longer

even pay C to lobby, and a new equilibrium would occur in which neither

party would lobby and the old plant would remain at site 1. This

illustrates a further point discussed later: High transaction costs, by

reducing the likelihood that a cooperative frequently will change its

existing policies, protect the utility of those favored by existing

policies (in this case, members of C, who prefer that the plant remain

at site 1).

Several board members interviewed by the author cited access to such

information as a major benefit of serving on the board.

For details, see Staatz 1984, chap. 6.

For a more detailed analysis, see Taylor, chap. 4 .

This is the "horizon problem" discussed in Staatz, "The Structural

Characteristics of Farmer Cooperatives and Their Behavioral

Consequences," in this volume.

Low price is but one component of the benefits (payoffs) available from

a cooperative (see Staatz, "Farmers Incentives to Take Collective Action

via Cooperatives: A Transaction-Cost Approach," in this volume).

Quality of service and provision of certain public goods (e.g.,

lobbying, enforcement of competition) have traditionally been major

benefits of cooperatives. Nonetheless, prices are important as the

recent emergence of *tsuperlocalt' or Mminiregional** supply cooperatives

144
in the Midwest demonstrates. These are large local cooperatives that

have defected f'rom their regionals to deal directly with suppliers

becaus e the Prices available from the suppliers were substantially below

those avail able from the regionals

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Cambridge University Press, 1981.

146
Schotter, Andrew, and Gerhard Schwodiauer. 'Economics and the Theory of

Games: A Survey." Journal of Economic Literature 18(1980):479-527.

Shubik, Martin. "Information, Theories of Competition, and the Theory of

Games." Journal of Political Economy 60(1952):1945-50,.

Staatz, John M. **The Cooperative as a Coalition: A Game-Theoretic

Approach.*' American Journal of Agricultural Economics 65(1983):1084-89.

Cooperatives:"

"A Theoretical Perspective on the Behavior of Farmers'

Ph.D. dissertation, Michigan State University, 1984.

Cooperativesl

"Farmers Incentives to Take Collective Action via

A Transaction Cost Approach." In this volume.

"The Structural Characteristics

Their Behavioral Consequences."

of Farmer Cooperatives and

In this volume.

Swank, C. William. "Competition Among Cooperatives and Relationships of

Operating Cooperatives, Bargaining Associations, and Farm Organizations." In

Research on Cooperatives in the 198Os, pp. 80-82. Washington, D.C.: USDA

ACS Staff Rep., 1983.

Taylor, Michael. Anarchy and Cooperation. New York: John Wiley and Sons,

1976.

Zusman, Pinhas. "Group Choice in an Agricultural Marketing Co-operative."

Canadian Journal of Economics 15(1982):220-34.

147
COMPETITION AMONG COOPERATIVES

V. James Rhodes*

No issue brings to the fore more incisively one's conception of the basic

character of cooperatives and of their role in the market system than the

question as to whether each of them engaged in a particular type of

operation should have an exclusive territory. (Heflebower, p. 195)

Is competition among cooperatives a good thing? To many readers, the answer

will seem so obviously yes that there is no point in pursuing the matter.

The merits of competitive markets in providing efficiencies are well-known.

Note, however, that the question is not about abandoning competitive markets

or creating cooperative monopolies but about the relationships among a

special type of firms competing in a market. It is not at all unusual for

competing firms to merge, and even when one or both firms are relatively

large, the merger is often judged by the Department of Justice to be

acceptable. In most regional or national agricultural markets, the merger of

all existing cooperatives would not create a monopoly and frequently would

not create a firm that ranked in the top four firms in that market.

Historical Background

Cooperation was regarded early as the antithesis of competition. The slogan

of early British cooperators was **cooperation, not competition" (Wiles, pp.

253-54). These early practitioners saw cooperatives as a type of public

enterprise with multiple social objectives- -objectives that could not be

fulfilled if all energies were focused on prices and patronage refunds. As

transportation improved in the early 20th century, British cooperative stores

encountered more and more overlap among their trade areas. The Cooperative

Union campaigned to eliminate this intercooperative competition through

negotiation of boundaries or of mergers. Generally these early British

leaders felt that competitive overlapping led to wasteful duplication,

unsound financial practices, and the erosion of the cooperative spirit

(Boner, pp. 98-101 and 340-42).

Transportation improvements in the United States in the past century have

led--as in Britain--to more overlapping of the trade areas of local

agricultural cooperatives. Such cooperative competition sometimes has led to

mergers or to the demise of one or more of the participants, but it has

sometimes persisted for many years.

The regional cooperatives rather quickly encountered other regionals as they

grew in the 1920s and 1930s. Responses to interregional competition have

varied. As one example, Consumers Cooperative Association (CCA) (Farmland

Industries' predecessor) overran the rather bitter opposition of the Farmers

Unions of Nebraska and Kansas to CCA's solicitation of business from their

locals in those states (Fite, pp. 112-15). On the other hand, the Virginia

Seed Service (the predecessor of Southern States) withdrew from North

Carolina upon the organization of FCX in that area and later withdrew from

*The author gratefully acknowledges helpful reviews by James Shaffer, Peter

Vitaliano, and Brice Ratchford.

148
Tennessee as a result of an understanding with Tennessee Farmers (Knapp et

al., pp. 535-46).

The only cooperatives with exclusive territories--the rural electric

cooperatives (RECs) and the Farm Credit System--resulted from government

sponsorship in their organization plus the utility nature of the RECs. Note

that the Farm Credit institutions have much investor-owned competition and

that the boundaries limit cooperative competition, not proprietary

competition.

On request, Joseph Knapp, the first administrator of the Farmer Cooperative

Service, presented a paper on this topic at the 1949 annual meeting of the

American Institute of Cooperation. Knapp reported the findings of an

informal survey of cooperative managers and outside observers on the subject

as well as his own judgments. Knapp found that:

1 . Excessive competition among cooperatives was judged to be a

problem- -often expensive and divisive;

2 . Competition also had its good points in keeping managers on their toes

and eliminating the inefficient;

3 . Excessive competition among cooperatives often was due to

managers --their vanity or their empire-building ambition;

4 . An ideal cooperative system would not have competition among

cooperatives, but that probably is not attainable.

Theoretical Considerations

From society's viewpoint, is any restriction of competition among

cooperatives a bad thing? That depends on how much competition would survive

among the investor-owned firms (IOFs) and the cooperatives. Generally, as

suggested earlier, active competition would survive because the market

structure is not highly concentrated, product differentiation is often rather

small, and entry barriers are moderate or lower. The argument could be

carried into less competitive markets. To the extent that a few markets may

be highly contestable, competition is adequate even when there is high

structural concentration or even monopoly (Rhodes). Moreover, arguments

could be made that section 2 of the Capper-Volstead Act can be used to

regulate adequately even cooperative monopolies. Without judging the merits

of that position, this paper does not go that far. It is simply argued that

in most markets the elimination of competition among the cooperatives would

not affect the public interest. Where there are exceptions, perhaps

competition among cooperatives should be preserved for public policy

reasons. The next section proceeds on the assumption that there will be

adequate competition in the market regardless of how little the competition

among the cooperatives.

There also is a criterion of cooperative member welfare as well as the public

interest. Is any restriction of competition among cooperatives a good thing

149
for the members? Would it be economical for a given set of farmers to - - - -

originate two or more independent cooperatives to compete in hauling their

milk, making cheese, marketing grain, or whatever? Generally not. That is,

any volume that these farmers demand to be handled has a lower total cost for

one firm handling it than would be the combined total cost of two or more

firms doing it. In figure 1, output qc is the output marketed through a

single cooperative; output qb is l/2 qc and output qa is l/3 qc; TC

is the long-run total cost curve for the most efficient performance of that

particular marketing function. It can be seen that 3TC, > TC, and 2TCb

> TC,. It is likely, of course, that there is some output qd (where qd

> q,) at which the TC is rising faster than a linear rate because of

diseconomies of scale and it is no longer efficient for the total volume to

be handle

P

by one firm. What is argued here is that this subadditive

condition of one firm being the most efficient to serve a given set of

farmers is empirically true for many markets.

Likewise it generally would not be economical for a given set of local

cooperatives to set up two competing regionals to make their fertilizer,

provide them fuel, or market their grain. Because of the costs of

duplication of facilities, personnel, and efforts, setting up competing

cooperatives ordinarily would not be beneficial for the members. The

argument that competition among cooperatives is essential to X-efficiency

("keeping cooperative managers on their toes") is not valid because plenty of

competition from the IOFs exists with the possible exception of one or two

commodities.

Competition among two cooperatives usually involves not one set of

farmer-members, but two overlapping sets. The overlap is formed roughly by

the members being competed for by both cooperatives. The overlap members may

vary from a tiny percent to a majority of all members. Member interests are

even less homogeneous. Even boards of each cooperative may have some

thoughts of "winning" the competitive battle. Those members being competed

for may obtain special prices and services. Those beneficiaries will likely

praise cooperative competition. Even if beneficiaries realize their gains

are at the expense of the financial health of their organization, they

probably can rationalize their gains. For example, those nearing retirement

can reason that they merely are getting back some of their investment that

they otherwise would not get for a long time.

While farmers as a grouD clearly may benefit from cooperation among

cooperatives, their members may focus more on individual payoffs. The

problem is the same in any coalition. There is a natural struggle over the

division of the benefits. An individual is likely to focus on his or her

return rather than on the group's total returns. An individual is not likely

to consider whether action to increase their own return may reduce the total

group return. He or she may be caught in a fallacy of composition in which

they presume that individual gains translate into group gains rather than the

opposite. If an individual does consider and does perceive the negative

relationship of individual and group returns, he or she does not necessarily

restrain himself or herself. The individual may justify his or her action by

arguing that others will take similar advantage of the situation. The

possibility of beggaring thy fellow member is the reason that citizens may

150
Figure 1

Total

costs

4,000

3,000

2,000

1,000

TC

-

4 a 4 b9 Volume

C

151
voluntarily vote a compulsory tax, or farmers may voluntarily vote the

compulsions of a marketing order. While various cooperative rules and state

and federal legislation ameliorate the individual-group conflicts within a

cooperative, various members persist in using competitive market place

opportunities (IOF as well as cooperative) as a way to enhance their

individual bargaining power and economic returns. If there were an

institution similar to a marketing order to minimize coop rative competition,

members could avoid the prisoner's dilemma they now face. 5

What will be the outcome of this conflict of interests? Will the cooperative

spirit (the community of interest) of all farmers cause members to object to

the cooperative competition? Will their objections affect cooperative

policy? Answers must be empirical. On the European continent, agricultural

cooperative competition generally is not permitted (Straub). Some of that

restriction may arise from the intervention of government or other

supracooperative organizations as well as from the solidarity among

farmer-members (Foxall). That is, the Europeans generally have developed the

institutions necessary to solve the problem. In this country, our brief

historical survey suggests that "cooperative statesmanship" sometimes

prevails. However, competition among cooperatives sometimes is especially

aggressive and even vindictive.

Cooperatives and Government Policy

Government policy could range from active intervention to nationalizing a

cooperative system (as in some European countries) to stern antitrust attacks

on any attempts to reduce competition among cooperatives. The present

political climate certainly does not support nationalization. Likely, the

government will not be much involved as long as there is general adherence to

the antitrust regulations.

What can cooperatives do about reductions in competition if and when desired

by membership? A chief remedy for excessive competition would appear to be

structural. Mergers and acquisitions can remove many of the worst overlaps

of territories and the clash of opposing interests. Managers and boards have

their own personal reasons for dragging their feet on mergers and

acquisitions, but they feel more comfortable considering structural rather

than conduct remedies to excessive competition. Structural consolidation of

cooperatives offers much promise in certain areas such as milk assembly and

grain marketing, but it has its limitations. Members are concerned about the

impacts of structural consolidation on their market outlets, their sources of

inputs, their claims to capital in the cooperative, and their influence in

governance. These quite legitimate concerns of members tend to hinder

structural consolidation even where economies of scale appear favorable. The

feasibility of joint ventures or common sales agencies needs to be examined

as a halfway step in many situations.

Certain principles of conduct by cooperative board and managers should be

considered:

152
1. Do not build or acquire a facility or enter a market when that effort

can only succeed at a substantial cost to another cooperative;

2 . Do not dump excess inventories in another cooperative's market;

3 . Do not start price wars;

4 . Develop the kind of healthy interaction with members and a program of

equity rotation so that most members will not consider the cooperative

of more value dead than alive;

5. Develop member understanding of the larger payoff available to the

group if it is not undermined by excessive competition among

cooperatives- -a competition that is often incited or abetted by

individual members.

Summary

The "problem" of competition among cooperatives often is discussed by

cooperators, but not for publication. Early British cooperators sought a

cooperative or socialist system rather than market capitalism. American

agricultural cooperators accept the market system and the values of the

competitive market.

The question is twofold: (1) Can competition among cooperatives be moderated

without damaging the competitive market? (2) If so, does moderation of

competition among cooperatives benefit their members? A qualified yes is

given to both questions. Most regional and national markets are dominated by

IOFs, not cooperatives, and preservation of the competition among the IOFs

and between them and the cooperatives is not at question. Ordinarily, a

reduction of competition among cooperatives would benefit members as a

group. However, such reduction may likely reduce the individual returns of

some members who have benefited directly from the competition.

The earlier literature, as shown in Knapp, emphasized that the attention of

cooperative managers to their individual goals was a cause of cooperative

competition. While that problem remains, more recent thinking emphasizes

that membership attention to their individual payoffs may be equally at

fault. This prisoner's dilemma can be solved by group solidarity, by

farsighted board and management action, or by more far-reaching

institutions. The European cooperative solution typically is that of our

Farm Credit districts --erect boundaries between cooperatives by regulation.

Some regional cooperatives have respected boundaries, but many have not.

Ordinarily there are no boundaries to guide local cooperatives. It is not

feasible to tell farmers where to market their grain or purchase their

supplies. Boards of directors are likely in the best position to appreciate

and to push for the maximum long-term payoffs to all cooperative members. It

is doubtful that most boards are well enough informed and strong enough to do

much about the problem. Thus the problem of competition among cooperatives

remains a challenge to educators, cooperative leaders, and those who could

design new institutions.

153
Notes

1 . See discussion of subadditivity in chap. 2 of Baumol, Pangar, and

Willig.

2 . Staatz presents an excellent development of this problem.

References

Baumol, William J.; John C. Panzar; and Robert D. Willig. Contestable

Markets and the Theory of Industry Structure. New York: Harcourt Brace

Jovanovich, 1982.

Bonner, Arnold. British Cooperation: The History. Principles and

Organization of the British Cooperative Movement. Manchester, England:

Cooperative Union, 1961.

Fite, Gilbert. Farm and Factory: A History of the Consumers Cooperative

Association. Columbia, MO.: University of Missouri Press, 1965.

Foxall, Gordon. "Marketing Development in Agriculture: The Contributions of

Supra-Cooperative Organizations." Oxford Agrarism Studies 7(1978):75-86.

Heflebower, Richard. Cooperatives and Mutuals in the Market System.

Madison, Wis.: University of Wisconsin Press, 1980.

Knapp, Joseph. "Competition Between Cooperatives: Meeting the Problem." In

American Cooperation 1949, pp. 341-61. Washington, D.C.: American Institute

of Cooperation, 1949.

Knapp, Joseph, et al. Great American Cooperators. Washington, D.C.:

American Institute of Cooperation, 1967.

Rhodes, V. James. tCooperatives and Contestable/Sustainable Markets? In

this volume.

Staatz, John M. "A Game-Theoretic Analysis of Decisionmaking in Farmer

Cooperatives.'* In this volume.

Straub, Willy. "A European Perspective of Cooperative Thought." Paper

presented at Graduate Institute of Cooperative Leadership, Columbia, MO.,

July 19, 1982.

Wiles, Peter J. D. Economic Institutions Compared. New York: John Wiley

and Sons, 1977.

154
LARGE AGRICULTURAL COOPERATIVES: ON THE ROAD TO WHERE?

V. James Rhodes*

The cooperative and the common-stock corporation are highly flexible forms of

business organization. The cooperative has been put to use by people with

highly divergent interests and beliefs. This diversity leads to some

confusion as to how cooperatives are perceived by both members and

nonmembers.

This paper suggests some of the variety of uses of cooperatives and develops

a certain evolution over time. However, the paper does not attempt a history

of cooperatives. This presentation highlights by its incompleteness.

There can be little doubt about the basically anticapitalist ideology of the

famed Rochdale weavers. The 34 Rochdale pioneers included more socialist

thinkers than weavers (Bonner). Those early British cooperatives emphasized

mutual aid, equality, democracy, decentralization, and the poor instead of

competition, hierarchy, and unlimited&accumulation (Wiles).

U.S. agricultural cooperatives owe as much to the American frontier as to

Europe. "Cooperating" in barn raisings, threshing, and other large-scale

activities was a virtue born out of necessity on the frontier. It was a

short step from shared labor and shared machinery to shared enterprises

serving essential needs for insurance, farm supplies, or simple marketing.

Of course, there were personal and intellectual connections with the European

cooperative movement, and the so-called Rochdale principles were widely

adopted as guidelines.

Sixty years ago one of the founders of our profession with an intense

interest in cooperatives, E. G. Nourse, enumerated the Rochdale fundamentals

and discussed their then-current relevance. The three fundamentals were:

1 . Reduced costs through increased efficiency and/or reduced services;

2 . Popular distribution of savings (net earnings);

3 . Democratic control --one-member/one-vote.

Nourse argued that each of these fundamentals was a protest against perceived

shortcomings of the economy. First was the perception of a wasteful system

that had much excess capacity and that provided several services for which a

large market segment would prefer not to pay (e.g., retail credit in 19th

century England). Nourse argued in 1922 that U.S. farmers still perceived

cooperative opportunities for reducing overcapacity, streamlining services,

and reducing some of the other costs associated with nonprice competition

among investor-owned firms (IOFs). A few years later the new theory of

monopolistic competition would explain why competitive markets could have

overcapacity and extra costs while being at a zero-profit equilibrium.

*The author appreciates helpful reviews by James Shaffer, Harold Breimyer,

Charles Cramer, and C. Brice Ratchford.

155
The second complaint arising from Rochdale days was the belief that

stockholders should not be the residual claimants of firms. That

anticapitalist notion was the justification for cooperatives paying minimal

interest on capital stock and paying out the rest as patronage refunds. By

1922, Nourse saw clear erosion of the basic complaint. American farmers

shared no anticapitalist ideology with labor. Nevertheless, the principle of

patronage refunds still was strongly held.

The third perceived shortcoming was the closely allied belief that economic

control of IOFs by stockholders (and often a relatively few of them) was

basically antidemocratic. While a cooperative, even as an IOF, is a union of

people and capital, the cooperative ideology emphasized the primacy of the

people. Nourse notes that U.S. cooperatives still were holding tenaciously

to the one-member/one-vote working rule. Democracy of control fitted well

with American populist ideas and the antitrust sentiments of the early 20th

century. There also was the pragmatic perception that democracy is very

compatible with the cooperative philosophy of bringing together farmers with

a common need.

Nourse summarized by noting that cooperatives have been utilized by three

social classes --each attempting to enlarge its class share of the fruits of

the economy. Labor tried cooperatives but soon turned to trade unions.

Consumers tried cooperatives with little success except in England where

Nourse astutely observed that they had overreached and were on the way to

socialism. Farmers, only mildly class-conscious in Nourse's judgment, have

used cooperatives in a very pragmatic way to improve their position in the

economy. Their purpose has been "functional reorganization" rather than

"comprehensive economic regeneration" (Nourse 1922).

In Europe and North America, most agricultural cooperatives were organized

in reaction to agricultural distress. In Europe it was the agricultural

crisis of the 1880s that spawned many farm cooperatives (Natronale

Cooperatieve Raad). The Grange in the 1870s organized cooperatives and

supported populist causes. Later the Farmers' Alliance in the South and the

Farmers' Union and eventually the Farm Bureau helped to organize more locals

(Bakken and Schaars). Although farm cooperatives were part of a general

reform movement and were seen as a corrective to the unequal bargaining power

of farmers, their members placed them in a capitalist perspective.

Cooperation per se was extolled as virtuous but the dominion of the market

was accepted.

Some Cooperatives Became Large-Scale Organizations

Regional cooperatives developed in the early 20th century in a variety of

ways. Farm organizations often promoted them. In a few cases, able

entrepreneurs, seeing the opportunities to serve locals, developed the

regional organizations. For the first time in the U.S. experience some

cooperatives became large firms after World War II.

While American cooperative theory,

readily to capitalist cooperatives

as previously shown by Nourse, had adopted

9 it had not foreseen large cooperative

156
firms and their implication. Nourse had fought the

which was certainly conducive to large cooperatives.

Sapiro cartel concept,

Nourse's views were to be characterized later as the competitive yardstick

role for cooperatives. The objective of cooperatives was to stimulate

competitive performance but not to supersede other business forms.

Cooperatives could serve a real purpose by entering agricultural markets i

which services were inadequate or were provided inefficiently. Once

cooperatives had innovated superior methods or broken a monopolistic

bottleneck, Nourse urged a halt to further cooperative growth.

**[Cooperatives] should then be content merely to maintain ‘stand by'

capacity, or a 'yardstick' operational position rather than try to occupy

whole field or a dominating position within it. In some cases, they may b

well advised in entirely terminating operations once they have stimulated

regular commercial or manufacturing agencies to competition amongst

themselves" (Nourse 1945).

Study of large-scale organizations indicates the small probability of the

management of any large firm--cooperative or IOF--taking a passive standby

position or terminating the firm because its objective has been

accomplished. Any large-scale organization is greatly different from a small

organization. A hierarchy of management develops bureaucratic procedures.

In large firms, there is a greater gulf between owners and management.

Boards of directors find the large firm less easy to comprehend and the

performance of its management more difficult to evaluate. The operating

philosophy is not the competitive yardstick but rather: This firm must

survive.

Some later writers of the Chicago school have abandoned the tenuous arguments

that IOF stockholders have either the motivation or the institutional

mechanisms for directly monitoring the behavior of management (Fama). But

they insist that effective monitoring exists. The monitoring is by the board

of directors, which generally consists of top management plus some

outsiders. According to this view, the nationwide market for managerial

talent motivates managers to be good monitors of each other and to be helpful

to board members in assessing performance. The stockholders' indirect role

is exercised through their market-revealed attitudes toward the firm's

stock. A bearish attitude conveys a negative signal. Likewise the

attentions of a potential raider stimulate the monitors and management.

While there are obvious differences among modern theorists as to how

completely the market does pressure the managers of large-scale corporations

to keep their shoulders to the wheel and their noses to the grindstone, there

is a common emphasis on conceptualizing the firm as an organization.

Various authors stress various views of the large organization. Wil

emphasi zes the hierarchial nature of the firm and the advantages of

solving; certain transactional difficulties arising out of the inevit

conflic ting goals of firm members. Galbraith, impressed by the brea

technic al information assembled in modern decisionmaking, refers to

as a hierarchy of committees. Fama and Jensen focus on the organiza

nexus 0f written and unwritten contracts among managers, employees,

liamson

fiat in

ably

dth of

the firm

tion as a

157
suppliers, and customers. If somehow all those contracts were to be

destroyed in one fell swoop, the organization would have likely lost its

ability to survive. The focus on contracts emphasizes the pervasive

impingement of the markets for people and commodities on the decisionmaking

within the organization.

Earlier in this century, Commons anticipated much of the current discussion

about transactions and firms as organizations. A firm is a going concern--'*a

visible, tangible, living body of men animated by a common purpose** (p.144).

There is no facile assumption that a firm is nothing but a money-making

machine. However, such an organized mass movement as a firm expects income;

if that expectation fails, the promised corporate immortality is a casualty.

A going concern exercises purposeful control over property and people. The

members of the organization are guided by two sets of working rules--those

internal to itself, and the external rules and laws of the state. To a

considerable extent the state has granted industrial self-government to those

aggregations exploiting economies of size. Everyone in a going concern has

some discretion in performing his or her duties (the higher the rank the more

the discretion) and thus each contributes to "the collective will." A going

concern is a set of transactions guided by the precedents and customs of the

past. As an association, a set of future transactions may be anticipated

extending beyond the expected life of any individual in the group. Working

rules for an organization are essential "to hold together in a continuing

concern the overweening and unlimited selfishness of individuals pressed on

by a scarcity of resources" (p. 138). Working rules are all of those laws,

regulations, business ethics, and norms that guide transactions among people.

Commons's view of the firm complements that of those who focus on market

forces. Commons focused on rules and customs that evolve in a society to

handle interpersonal relationships. Conflict within and between associations

of people is recognized as inevitable. The working rules define duties and

rights and the processes for the achievement of some common purposes by an

organization. These working rules guide much of the self-monitoring and

board-monitoring so central to numerous modern theories of the firm. These

working rules evolve as perceived circumstances change. What is right and/or

legal for a manager in 1950 is not necessarily identical to what is right

and/or legal in 1980. What a society expects of its industrial empires will

change with accumulated experience, and those changing expectations will

impact on the working rules according to Commons.

Red ink on the bottom line can lead to belt-tightening (i.e., new corporate

rules), dismissals of lower level managers, and, at the worst, to selection

of new top managers. Management teams may reflect other market forces as

they set goals for themselves of continued growth in sales or in net

earnings, or the continuity of stable dividends. These market influences are

interwoven with the working rules already described. The size of top

executive compensation and the depth of the associated perquisites is decided

within the context of both market comparisons and ideas of equity. Similar

forces affect the wage contracts negotiated with the unions.

158
Cooneratives and IOFs

The cooperative has much in common with IOFs--more commonalities than

differences. The differences arise less in market forces imposing on them

than in the set of working rules that apply to each type of firm. In view of

the anticapitalist origins of English cooperatives, there is irony in the

difficulties frequently perceived in distinguishing large regional

cooperatives from other large corporations in our capitalistic economy..

The cooperative board is structured to have more independence from management

than is the case with IOFs. Generally members of management, with the

possible exception of the president, are not voting members of cooperative

boards while IOF boards typically have several members from management. The

election of cooperative boards also is structured to be representative of the

broad range of members via democratic voting procedures and the absence of

proxy voting. The typical IOF boardis a self-perpetuating closed group

except when a crisis or a raider breaks the network.

Whether the actual performance of a cooperative board is much different from

an IOF board still is the subject of much debate. A lot has been said about

the possibilities that farmer board members are too unsophisticated and

uninformed to monitor management effectively. IOF boards often include

outside experts in finance and marketing while cooperative boards rarely

include any nonmembers. If there is widespread apathy among voters--as might

appear rational when members number in the tens of thousands--then the

cooperative board may become a self-perpetuating closed group. Undoubtedly

the degree to which the structural potential for **owner control" actually is

realized depends on the quality of leadership and acceptance of cooperative

ideals in both the cooperative board and management.

Cooperative growth--and even survival- -depends on a continual infusion of

capital. If cooperative ideals are assumed away, then each member tries to

minimize their capital contribution. It is frequently observed that members

are reluctant to subscribe to new capital and that they want their dividends

in cash. Management, to preserve the organization, must protect it against

the chipping away by individual members that would destroy it. Members may

perceive as empire building by management the actions that managers perceive

as proper stewardship of the organization. The debates about plans for

equity redemption and allocated versus unallocated reserves reflect--among

other things- -attitudes as to whether rules on capital should be used by

members to control cooperative size (Cobia et al.; Royer; Murray).

The Hunter Cooperative

Those who guide the long-term planning and decisionmaking of large firms must

decide the range of potential activities that will be considered. Many firms

have been committed to a single industry. For generations, the family firm

may have been in a single business: tentmaking, banking, or whatever. A

railroad firm with its immense fixed assets has been presumed to remain a

railroad firm into perpetuity. All the great advantages of industry know-how

were passed down through the years as assets--intangible but valuable.

159
However, technological advances frequently have invalidated single-industry

commitment. The harnessmaker faced a disastrously declining demand. The

railroad encountered a no-growth future. The railroader was encouraged to

consider himself or herself in the transportation business, not the railroad

business. The final step was simply to consider himself or herself as being

in business- free to enter and leave industries at will as he or she hunted

for the best opportunities for the firm.

Modern business schools have stressed the flexibilities of good managers.

Their MBAs are trained to manage anything in any industry. The large

conglomerates of the 1960s and 1970s epitomized the hunters. Go wherever the

dollars beckon.

The hunter firm may lose something in its unbounded chase after earnings.

Peters and Waterman's best seller, In Search of Excellence, suggests that

excellent performance requires commitments to certain values involving

customer service. McDonalds is committed to QSCV (quality, service,

cleanliness, and value). IBM is committed to service of the business

machines they sell. People are buying IBM's home computers because they

believe IBM will be there to service them when many other firms are gone.

IBM's commitment, as much as its relative size and strength, are the bases

for that belief.

Peters and Waterman argue that earnings are a necessary, but not a

sufficient, condition for a firm's excellence. Profits are like health, they

say, necessary and the more the better. But also like trying to be healthy,

one does not focus exclusively on getting profits. Fortune conducts an

annual survey of executives concerning the most admired large corporations

(Perry). "The most admired U.S. companies believe that their ultimate

success depends on how they are perceived by the public. . . . Repeatedly,

corporations with first class reputations are seen to put quality, integrity,

and respect for the customer alongside profits on the bottom line** (p. 56).

In 1983, Dow Jones was second only to IBM among admired companies. Dow

Jones's CEO, Warren Phillips, is quoted as saying: "Lots of companies set as

a goal maximization of earnings, return on equity, etc. We set high

standards of performance in terms of content and quality. Financial

excellence follows from that" (p. 54).

Commitment to service and to excellence obviously is not identical with an

unchanging commitment to a single line of activity. A committed service

harnessmaker still would have gone out of business. However, a commitment to

service and excellence is even further away from indiscriminate

profit-hunting. The committed firms do not view themselves as solely

financial managers seeking the top dollar of returns. The committed firms

move with technology and with the times but they strive to be experts in a

limited set of activities, not in anything and everything.

Owners of most large IOFs generally do not determine the firms' long-run

strategies. It is the firm's employees and especially its top management and

directing board that set a corporate culture and the long-term objectives.

Despite elaborate attempts to argue otherwise (Fama; Fama and Jensen), the

relationship of ownership to firm direction and control for most large IOFs

160
generally is seen as exceedingly tenuous. Moreover, because IOF owners are

seldom major customers of their firm, they really do not care about its

customer service and commitments so long as the earnings are produced

somehow.

Cooperatives are different from IOFs because many or all of their customers

are their owners. Cooperative owners care about commitment to customers'

service because they are the customers. In the beginning, the cooperative

was set up by its potential customers to serve their needs. The

cooperative's owners demanded the firm's commitment to themselves as

customers. The classic cooperative with its special form of vertical

integration of farm and agribusiness is the epitome of commitment.

Shifting Membership to Support Cooperative Growth

The life cycle of the classic cooperative was as follows: Set up by members

for a specific purpose; served that purpose for decades; disbanded when no

longer needed. This classic life cycle doubtlessly has applied to many

smaller cooperatives. It does not apply to the large regionals.

The participants in any large organization generally desire its survival as a

minimum and its rapid growth and prosperity as the standard. While the

performance of any firm is affected by its economic, political, and cultural

environment, much depends on the quality of its participants and the way they

interact. Theorists such as Fama conceptualize a firm as a nexus of

contracts among the participants. While this concept properly emphasizes the

valuable coordination of specialists made feasible by the firm, it lacks a

flesh-and-blood dimension. As Williamson and Leibenstein emphasize,

contracts must necessarily be incomplete so the exercised discretion of the

people in a firm is an important factor in firm performance. Firm

performance is a social achievement and, as such, is quite variable among

organizations.

Large cooperatives frequently face lack of growth or even decline if they

stick with their original purposes and their original members. It is hardly

thinkable that a cooperative management will so commit itself to its original

purposes and membership as to accept firm stagnation or decline. It is

difficult to fault such managerial decisions. The question is how far shall

the cooperative swing toward the other extreme. Shall it become an

aggressive hunter, seeking new members and activities wherever a profit seems

likely? How readily shall it drop old activities and members when associated

earnings shrink? What equity issues arise in transferring the cooperative

owners from the old set of owners to the new set?

Cooperative theory has hardly recognized the issue of a cooperative

abandoning much of its membership. Much has been written about "disloyal"

members deserting their cooperative, but not the reverse. Theories dealing

with cooperatives with large earnings generated by market power often have

argued that an influx of members will dissipate the excess earnings.

However, much of cooperative theory implicitly takes an existing membership

as a constant. When economists have modeled agricultural cooperatives, they

have often included the earnings of both the organization and g given set of

161
farmer members. One considerable debate concerned whether the cooperative

even should be considered as a maximizing unit separate from its individual

members (Phillips vs. Helmberger and Hoos). The one group of cooperative

papers that relates even indirectly to this membership issue is that on the

revolving of ownership equities associated with death, retirement, or other

reasons for members' leaving the cooperative (Cobia et al.; Royer; Murray).

Hunter cooperatives may contribute in some ways to more competitive markets.

An alert and sophisticated cooperative management can likely organize a new

cooperative activity better than can a group of producers organizing a

cooperative de novo. The large existing cooperative is likely to have a

better appraisal of markets and of input costs and be better at producing

information. In some industries, the entry barriers are sufficient that de

novo entry is difficult while the existing regional cooperative can more

readily project its capital and managerial skills into those industries.

It can be argued that many of the cooperative successes of the past half

century have been achieved by cooperative managers enlisting members and

developing cooperation rather than by farmers building cooperatives.

Federated regionals often are built top down by a cooperative that captures

the business of locals rather than bottom up by locals uniting to create a

regional.

Other Issues Associated with Hunter Cooperatives

There are various ramifications of this new organizational force. Members

are obtained by "merchandising@@ rather than by their own organizing.

Consequently, membership loyalty is lost in two ways: (1) The new members

had no particular occasion for developing loyalty differently from the way

cooperative satisfied customers of IOFs might develop it; (2) the old members

likely become estranged as they perceive the resources and interests of

"their" cooperative being diverted into new fields. Management of a hunter

cooperative must develop expertise in seeking out profitmaking opportunities

and in selling its board on them- in much the same way an IOF does.

Management finds it more difficult to keep in mind the cooperative's basic

objectives when the membership base is not a constant, but a variable that

can be manipulated. Serious equity issues arrive when capital contributed by

one group of members is switched to the use of a new group (see next

section).

In the case of federated regionals that provide farm supplies or market

grains and oilseeds, their hunting leads to competition with other regionals

and with IOFs for the business of local cooperatives. The local cooperative

often winds up buying feed from one regional, fertilizer from a second, farm

chemicals from an IOF, and fuel from a third regional while marketing grain

through a fourth. In such a situation, it would be surprising if any sense

of a cooperative system or of particular cooperative loyalty would be

developed by either the local management or its farmer members. Another

hunting result is intensified competition among regionals. The head-to-head

competition of regionals for the business of locals and the various

Ynvasionsff of one regional's "territory" by another regional leads to

cooperatives becoming most uncooperative with each other.

162
Still large cooperatives are not likely to become as aggressive and

far-ranging hunters as the conglomerate IOFs. The old owners do exercise

some voice for restraint in their cooperatives through various channels,

including the elected boards. Boards typically are- torn between continued

service to old members and the tempting potential profits of new, but less

familiar, enterprises. The difficulty of cooperatives in raising new capital

is another important constraint. Some cooperatives have ties to State farm

organizations that tend to delimit their market boundaries.

When a hunter cooperative tends to stand some traditional cooperative ideas

on their head, is it worthy of Capper-Volstead protection and the support of

the cooperative community? The answer may depend on where the cooperative

falls on the commitment-hunting scale. A cooperative that is genuinely

committed to the interests of its current members and serves them with

enthusiasm and dedication and hunts only as necessary to maintain the

organization is serving those needs that Capper-Volstead was meant to

support. A cooperative that is strictly an earnings-oriented maximizer and

that does not allow service and current member interests to get in the way of

such earnings maximization has a less obvious claim to uniqueness. Even the

classic defense of the cooperative monopoly--that it does not really

monopolize because the flow through to members of earnings encourages

producer supply response rather than supply restriction--would not apply to a

cooperative management that diverts its earnings into developing new

enterprises and markets. The difficult cases are those in between the polar

cases just discussed.

Cooperative leadership needs to deal more openly with this issue.

Cooperatives are a special form of vertical integration undertaken to obtain

efficiencies, to secure continued access to markets without fear of

opportunistic exportation, to reduce uncertainty, and for other reasons.

Generally those objectives require commitment. A member whose cooperative

can abandon him or her at any time does not have much incentive to be a

member. But a cooperative that can never turn away from old members is

likely a firm condemned to eventual insolvency. Hence a middle way must be

followed between the twin dangers. Understanding and statesmanship by

cooperative leadership--management and board- is essential to maintaining the

merits of committed service cooperatives while allowing that freedom for the

cooperative to seek new avenues when it is essential to the continued

economic viability of the organization.

For example, more attention needs to be given to the equity issues within the

cooperative. Because risk capital is hard to get from members, managers

typically make it even more difficult for the members to get it back.

Consider the following scenario. A marketing cooperative has served

successfully a group of members (designated as Set A) for 2 decades and has

built up a net worth of $100 million. However, demand for the crop produced

by its members is dropping and eventually the first loss is encountered--a

million dollars in 1 year. Managers decide that net earnings likely could be

restored to $5 million a year by shifting activities to serve a largely new

group of members (call them Set B). When should the shift be made? Should

there first be a major effort to cut costs and/or restore demand so as to

continue serving Set A? The true hunters would say the cooperative should

163
shift immediately. Set A members might reply that the cooperative can shift

when their net worth of $100 million is exhausted, which implies a shift in

100 years! Alternatively, the Set A members might demand their shares of the

cooperative in cash. Or Set A members might demand that all capital and

expenses associated with Set B must be provided by Set B producers.

Obviously, there is a genuine and major conflict of interest between Set A

members and management. Compromises need to be found that are acceptable to

all. The bargaining problem is similar to those discussed by Staatz.

Obligations and Legitimate Activities of Cooneratives

Observers are frequently struck by the extent to which the young, able,

middle-managers of cooperatives deny the uniqueness of their organizations.

Have large cooperatives lost their uniqueness and their rationale for being?

Does the management of cooperatives face a set of obligations and legitimate

activities that differs from those of IOF management? This section is

directed at those people who have trouble with these questions.

Cooperative managers seem to agree that their goal is "to improve the

economic position of members (French et al.). The goal is roughly similar to

that of "profit maximization" that is generally attributed to IOF

management. It seems that much of cooperative management views these two

goals as having similar or even identical implications for firm management.

They are not identical.

I believe that the usefulness of the cooperative to its members depends on

three conditions:

1 . The degree to which its members can rely on the cooperativ to serve

their specialized needs in vertically adjacent operations; f

2 . The degree to which the cooperative can provide an economic return

over time (higher marketing prices and/or lower input prices) as

compared to competitors;

3 . The degree to which economic returnsin the entire market have been

improved by the presence of the cooperative.

The third condition--an externality- -is Nourse's competitive yardstick.

While it may have been sought by a cooperative's founders, it tends to become

invisible or at least unconvincing to later generations of members (see

Rhodes). Thus, we ignore its possible relevance to the obligations of

cooperative management.

Obligations of an IOF Management to Its Owners

Management is expected by IOF owners to:

1 . Operate within the law and the general culture;

164
2 . Not mislead owners or potential owners as to the financial position of

the firm and its reasonable expectations for future profits;

3 . In some general sense, maximize net earnings over some vaguely defined

time span.

Beyond that brief list, managers of today's larger IOFs-with board

approval- -are relatively free to operate as they please. Managers of a

railroad or chemical factory are free to move assets into other wholly

unrelated businesses consistent with these obligations, even if such moves

may be inconvenient to current customers. Managers are free to shift

services, adopt new practices, close facilities and do whatever else is

consistent with the listed expectations.

Obligations of a Cooperative Management to Its Owners

Management of a cooperative is generally expected by the owners to:

1.03. Follow the rules listed for IOFs;

4 l Provide, where feasible, the services desired by members and continue

to provide them as long as feasible;

5. Fully inform members so as not to mislead them in any way--not even in

ways generally accepted as legal and moral;

6 . Deal properly and fairly with each group of customers and their

investments where various products and/or services are handled (i.e.,

do not cross-subsidize enterprises too much).

Independent economic units do business with each other in a free marketwhen

transactions are to their mutual benefit. When pairs of firms find

themselves to its members depends on trading regularly, they may place more

emphasis on the worth of the continuing business relationship than on the

gains of each specific transaction. Nevertheless, no firm can expect that a

trading relationship will survive any significant series of transactions that

is unprofitable for one or both parties.

Firms, including farmers, with needs for specialized inputs or for

specialized marketing services must find someone to perform the service or

must perform it themselves. Economies of scale in farming and in the

adjacent input and marketing stages usually are different enough that farmers

cannot individually integrate forward or backward. However, they often have

united as a cooperative "to perform a service for themselves." Over time,

those cooperatives often have expanded into other services and othgr

territories. Eventually, the cooperative- -a separate legal entity20-may

find it uneconomic to continue to perform a particular service or operate a

particular facility. The affected farmers cannot expect that either a

cooperative or an IOF will continue indefinitely to engage in a stream of

10s ing transactions.

165
Cooperative owners have some legal and moral claims to the cooperative's

assets. In many cooperatives, the discounted value of those claims for any

individual owner is relatively small because equities are rotated slowly and

sometimes not very dependably. The claims of ownership then become largely a

rather intangible claim to service (cooperative obligation no. 4). It is

this dual owner-customer status that makes cooperatives unique. The claims

to service are defined by custom and procedures rather than hard and fast

laws and regulations. Each obligation contains such significant modifiers as

"where feasible" and "properly and fairly." No member can be absolutely sure

of service. The early rural electric cooperatives (RECs) took pride in

serving everyone even if the practice meant running a line an obviously

uneconomic distance to an isolated farmstead. In times of high interest

rates, hard-pressed REC boards and managers no longer will subsidize such

distant customers.

Suppose a regional cooperative that emphasizes milk marketing and farm

supplies finds that its poultry operation is losing money according to the

cost accountants. If the accounting numbers are bad enough, the poultry

member surely will lose his or her claim to service. If the numbers are a

little better, but not good, a "political decision" may determine his or her

claim to service. Certainly, the cooperative member, as an owner, has a

*'right** to expect some consideration and some cost justification for a

loss-of-service decision, while an IOF manager is free to make such decisions

without providing any consideration or justification to his or her customers.

Suppose a farm supply cooperative has been built through the efforts of

management and many relatively small farmers. As times change, the managers

perceive that the larger volume of business lies with larger farmers. They

propose to transfer the assets "owned" by the smaller farmers into facilities

and practices that will serve better the larger farmers but will largely

abandon the present "owners." Would it be surprising if the current owners

exercise a claim to service and if they argue that management is failing its

responsibilities? In the game-theoretic bargaining discussed by Staatz, the

small farmers may have little bargaining power to enforce their moral claims.

In summary, one of the unique obligations of cooperatives is a commitment to

the continuation of past and present member service that goes beyond that of

the IOF. While there is no easy or lucid way to define the difference in

commitment, it exists and its existence is important. A frequent criticism

of cooperatives is that they stay too long in losing businesses. The

presence of such criticism suggests that many cooperatives have stayed with

their commitments longer than have IOFs.

The dual customer-owner status of cooperatives applies to the problem of

providing information and avoiding deception of any sort in advertising and

all types of communication (obligation no. 5). It is unlikely that

cooperative management will "improve the economic position of members" while

misleading them. A farm supply cooperative should view itself as the

procurement representati e of farmer members; instead it often views itself

as marketing to farmers. Y The difference is important. A profit made by

exploiting the ignorance of cooperative members is an empty profit indeed.

Again, the differences in management practices of cooperatives compared with

166
many well-run, consumer-oriented IOFs will not be large. The point is that

the very nature of the cooperative demands a customer-benefit standard of

conduct that is beyond that of the ordinary IOF.

The sixth obligation of a cooperative is very close to the fourth. Because

of the customer-owner duality, the conglomerate or diversified cooperative

faces some special problems of equity. Owners of an IOF have no concerns

about cross-subsidization of enterprises within a firm as long as they

contribute to the firm's objectives. But the cooperative that markets

widgets and gidgets has problems when the widget producers are different

people from the gidget producers. Assuming that there are "economies of

scope" that justify the union

Z

f the two enterprises on a cost basis, each

group benefits from the other. Then each group can afford to share a bit

when there is a need for investments or for meeting a shortfall in cash

flow. However, neither group can expect a continual subsidy. An economic

limit to cross-subsidy can be defined. When either group is potentially

better off without the other group in the cooperative, the limits of

cross-subsidy have been reached.

It is tempting for cooperative managers to use the funds available regardless

of the lack of relationship between the groups (enterprises) generating the

funds and the groups that will benefit from them. Farmer groups usually are

patient about cross-subsidy within cooperatives when it involves the short

term and relatively small sums. Member perceptions may differ widely from

reality. It frequently is easy for significant cross-subsidization to occur

without farmer awareness. However, if some crisis develops, farmers may

imagine far more damage from cross-subsidy than has in fact occurred. Thus

management bears a special responsibility to try to keep cross-subsidy within

the economic bounds previously specified. Cooperative policy in funding new

enterprises generally should be that the new group must provide its own

capital ("each tub sits on its own bottom"). It also is proper to insist

that the "accounts" should be assessed as the average of several years rather

than each group trying to obtain its precise share of benefits each year.

Situations should not be allowed to arise that will cause farmer-members to

become obsessed with keeping score.

Social theorists have had great difficulty in explaining the rationality of

loyalty or any allegiance to a group that seems to contradict immediate

self-interest. The best answer to date seems to be that many individuals

recognize the problem and are ready to foreswear free riding if they are

convinced that a reasonable number of others will match their behavior

(Guttman). The voluntary contributions to the dairy PACs (political action

committees) by thousands of dairymen is a case in point. Under those

assumptions of matching behavior, one's actions make a difference and it

becomes rational to support the cooperative rather than take a slightly

better option elsewhere.

To sum up this section,

their uniqueness.

the customer-owner status of cooperatives continues

The differences of cooperatives from IOFs create different

obligations for management in the three areas of: (1) continued service of

current members needs as defined by members, (2) full information in sales

and service, and (3) limitations on internal cross-subsidization.

167
Summary

A cooperative is an organization linking assets, business activities, and

people in a distinctive way. The dual status of people as both customers and

owners of the cooperative- -with earnings distributed according to customer

patronage --has been the important constant in cooperatives. Much else has

changed about cooperatives in the past century. The large agricultural

regional cooperative is far different in organization, management, and

ideology from the Rochdale weavers' cooperative. More changes can be

expected as the cooperative's participants continue to adapt it to their

current needs.

The ultimate cooperation in the regional cooperative is between managers,

board, and members as they develop an organization that adequately serves all

their needs. A cooperative management does have some obligations to the

owners that are unique to cooperatives. A cooperative management faces

tighter constraints on its actions than the management of a conglomerate

IOF. Members of a cooperative expect a high degree of managerial commitment

to member service. It is gratifying to note that some of the most successful

IOFs have a deep commitment to customer service. Instead of being a burden,

the cooperative's member commitment can be a shared mission that energizes

and guides the entire organization.

Some firms are hunters --continually seeking new activities in any parts of

the economy that promises a better return on investment. Owners of IOFs may

appreciate managers that are aggressive hunters, although the long-run

consequences may not be as impressive as often suggested. Hunter

cooperatives present a special problem. A conflict of interest candevelop

quickly between the old member-owners of the cooperative fearful of losing

service, capital, and influence and the new members. These very divisive

potentials need to be faced squarely. In a changing world, it is usually

unreasonable to expect a cooperative management to do no hunting. However,

the consequent equity problems need to be managed carefully to protect the

legitimate interests of new and old members and of management. There is a

strong caution to managers. If their concern for future growth and security

leads to aggressive hunting that endangers the mutual commitments of members

and cooperatives, they endanger the cooperative in its special role in

society and the Capper-Volstead protections it has enjoyed.

Notes

1 . "Some of the greatest benefits of cooperatives arise from greater

stability of prices and returns, retaining decision making authority at

the producer level, assuring producers of an outlet for their products

and assurance of input supplies" (Knutson, p. 11).

2 . Because farmers united to form a cooperative, they may feel that they

are the cooperative. They, as owners, are an important part of the

cooperative, just as cooperative management and cooperative boards also

are important parts. Together, they form an organization which both

legally and operationally is an entity separate from each of them.

168
3 . Schaars expressed this idea many years ago in his argument that the

cooperative is the 'agency" of its members.

4. See the definition of economics of scope and an extensive discussion of

the attributes of multiproduct cost in Baumol, Panzar, and Willig.

References

Bakken, Henry, and Marvin Schaars. Economics of Cooperative Marketing. New

York: McGraw-Hill Book Co., 1937.

Baumol, William J.; John C. Panzar; and Robert D. Willig. Contestable

Markets and the Theory of Industry Structure. New York: Harcourt Brace

Jovanovich, 1982.

Bonner, Arnold. British Cooperation: The History. Principles and

Organization of the British Cooperative Movement. Manchester, England:

Cooperative Union, 1961.

Cobia, David W., et al. Euuity Redemption: Issues and Alternatives for

Farmer Cooperatives. Washington, D.C.: USDA ACS Res. Rep. 23, Oct. 1982.

Commons, John R. The Lena1 Foundations of Capitalism. Madison, Wis.:

University of Wisconsin Press, 1968.

Fama, Eugene. "Agency Problems and the Theory of the Firm." Journal of

Political Economy 88(1980):288-307.

Fama, Eugene, and Michael C. Jensen. "Separation of Ownership and Control."

Journal of Law and Economics 26(1983):301-25.

French, Charles, et al. Survival Strategies for Agricultural Cooperatives.

Ames, Iowa: Iowa State University Press, 1980.

Galbraith, J. K. The New Industrial State. Boston: Houghton Mifflin Co.,

1967.

Guttman, Joel. "Understanding Collective Action: Matching Behavior."

American Economic Review 68(1978):251-55.

Helmberger, Peter, and Sidney Hoos. "Cooperative Enterprise and Organization

Theory." Journal of Farm Economics 44(1962):275-90.

Knutson, Ronald. "Cooperative Strategies in Imperfectly Competitive Market

Structures --A Policy Perspective." American Journal of Asfcultural

Economics 56(1974):904-12.

Leibenstein, Harvey. Beyond Economic Man. Cambridge, Mass.: Harvard

University Press, 1976.

169
Murray, Gordon C. "Management Strategies of Corporate Control in British

Agricultural Cooperatives--Part 2." uricultural Administration

14(1983):81-94.

Natronale Cooperatieve Raad. The Cooperative Movement in the Netherlands:

An Analysis. The Hague, Netherlands: Natronale Cooperatieve Raad, 1957.

Nourse, E. 2. "The Economic Philosophy of Cooperation." American Economic

Review 12(1922):577-97.

"The Place of the Cooperative in Our National Economy." In

American Cooieration 1942-45, pp. 33-39. Washington, D.C.: American

Institute of Cooperation, 1945.

Perry, Nancy J. %nerica's Most Admired Corporations." Fortune, Jan. 9,

1984, pp. 50-62.

Peters, Thomas J., and Robert Waterman, Jr. In Search of Excellence:

Lessons from American's Best-Run Companies. New York: Harper and Row, 1982.

Phillips, Richard. **Economic Nature of the Cooperative Association."

Journal of Farm Economics 35(1953):74-84.

Rhodes, V. James. "Cooperatives and Contestable/Sustainable Markets." In

this volume.

Royer, Jeffrey S. "Financial Impact of Mandatory Equity Programs on Farmer

Cooperatives." bricultural Finance Review 43(1983):30-40.

Schaars, Marvin. "Basic Principles of Cooperatives: Their Growth and

Development." In Agricultural Cooperatives, ed. Martin Abrahamsen and Claud

Scroggs, pp. 183-203. Minneapolis: University of Minnesota Press, 1957.

Staatz, John M. **A Game-Theoretic Analysis of Decisionmaking in Farmer

Cooperatives." In this volume.

Wiles, Peter J. D. Economic Institutions Compared. New York: John Wiley

and Sons, 1977.

Williamson, 0. E. Markets and Hierarchies: Analysis and Antitrust

Implications. New York: Free Press, 1975.

170
AGRICULTURAL COOPERATIVES: A UNIFIED THEORY OF

PRICING, FINANCE, AND INVESTMENT

Ronald W. Cotterill*

Coonerative Princioles. Objectives.

and Social Science Method

Introduction

Agricultural cooperatives are a significant form of business enterprise. In

many respects, they are similar to the investor-owned, profit-maximizing

firms that, along with other organizations such as households and government

agencies, form the institutional framework for western economic theory. Yet

as so many authors have pointed out, cooperatives also are distinctly

different from investor-owned firms (IOFs).

A considerable body of literature exists on the theory of agricultural

cooperation, and it is very diverse in method as well as subject matter.

Cooperatives have been analyzed from both a normative perspective, i.e., how

cooperatives should perform to attain a particular norm or objective, and

from a positive perspective, i.e., how they actually do perform. Prior

theoretical work has primarily focused on static price theory and resource

allocation. Little purely theoretical work has been done on cooperative

finance and investment. As recently as 1978, Moore and Fenwick clearly

recognized the deficiency, writing:

A theory of "cooperative finance" does not exist. All we know is that

corporate finance capital budgeting models fail to provide assistance on

cooperative management decisions. (P. 30)

Cooperative taxation, and unique cooperative finance methods such as

revolving funds and the related issues of equity allocation and redemption,

’ have attracted most interest (Erdman and Larsen; Dahl and Dobson; Cobia

et.al .; Beierlein and Schrader; Royer 1983). Recent articles by VanSickle

and Ladd, and Knoeber and Baumer present advanced analyses of cooperative

finance issues.

This paper explores the possibilities for a unified theory of agricultural

cooperation. It does so by developing a theory of cooperative price,

investment, and finance decisions under conditions of risk as well as

certainty. This work also is a unified approach to theory in another sense.

It jointly examines two areas of cooperative action that usually have been

studied separately since 1945. Those two areas are the theory of the

*Several people have contributed to the completion of this paper. James

Shaffer initially encouraged me to do this research. Randall Torgerson's

enthusiasm for the project was energizing. V. James Rhodes and Jeffrey Royer

provided helpful insights at various stages. Charles Kraenzle, Peter

Vitaliano, and Andrew Condon deserve special recognition for having read

earlier drafts and providing detailed comments. Dorine Nagy typed and

retyped this paper with a cheerfulness that was extraordinary. Of course,

errors, oversights, and omissions of any sort are the exclusive

responsibility of the author.

171
cooperative firm and the impact of a cooperative on market performance. 1

Examining the link between theories of the cooperative firm and market

performance is timely for two reasons. First, there is a renaissance of

interest in the appropriate role of cooperation in the food system. Second,

the efficient market approach that has enabled economists to make great

advances in the theory of corporate finance has not been extended to

cooperatives. Using it here provides powerful new insights into several

issues facing cooperatives.

Among the many questions that this unified theory addresses are the

following:

Exactly how does a cooperative improve the efficiency of the economy, and

what does this imply for cooperative membership education efforts and

public policy in areas such as cooperative taxation and antitrust?

What rate of return do cooperative members require on their equity?

What is the role of unallocated equity, most notably retained earnings,

in a cooperative? Do they enhance member welfare?

How can one

investment?

measure the benefit stream for a projected cooperative

How can one develop risk-adjusted discount factors to evaluate

investments that have different levels of inherent risk?

As implied by these questions, the theory is testable. Empirical evidence

can provide cooperatives with direct operational guidelines.

The Coonerative Dilemma: An Obstacle to Progress in Coooerative

Theory--Perhaps the greatest obstacle to progress in the pure theory of

cooperation has been the lack of agreement on how to define a cooperative.

Briscoe describes this discord as the cooperative dilemma (1971a, 1971b). He

explains that cooperators tend to be attracted to two very different

concepts. According to him, idealists are concerned with how cooperatives

should be organized and what they should do to improve the welfare of their

members. Traders, on the other hand, focus on the actual organization and

readily observable monetary performance of cooperatives. Basically what is

at issue is a normative versus positive approach to the definition of a

cooperative.

Many cooperative practitioners derive their energy from a conceptualization

of what a cooperative should be. They fear that losing sight of the ideal

will harm the cooperative movement. One of the difficulties of this

normative approach to defining cooperation is that once one moves beyond the

cooperative principles- -which have the approval of more than a century of

practice to support them- -any concerned cooperative philosopher can produce a

set of cooperative organizational rules. This impedes advances in

cooperative theory as well as practice. Energy is focused on determining

whether a cooperative follows this or that creed. The normative approach

often degenerates into an exercise in catechism. On the other hand, it

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certainly is healthy for cooperative thinkers to envision how the cooperative

enterprise form can evolve to serve more perfectly its member owner-users.

Rather than shunt these normative issues aside, a theory of cooperation

should provide a vehicle for analyzing them. This is an important endeavor

because public policy toward cooperatives and the legal status of

cooperatives are based, to a large degree, on their unique structural and

operating features. Torgerson provides a concrete example of the need for a

broad approach:

The

In recent years a few cooperatives have taken on business characteristics

not entirely in keeping with cooperative character. They include

investment unrelated to use of the business, an orientation to growth

through mixed ownership arrangements, and capitalization techniques

relying increasingly on tax-paid surplus rather than patronage-based

investment. They appear to be changing to businesses that just happen to

have farmer ownership, but further similarity to cooperative character is

purely coincidental. . . . This trend spells trouble if it continues. It

poses a policy dilemma and raises concerns about the direction of

cooperation. (P. 2)

concern is for "cooperative character" and "the direction of

cooperation." What is needed to answer these questions is a scientific,

i.e., positive approach that analyzes different cooperative structures and

operating procedures to determine how they influence cooperative

performance. Then perhaps some insight can be gained into the normative

policy issues that cooperative strategic planners face, as well as the more

visible public policy issues.

One can begin defining what a cooperative is by reviewing the cooperative

principles. Of course, there are other approaches. A standard approach

common in many texts, e.g., Roy, is to compare cooperatives with other forms

of business enterprise to highlight what a cooperative is and how it differs

from other business forms. To do this, however, one must first identify,

i.e., define, a cooperative business. Yet another approach is to examine the

way cooperatives are defined in the incorporation statues of the states and

in federal statutes such as the Capper-Volstead Act. This involves a large

amount of legal research and does not contribute much. Different states

appear to have written the cooperative principles into law in different ways,

but the principles were the starting point for all statutory constructions.

The Organization of This Paoer--This section proceeds by reviewing the

cooperative principles. A short introduction to the questions of defining a

cooperative's objective follows. It helps to delimit the scope and method of

this paper. The last part of this introductory section addresses more

general methodological issues. It does not purport to be comprehensive.

Rather, itis a convenient vehicle for identifying those aspects of

cooperative activity that are important but unaddressed components of a

unified theory of cooperation. Briefly acknowledging some of the underlying

canons of scientific inquiry and related areas of inquiry is important for an

endeavor of this sort.

173
The second section proceeds from a microeconomic perspective. It focuses

attention on the cooperative as a firm within a market to analyze the price

and output performance of agricultural supply and marketing cooperatives.

The third and fourth sections incorporate investment and finance functions in

a model of a supply cooperative. The result is a unified theory of

cooperation comprising price, output, investment, and finance activities.

The Coooerative Princioles

Abrahamsen provides the most complete readily available discussion of the

history and evolution of the cooperative principles. Roy also has a chapter

on them. Bakken's classic article (1954), his book (1963), and Robotka

(1947) provide more perspective on the principles than the textbooks

mentioned.

The principles originated with the Society of Equitable Pioneers, a

purchasing cooperative, in Rochdale, England in 1844. The original Rochdale

principles, as they have come to be called, included the following:

1. Open membership to all regardless of sex, race, politics, or

religious creed;

2. One vote per member;

3. Any capital required should be provided by members and should earn a

limited rate of return:

4. Any net margins should be returned to members in proportion to

patronage;

5. Cooperatives should allocate some funds for education in the

principles and techniques of cooperation;

6. Market prices should always be charged, i.e., no price cutting to

pass on cooperative savings directly;

7. Cash trading: no credit given or asked;

8. Products should be accurately formulated and labeled;

9. Full weight and measure should be given;

10. Management should be under the control of elected officers and

committees; and

11. Accounting

5

eports of financial health should be presented frequently

to members.

Over time many of these have come to be recognized as business practices that

any firm may or may not follow for better or worse. The first five

principles, with minor modifications, plus the requirement that cooperatives

cooperate among themselves are the six principles that the International

174
Cooperative Alliance (ICA) recognizes today as the Rochdale principles of

cooperation.

Table 1 gives the ICA version of the Rochdale principles. Agricultural

economists, most notably Nourse; Bakken and Schaars; Robotka (1947); Bakken

(1954, 1963); Schaars (1980); and Abrahamsen, have interpreted and refined

these principles so that they more directly address the particular situation

of agricultural cooperatives. With regard to the first principle, membership

in an agricultural cooperative is always voluntary, but there are additional

considerations. Membership is available only to producers of agricultural

products, and agricultural cooperatives can have open or closed membership

policies. An open membership cooperative admits producers when they apply

for membership. A closed cooperative may refuse a prospective membership

application until such time as the cooperative wishes to expand its ranks.

Commodity marketing associations often have closed or selectively open

membership policies for two somewhat similar reasons. First, closed

membership helps to avoid the short-run free-rider problem that can occur

when producers who are playing the open market realize that the crop is very

large and, after the fact, wish to join the cooperative marketing effort to

obtain a higher price. Such late joiners do not contribute to the group

marketing plan by committing product and investment capital or by

participating in the group marketing decision in a timely fashion. Second,

membership policies that are closed over periods longer than the production

season allow the members to benefit from long-run investment strategies to

develop market channels and establish popular brands that command a premium

price. Agricultural purchasing cooperatives, especially secondary or

tertiary associations, also ration membership on occasion. The interregional

cooperative CF Industries is a tertiary cooperative because it is owned by

regional cooperatives such as Farmland Industries (secondary), which is

federation of local cooperatives (primary). Until recently, CF Industries

produced fertilizer only for the cooperatives that set it up. As will be

seen in the last three sections, whether a cooperative's membership policy is

open or closed can have a large impact on cooperative performance.

Note that with regard to the second principle, democratic choice systems

other than one-member/one-vote (e.g., voting proportional to patronage) are

explicitly allowed for secondary cooperatives. The third principle, limiting

the rate of return on share (equity) capital, helps to ensure that the

benefits of cooperation are distributed to users of the cooperative rather

than their investors. In many cases, users and investors are a common group

of farmers who are the members of the cooperative. Even then, however, this

principle helps to ensure that benefits accrue to members as users rather

than members as investors.

The fourth principle is the "operation at cost" principle. The modern

version allows considerably more latitude for the disposition of net

margins. Members must directly, or indirectly through their board of

directors as is usually the case, decide how to honor the operation-at-cost

concept. There are three possibilities. First, according to the ICA,

members can choose to retain net margins as capital to expand the business.

In the United States, this is done by declaring net margins to be earnings,

incurring any corporate income tax liability that arises, and using the

175
Table 1 .--The Rochdale Principles of Cooperation Established by the 1966

Congress of the International Cooperative Alliance

1. Membership of a cooperative society should be voluntary and

available, without artificial restriction or any social, political,

racial, or religious discrimination, to all persons who can make use

of its services and are willing to accept the responsibilities of

membership.

2. Cooperative societies are democratic organizations. Their affairs

should be administered by persons elected or appointed in a manner

agreed by the members and accountable to them. Members of primary

societies should enjoy equal rights of voting (one-member/one-vote)

and participation in decisions affecting their societies. In other

than primary societies the administration should be conducted on a

democratic basis in a suitable form.

3. Share capital should only receive a strictly limited price of

interest.

4. The economic results arising out of the operations of a society

belong to the members of that society and should be distributed in

such a manner as would avoid one member gaining at the expense of

others. This may be done by decision of the members as follows:

(a) by provision for development of the business of the cooperative;

(b) by provision of common services; or (c) by distribution among

the members in proportion to their transactions with the society.

5. All cooperative societies should make provision for the education of

their members, officers, and employees and of the general public in

the principles and techniques of cooperation, both economic and

democratic.

6. All cooperative organizations, in order to serve the interest of

their members and their communities, should actively cooperate in

every practical way with other cooperatives at local, national, and

international levels.

176
net-of-tax retained earnings for investment. Torgerson has called these

unallocated retained earnings "tax-paid surplus" (p. 2). Currently there is

major disagreement over whether cooperatives that employ unallocated retained

earnings are honoring the operation at cost principle. Torgerson seriously

questions whether such financial policies are operation at cost. Some

cooperative analysts point out that it is not known who owns the retained

earnings, and, except when a cooperative dissolves, they are not returned to

member-users. Perhaps more important to this position is a concern that the

management of cooperatives that are heavily capitalized by retained earnings

may not be as responsive to member-users (Torgerson, p. 2). A related

consideration is that members of cooperatives with large amounts of

unallocated capital may feel less need to control management through their

democratic voting rights because they do not have a direct claim on the

cooperative's investment capital. If one has little or no investment capital

to lose, why get involved? If member control is weak or nonexistent, is the

organization a cooperative?

These concerns are a very important example of the disagreement over what

constitutes a cooperative. I choose to include the retained earnings method

of operating at cost precisely because of this controversy. Some

cooperatives in the United States use it, most notably Agway Inc. The theory

developed in subsequent sections will suggest possible reasons why

cooperatives' use retained earnings and shed considerable light on their

impact on cooperative performance.

A second way for cooperatives to operate at cost is to allocate the net

margins to common services for the members. Such common services may be as

simple as an end-of-the-year banquet or as complex as a concerted political

action program to represent member concerns in public forums.

The third and most common way of operation at cost is to refund net margins

to members in proportion to patronage. Such patronage refunds may be in cash

or allocated to patrons' capital accounts and used for investment in the

cooperative. Note that allocated patronage refunds are different than

retained earnings because members have specific ownership claims on the

assets. Allocated patronage refunds may ultimately be returned to members.

Except for dissolution, retained earnings are not.

Historically, most agricultural economists have regarded principles two,

three, and four --democratic control by users, limited return on capital, and

operation at cost- -as the core of the cooperative business enterprise

structure. Both Bakken and Schaars emphasized that they are fundamental for

agricultural cooperatives. Abrahamsen reflects the opinion of most

agricultural economists today when he includes principle five, cooperative

education, in the set of core principles. Also, the fact that members own a

cooperative is now separated from the general principle of democratic control

to examine the relationship between ownership and control. In practice, one

may have ownership without effective member control. Control relates most

directly to the internal political process of a cooperative, whereas

ownership has major economic consequences: m st notably,

s

that owners bear

the risk of success or failure of their firm.

177
Rochdale principle six, cooperation among cooperatives, usually has been

regarded as a "practice" that cooperatives should undertake to satisfy the

more fundamental "principles." It is not essential for identifying a

cooperative. Some cooperative thinkers, nonetheless, have resisted demoting

it to secondary status (Rhodes).

In summary, for agricultural

commonly listed as follow:

1. Operation at cost;

2. Member control;

3. Member ownership;

cooperatives, the cooperative principles are

4. Limited returns on equity capital; and

5. Duty to educate.

Coonerative Business Practices --Schaars establishes six other practices for

agricultural cooperatives. They generally have been regarded as good

business management practices so "business" has been inserted to emphasize

this fact.

1. Members (of the business) should provide equity capital in proportion

to patronage.

2. All (business)

3. (The business)

4. (The business)

integration.

5. (The business)

6. (The business)

racial issues.

transactions should be at market prices.

should strive for operational efficiency.

should grow through horizontal and vertical

should control or own marketing facilities.

should remain neutral on political, religious, and

(Schaars 1951)

The first is most relevant for the theory developed in this paper.

Investment proportional to patronage greatly simplifies the analysis of

cooperative performance. Although this rule has not been followed by many

agricultural cooperatives, the outpouring of concern by farmer patrons,

public agencies, and cooperatives on the equity redemption issue suggests

that cooperatives will have to increasingly honor it or some other equity

investment plan that allows cooperatives to redeem equity on a systematic

basis. Otherwise they may have to pay market rates of interest on capital

that is not provided by current members in proportion to patronage (U.S.

General Accounting Office; Cobia et. al.). For theoretical purposes then, it

seems appropriate to assume that equity investment is, at least in the ideal

situation, proportional to patronage. One might add that this practice

178
supports an important aspect of the service-at-cost cooperative principle:

it helps to avoid one member benefiting at the expense of another.

The Coooerative Obiective--Structure based on cooperative principles is not

sufficient to develop an economic theory of cooperation. One also must know

something about organizational behavior. Organizational behavior can be very

complex. For an economic --as opposed to an organizational or

political--theory of cooperation, identifying a cooperative's objective

simplifies things a great deal. Once the objective is known in an

operational fashion, it can be used in conjunction with the constraints

imposed by the organization's structure and market environment to produce a

set of predictions or hypotheses about the organization's economic behavior.

Alternatively, the theory provides prescriptions for behavior that the firm

can follow to obtain its objective. Within the literature, there have been

two distinctive approaches to the economic objective of cooperatives issue.

One is market-oriented, and it usually has focused on the aggregate welfare

of the agricultural sector by examining the performance of the markets in the

sector. The other is microeconomic. It focuses on more narrow and immediate

firm goals. A cooperative, for example, that cannot pay its bills can hardly

advance the welfare of the agricultural sector.

Different schools of cooperative thought propound different market-oriented

objectives. There are several, but two have played an historically important

role in the development of agricultural cooperatives in North America. The

competitive yardstick school, as typified by the writing of Edwin Nourse,

reasons that cooperatives should seek to make the marketing system more

efficient, thereby benefiting the consuming public as well as farmers. The

commodity marketing school, as typified by the vibrant and visionary speeches

of Aaron Sapiro, argues that all producers of a particular commodity should

organize themselves into a single marketing cooperative. Sapiroism counsels

that strength through group action will improve the performance of markets

and benefit farmers.

To have historical validity, a theory of agricultural cooperation must at

least address this divergence in vision. Does the debate between the

efficiency and group power camps, which was most strident during the 1920s

and 1930s but lively and often heated today, imply that two distinctly

different economic theories of agricultural cooperation exist? The answer to

this question is no. The role of cooperatives in markets is circumscribed by

the political and economic philosophies of the country in which they operate

(Cotterill 1984). In the United States, cooperatives generally are

envisioned in law as market-perfecting instruments as Nourse argued, but the

concept of workable competition does allow for group action through commodity

marketing and bargaining cooperatives. Although cooperatives can exert

market power in some cases, they cannot pursue Sapiro's philosophy to its

logical extreme--complete control of the marketing system through a producer

cartel.

At the microeconomic level, work on cooperative theory has borrowed heavily

from the neoclassical theory of the firm. In static models, the IOF

maximizes profits. In dynamic models that analyze investment, production,

and consumption over time, the IOF maximizes the wealth of current

179
shareholders by maximizing the net present value of the company's stock

(Haley and Schall, p. 23). For cooperatives, there is even less agreement

here than there is among the proponents of market-oriented theories of

cooperation. In fact, some organization theorists assert that a cooperative

does not seek to maximize any objective. They prefer to conceptualize a

cooperative as a set of coalitions that makes decisions through a complex

political process like a legislature (Vitaliano).

A nonmaximizing approach to decisionmaking may be very useful for explaining

the rich detail of organizational behavior in cooperatives. However, the

approach taken here is more neoclassical. The reasoning that supports this

approach is as follows. Cooperative members cannot only voice their

preferences through the democratic control structure of a cooperative, they

also can exit the cooperative if 't does not meet their needs as well as the

next best alternative (Hirshman). t For a cooperative firm, the possibility

of entry and exit by members is a more general example of changing patronage

when the price of cooperative goods and services change. There is a demand

curve for cooperative services that represents the sum of members'

preferences for the cooperative's services. If the cooperative is a

marketing- -rather than a supply--cooperative then there is a supply curve.

Given that the cooperative faces such member supply or demand curves, the

quest for an economic objective assumes a well-known form. Cooperative

management must decide where to operate on the member supply or demand

schedule. This involves setting+prices and is a market transaction rather

than an exercise of administrative fiat. There is need for an objective

function of the standard microeconomic sort to guide management price,

finance, and investment decisions.

The second section of this paper examines several objective functions that

have been proposed for agricultural cooperatives. Because different

objectives can produce significantly different predictions about cooperative

behavior, it would be a significant advance in cooperative theory if several

objectives could be eliminated or shown to produce the same result

when particular competitive conditions and/or cooperative structural features

are given.

A Note on Social Science Methods

and Unexnlored Areas in the Theorv of Coooeration

Clark has described the method of inquiry in economics as follows:

General economics must simplify in order to interpret; otherwise its

description will be just as unwieldy and baffling as the world itself. .

. . It will be a never ending search for generalizations that are

significantly true and for that very reason are often neither one hundred

percent accurate, nor universally applicable. (P. 78)

In other words, a theory cannot be a complete catalogue of activity, nor can

it be, at the other extreme, a tautological statement that by construction is

impossible to reject. Friedman (1953) concurs by describing useful theory as

parsimonious and robust in the sense that it predicts observed behavior well.

180
Because economics is a social science, a feature of theory construction that

is undoubtedly more mettlesome than for the physical sciences is the issue of

scientific objectivity. Friedman and the logical positivists argue that

value (i.e., normative) premises are irrelevant. As long as the resulting

theory has descriptive content that is testable for empirical validity, it is

useful. A definition of the operation-at-cost principle, for example, that

includes the possibility of the cooperative retaining unallocated earnings

for investment can serve as a building block for a theory that may predict

many aspects of cooperative behavior well.

Others disagree, arguing that a vibrant and often implicit relationship

exists between value premises, the resulting theory, and its analysis of

economic events. Continuing the example, a concern for the impact of

unallocated retained earnings on cooperative performance may lead a theorist

to formulate a different theoretical model than he or she otherwise might.

Science may be objective, but in deciding what angle of attack to take in

their search for order, scientists are not. Myrdal has emphasized the

importance of this interdependence for social science theory. He writes:

In order to avoid biases in research and to make it "objective" in the

only sense this term can have in the 'social sciences we need to select

and make explicit specific value premises, tested for their feasibility,

logical consistency, relevance, and significance in the society we are

studying. (P. 146)

Aresvik argued for this approach in diffuse fashion during the 1950s debate

on whether a cooperative is a firm or an association (p. 142). With regard

to the theory presented in this paper, perhaps the most important general

value premise is: that the cooperative is a firm rather than an association

of firms. A substantial collection of scholarly work based on the anarchist

philosophy of Kropotkin and the economic analyses of Emelianoff and Phillips

views the cooperative as an association. Robotka (1947); Savage; and

Helmberger and Hoos argue otherwise and conclude that the appropriate premise

is to regard the cooperative as a firm. In response to the question does a

new economic entity emerge when a cooperative is formed, Robotka dismissed

the decentralist and individual approach of the anarchists. He wrote:

"The cooperative organization is a business enterprise firm" is almost

universally accepted without question or verification. . . . Although a

cooperative does not appear to meet all the specifications of a firm, it

cannot be denied that it is an economic entity. . . . A new decision

making body i

3

created; . . . a new risk bearing body emerges. (Robotka

1947, p. 103)

Less attention will be paid to related avenues of inquiry that are very

important for a complete theory of cooperation if one values member control,

democratic organizations, and the quality of cooperative management. To

proceed in this area, one must examine the structure and operation of the

member control process. Ostergaard and Halsey pioneered formal analysis in

this area with Power in Coooeratives. Craig's "Representative Control

Structures in Large Cooperative" and subsequent work establish him as a

skillful theoretician in this area. A recent research report by Mirowsky

181
uses organization theory to explain how different democratic control systems

can be analyzed in agriculture cooperatives. Finally, Vitaliano considers

similar issues by applying the agency theory that Jensen and Meckling and

others have developed to cooperatives. A truly comprehensive effort to

establish the general theory of agricultural cooperation would integrate the

current efforts with a theory of member control and the internal political

process of cooperative firms. That, however, is beyond the scope of this

effort.

The Coonerative Objective and Coooerative Price

Eauilibrium Without Investment or Finance

Introduction

One way to expand the theory of cooperation is to begin with the competitive

yardstick theory, critique it, and ultimately generalize it. Nourse first

explained that a major objective of the agricultural cooperative movement is

to act as a competitive yardstick for farmers in the food system (Cotterill

1984). As cooperatives perform this strategic function, the economy becomes

more efficient because competitive pricing allocates resources without

waste. Efficiency gains accrue primarily to farmers and consumers.

A yardstick cooperative, Nourse explained, produces this result by moving

into a oligopolistic input or oligopsonistic processing industry. Like an

invention that lowers costs, the cooperative provides its members benefits

directly and other farmers benefit indirectly because IOFs must match the

cooperative's performance. With a farm marketing cooperative, farm prices

are higher and farm output increases. These results can be attained without

raising prices to consumers. With a farm supply cooperative, input costs are

lower and farm production and income increase. Increased output in the

supply cooperative case ultimately produces lower food prices for consumers.

However, the monetary reward for innovation (in this case, organizational

innovation) that farmers enjoy can be transitory. This is because farming is

a competitive industry. Once equilibrium is regained, farmers' profits will

be no higher than they were at the outset. The only exception to this rule

is that rents for any resource in limited supply and owned by farmers may be

bid up as output expands. Strictly speaking, however, increased rents are

capitalized into increased factor values, e.g., value of land or the genetic

potential of purebred cattle. Such capital gains are due to resource

ownership rather than farming per se.

Two criticisms commonly are made of the competitive yardstick theory. To

some, it is simplistic. Cooperative performance has more dimensions than

this competitive price model suggests. Marketing cooperatives often benefit

their members by differentiating their product to improve producer returns.

Cooperatives also benefit members and society in other ways not captured by

the yardstick theory, for example, leadership training or representation of

farmers in the political arena as well as results of a more economic sort,

for example, services directly related to product use. They point out that

such cooperative activities are public goods that benefit many, and it is

182
difficult if not impossible to charge a price for them. Th s is a more

general, even sociological, approach to cooperative theory. g

The second major criticism of the yardstick theory manifests itself in a

subtle but pervasive fashion. Economists and cooperative executives making

public statements, such as speeches at annual meetings, often shy away from

yardstick pronouncements because they feel that the theory does not focus

attention on the activities and performance of the cooperative enterprise in

a constructive fashion. Under the yardstick theory, cooperatives must not

only be well-run businesses that provide members value through desirable

prices or handsome year end net margins; they also must change the

competitive behavior of IOFs with whom they compete. It is this second

charge that creates uneasiness, especially if the cooperative is not a

well-established firm with a leading position in the industry. Executives in

smaller cooperatives understandably do not like to make claims or promises

about their ability to change industry conduct. Executives in larger

cooperatives may prefer to be known in the industry as good corporate

citizens rather than tough competitors. This reticence to embrace the

yardstick philosophy in a day-to-day operational sense suggests an important

proposition. The competitive yardstick objective at best is a long-run goal.

A similar situation exists for IOFs. No IOF reports to its stockholders that

it had a good year because it caused other firms to lower prices. Its

executives report the amount of profits earned. Profitability is a goal in

itself. It directs business decisions. Adam Smith's invisible hand ensures

that such overt self interest serves broader social interests. In other

words, competitive markets ensure that the long-run performance goal (price

efficiency) is met when firms maximize profits.

For a cooperative, then, an intensive approach to theory would be to

articulate and analyze an analogue to the IOF profit maximization-invisible

hand combination. To do this, one needs a theory of the cooperative firm

that is an integral part of a theory of market equilibrium. The analysis

presented here demonstrates that cooperative membership policies, financial

practices, and members' expectations interact with cooperative objectives to

produce considerable variation in cooperative price-output performance. Some

results produce competitive yardstick equilibria; others do not.

The approach planned is as follows. First, here in the introductory part of

this section, there will be a brief discussion of cooperative equilibrium.

This concept has implicitly played a central role in many early theories of

cooperation (Helmberger and Hoos; Phillips). Cooperative and market

equilibrium concepts are the core of the theory developed here. Next the

basic assumptions of this analysis and the cooperative objectives commonly

advanced by economists will be presented.

The next part of this section will examine agricultural supply or purchasing

cooperative theory. First, some facilitating assumptions will be made.

Second, the demand curve for a monopoly purchasing cooperative (the market

demand curve) will be partitioned in a useful way. Then supply cooperative

equilibrium will be explored in different market environments--most notably

in monopoly and oligopoly markets. An important feature of this section is

183
that it extends the cooperative yardstick concept to cover supply

cooperatives that are monopolists. Monopoly cooperatives, do not, for

example, behave like IOF monopolists. The impact of retained earnings, of

closed versus open membership, and cash patronage refunds will be examined.

Finally, the question of competition among cooperatives and the implications

of extending the theory to the multiproduct case are discussed.

The third part of this section will explain agricultural marketing

cooperative price theory. First, some facilitating assumptions are made.

Then the input supply curve is partitioned, and, finally, cooperative

performance is analyzed in monopsony and oligopsony markets. The possibility

of a marketing cooperative developing market power through product

differentiation in the processed product market will be introduced, but not

analyzed. Such an analysis is a straightforward and major extension of the

theory developed in this section.

Cooperative Eauilibrium--A cooperative that transacts business in a market is

considered to be in equilibrium as an organization when its management has

attained its objective and no members or potential members determine that, as

a result or‘ the cooperative management policies, they must change their

business relationship with the cooperative to attain their own business

objectives. A cooperative objective, for present purposes, need not be an

exact quantitative target such as a 15 percent growth rate. It could be a

more general commitment, e.g., to maximize sales within the constraint that

net margins are nonnegative.

The definition of cooperative equilibrium is comparable to the long-run

equilibrium condition for an IOF. Such a firm is in equilibrium when its

management has attained its objective, e.g., profit maximization, and no

patrons or potential patrons determine that, as a result of the firm

management's decisions, they must change their relationship with the firm to

attain their own goals, i.e., there are not shifts of or movements along the

supply or demand curves facing the firm.

Cooperative price-quantity equilibrium, however, can be different from IOF

equilibrium even when the two firms have identical cost and demand conditions

and the same objective. The reason for this is that a cooperative does not

distribute net margins as profit to equity holders; it distributes net

margins to members in proportion to patronage. Given the assumption that

equity investment by members is proportional to patronage, net margins

distributed according to patronage also are distributed proportional to

investment as in an IOF. Nonetheless, as will be demonstrated, channeling

the distribution through patronage can produce a different equilibria for the

cooperative firm. Other features of a cooperative also can establish

cooperative equilibria that differ from IOF equilibrium. These differences

are the source of a cooperative's yardstick impact on market performance,

i.e., the movement toward an efficient allocation of resources in a market

economy.

Basic Assumntions --To analyze the relationship between cooperative objectives

and cooperative equilibrium, it is convenient to assume the following.

Assume that the economy is static. All production and consumption decisions

184
are made at a point in time. Points in time occur in a successive but

unrelated fashion, i.e., there is no investment to link present and future

economic activity. Thus equity capital is a purchased input for immediate

use in the production process and its price (rate of return) is determined in

the market for capital at that point in time. Also assume that there are no

taxes. With regard to cooperative structure, the cooperative is organized

according to the cooperative principles listed in table 2. With regard to

the operation-at-cost principle, assume all net margins are paid as cash

patronage refunds in the following period. The model could be generalized to

encompass patronage refunds that are allocated into revolving funds. It also

can accommodate per-unit capital retains commonly used in marketing

cooperatives. With regard to the limited rate of return on capital, assume

it is equal to the return on capital in alternative uses. If it is not, one

can alternatively assume that members have provided the capital in proportion

to patronage. Then prices paid can be adjusted so they are net of

opportunity costs payments to equity capital. In addition to the cooperative

principles, also assume the cooperative sells only to members. This

assumption could, but will not, be relaxed to analyze the impact of

nonmembers patronage on cooperative performance.

Coooerative Obiectives--Several objectives commonly have been advanced for

use by cooperatives. The most important ones and some of the authorities

that have argued for them are listed in table 3. Other objectives that have

attracted some attention are minimizing the cooperative's costs and

maximizing the patronage refund per unit (Kennedy, p.77). They are not

included because the former is equivalent to characteristic three in table 2,

and the latter produces no insights beyond those obtained from examining

objective one.

SUDD~V CooDerative Theorv

To facilitate a systematic analysis, the following assumptions are made and

will be relaxed at various points in this section. Assume members base their

patronage decisions on the market transaction price. Members regard the cash

patronage refund in the next period as a windfall gain. Also assume the

cooperative is a monopoly and entry is blockaded. Finally, assume the

cooperative sells only one product to farmers.

Partitioninz a SUDD~V Coooerative's Demand Curve --To analyze the objectives

listed in table 3 within the context of a purchasing or supply cooperative,

it first will be helpful to partition the cooperative's demand curve into

demand from a set of members and demand arising from changes in that set of

members. Because at this stage of the analysis the cooperative is by

assumption a monopoly with blockaded entry, it faces the market demand curve

DD in figure 1. DlDl is the demand for the cooperative's product from a

given set of cooperative members Ml. Thus it is the demand schedule for a

closed membership cooperative.

price decline to P2

In a closed membership with Ml members, a

would cause the quantity demanded from those members to

increase from Ql to Q12. This is a move down DlDl. If the cooperative

were an open membership organization with membership Ml at price Pl, a

price decline to P2 also would increase demand because new members join the

185
Table 2.- -Basic Assumptions for Price Analysis

Static Model Assumotions

1. All economic activity occurs at unrelated points in time

(exception: patronage refunds, if any, are distributed at the

following point in time).

Coooerative Organizational Characteristics

1. Member control.

2. Member ownership.

3. Operation at cost by paying patronage refunds in cash at the next

time point of economic activity.

4. Limited rate of return on equity capital that is:

(a) equal to the market rate of return, and

(b) equity capital input is provided proportional to patronage.

5. The cooperative promotes education about cooperatives.

6. The purchasing (marketing) cooperative sells (buys) only to (from)

members.

Table 3.- -Possible Objectives for a Cooperative

1. Maximize cooperative net margins.

2. Maximize members' welfare (Ladd; Royer 1979, 1981; Enke).a

3. Minimize (maximize) price in a purchasing (marketing) cooperative

(Nichols; Clark; Helmberger and Hoos; Heflebower).

4. Charge market prices and refund surplus (Rochdale pioneers; Walsh).

a Ladd and Royer address different types of agricultural cooperatives, and

Enke examines only a consumer cooperative. Nonetheless, the objectives they

proffer are the same.

186
Figure l--Partititioning a supply cooperative's demand into demand from a set

of members and changes in the set of members

PRICE

1

0 Ql Ql2 Q2 QUANTITY

187
cooperative. The quantity sold at P2 would be Q2. The market demand DD

is a combination of these two separate effects. Thus an open membership

cooperative faces the market demand curve. D2D2 is the new membership

demand curve at membership level M2, which is greater than Ml.

It is insightful to note what happens when price increases in a closed

membership cooperative. First, assume that members can quit the cooperative,

i.e., there are no real or perceived barriers to exit. Then raising price

from P2 to Pl will not reduce the quantity demanded by moving up

D2D2. Rather the quantity demanded is reduced by members quitting until

membership demand shifts to DIDl, and the remaining members purchase

41412 less of Q. An important conclusion follows. A closed membership

cooperative's demand curve is kinked. Purchase behavior along any membership

demand curve is bounded on the upper side by the market demand curve.

If members, for whatever reasons, cannot exit the cooperative when price

rises, the new equilibrium would on D

1

D2 at price level P2. Although

there may be cases where members are ocked in because of contracts or other

ties to the cooperative, this probably does not occur often. Thus the demand

curve in a closed membership cooperative normally will be kinked.

Analysis of SURD~Y Coonerative Obiectives--Turning now to the analysis of the

four objectives listed in table 3, figure 2 portrays the cost and demand

conditions for a supply cooperative with an open membership policy that has a

monopoly and expects no entry by outside firms. Because the cooperative is

the only firm in the market, DD is the market demand curve. Point 1

indicates the price a private profit-maximizing monopolist would charge,

which is the price that a cooperative charge if it seeks to maximize net

margins. Few cooperatives explicitly adopt this pricing objective.

Enke; Ladd; Royer (1978, 1982); and undoubtedly others have reasoned that the

appropriate goal for a cooperative is maximum welfare gain for members.

Royer analyses a more complex cooperative than is presented here. For an

agricultural cooperative that sells several inputs to farmers and purchases

several products from them, he concludes that the maximum welfare gain for

members occurs when the sum of the members profits from on-farm operations

plus cooperat7ive net margins (patronage refunds) are at a maximum (Royer

1982, p. 30)

For a supply cooperative, one can express this condition in terms of

maximizing the sum of the cooperative's producer surplus (profits) and the

aggregate Hicksian consumer surplus members derive from purchasing the

product (Royer 1982, p. 36; Enke). In figure 2, a cooperative can attain

this result by charging P2 and selling Q2. At point 2, cooperative's

marginal cost intersects the farmers' aggregate derived demand curve for the

input. The cooperative's profits or net margins are represented by area

P22&. Because the area under the demand curve equals the amount farmers

would be willing to pay rather than do without the input, that area is

Hicksian consumer surplus. Both Royer and Enke demonstrate that, at point 2,

the decrease in the cooperative's profits from an increase of one unit of

output is just offset by the increase in the consumer surplus. Beyond that

point, the marginal profit loss is greater than the marginal consumer surplus

188
Figure 2--Cost and demand conditions for an open membership supply

cooperative with a monopoly and blockaded entry

DOLWiS

p1

p2

p3

5

1

\

MC

/

4

AC

/

\D

[13 QUANTITY

189
gain, indicating that point 2 gives the output level that maximizes the sum

of cooperative profits and members' consumer surplus.

In Enke's consumer cooperative framework, where the demand curve is for

consumption, this member welfare-maximizing solution also maximizes social

welfare. For the same property to hold in the agricultural purchasing

cooperative situation, one need only require free entry and adjustment to a

long-run equilibrium of zero profits in the farming industry. As this

process occurs, any short-run quasi-rents (profits) are passed on to

consumers, assuring economic efficiency. Cooperatives following the member

welfare-maximizing goal could do so with the following pricing rule: charge

farmer members the price (P2) that produces the volume of business (Q2)

that equates price and marginal cost. Because price P2 is greater than the

average cost at output level Q2, the cooperative enjoys a positive net

margin. To honor the operation-at-cost pri ciple the cooperative could,

among other things, pay a patronage refund. B

Helmberger and Hoos; Heflebower; and others have asserted that a single

product open membership supply cooperative will seek to offer farmers the

product at the lowest price consistent with covering the cooperative's

costs. A cooperative would attain this goal by charging P3 and selling

Q3* No net margins remain, so there are no patronage refunds, or any other

type of surplus distribution, to members. This minimum price objective in an

open membership cooperative also can be described as output maximization.

The fourth objective in table 3, charge the market price and refund any net

margin, is not applicable under current assumptions. Because the cooperative

is a monopoly, it sets the market price. It cannot follow other firms.

Given the assumptions made about cooperative structure and market conditions,

objective two is the most desirable objective for the cooperative because it

maximizes member welfare.

Analysis of Cooperative Obiectives: L-Shaned Long-Run Average Cost

Curves --Consider figure 3 where the long-run average cost curve of the

cooperative is now assumed to be L-shaped. A cooperative behaving like a

profit-maximizing monopolist and maximizing net margins would charge Pl,

sell Q1, and return net margins to members as patronage refunds. The novel

result is that objectives two and three, maximum member welfare and

minimizing product price, occur at the same price-quantity point. Following

a marginal cost pricing rule gives the same results as following an average

cost pricing rule because long-run average cost equals long-run marginal cost

beyond the minimum efficient scale (MES) in figure 3. Therefore, if long-run

cost conditions are as portrayed in figure 3, objectives two and three are

the same for analytical purposes, and one no longer needs to argue the merits

of one over the other.

Analysis of Cooverative Obiectives: Consideration of Patronage

Refunds--Relaxing the assumptions that members consider only the transaction

price when deciding how much to buy from the cooperative produces an even

more powerful result. Assume that member demand for the cooperative product

is now a function of expected net price E(NP), which is defined as the

transaction price P minus the expected patronage refund per unit E(PR).

190
Figure 3--Open membership cooperative monopoly with declining and then

constant long-run average costs

DOLLARS

‘23

\

Q

1

Q23 QUANTITY

191
That is,

(1) E(W - P - E(PR).

Furthermore, assume that the expected patronage refund E(PR) in the current

period equals the actual patronage refund of the preceding period. More

realistic specifications of farmers' expectation formation processes could be

developed. However, the added complexity adds little to the general results

obtained here.

The cooperative equilibrium concept now becomes important. Management may

seek to maximize net margins or member welfare, but in this dynamic model,

they will be thwarted by member demand behavior. Consider the following

scenario illustrated in figure 4. The cooperative has been charging P,

selling Q, and paying no patronage refunds in the past. In the next period,

period two, management decides to maximize member welfare by charging P2

and returning P2

In period three,

- AC2 per unit as a patronage refund on quantity Q2.

management continues to charge transaction price P2, but

members now expect a per-unit patronage refund of amount P2 - AC2. Thus

they decide to purchase Q3. The cooperative experiences higher average

costs and the actual per unit refund is P2 - AC3. Given this lower

patronage refund, in period 4, members only demand amount Q4. This cobweb

adjustment process continues until equilibrium is reestablished at Q.

Management continues to charge P2, but expected net price is now equal to P

because members know they will receive P2 - P as a per-unit patronage

refund.

The conclusion of this analysis is as follows. The only objective for an

open membership supply cooperative that is consistent with long-run

cooperative equilibrium is objective three, minimize the price of the

product. Alternatively, an open member supply cooperative will seek to

maximize quantity sold given market demand and subject to covering costs of

operations. This is a constrained sales maximization goal only if the

elasticity of demand is greater than one.

Analysis of Coooerative Obiectives: Consideration of Patronage Refunds and

Closed MembershiD;-How, one may ask, would converting to a closed membership

cooperative affect the results of the previous section? Figure 5 can be used

to answer this question. The market demand curve has been partitioned into

two membership demand curves. DlDl is the membership demand curve for

all farmers who would purchase the product at expected net price Pl. As

explained earlier, usually only the portion below the market demand curve has

economic significance; an exception would occur if there are barriers of any

sort that prevent members from ceasing to purchase the product at the

cooperative. The same is true for D2D2, the membership demand curve for

farmers who would purchase the product at P2. The number of members here,

M2' is less than Ml, the number associated with DIDl. Restricting

membership to the M2 level would temporarily raise the price to P3.

However, it is not a long-run equilibrium solution. The cobweb adjustment

process would ultimately lead the cooperative to equilibrium at expected net

price P2 and output level Q2. Expected net price would be composed of a

192
Figure 4--Dynamic analysis of a cooperative equilibrium when members

recognize the value of expected patronage refunds

DOLLARS

p2

AC3

P

AC2

6

/

\

xc AC

/

/

193
Figure 5--Impact of a closed membership policy on monopoly supply cooperative

equilibrium when members recognize the value of expected patronage refunds

DOLLARS

*3

5

*2

%I

MC

/

D1

AC

\

D1

E

QUANTITY

194
transaction price equal to PS set by management and a patronage refund

equal to Pg - P2.

Two important results of this analysis follow. Membershlp restrictions

cannot be used to establish the maximum member welfare objective. To attain

it, the cooperative must adopt some form of quota or production control

scheme. Note, however, that membership restrictions can be used to lower the

cooperative's expected net price to the minimum value of the long-run average

cost curve. This produces a member welfare maximum for the remaining members

because at that point price equals marginal cost, but it does not produce

maximum social welfare for the obvious reason. A number of producers have

been excluded from the input market. The quantity of the product sold is

considerably less than Q3, the socially desirable amount. As a result, the

amount of agricultural production is less than it would otherwise be.

Consumers pay higher prices and the fortunate farmers who are in the

cooperative earn economic rent (profit) on their cooperative membership. If

the membership was attached to the farm, it would be capitalized and raise

the value of the farm. Thus a restrictive membership policy would not

benefit future cooperative members who buy the farm and have to pay for

cooperative access as trell.

Retained Earnings in a MonoDolv SUDD~Y Coooerative--Retained earnings, i.e.,

net margins that are not distributed as cash or allocated to members' equity

accounts, affect cooperative equilibrium. A cooperative that retains net

margins can attain any price output point on the market demand curve in

figure 2, including points 1 and 2. Because members do not expect to receive

any patronage refunds, they base their purchase decision on the transaction

price. The cooperative can, for example, price like a profit- (retained

earnings) maximizing firm by setting price at level Pl. Setting price at

level P2, however, does not maximize member welfare because members do not

receive retained earnings.

The Three Stages of Coonerative OutDut--A useful concept worth mentioning is

related to the conclusion that the price received by members is determined by

the intersection of the market demand curve and the average cost curve. One

can define three different stages of cooperative output according to the

economic relationship that exists among members. If demand intersects the

average cost curve to the left of its minimum, this is known as the

complementary output stage. Increases in demand lower price for all

cooperative members. If demand intersects a flat section of the average cost

curve, if any exists, this is known as the supplementary output stage. If

demand intersects the rising portion of the average cost curve, the

cooperative is in the conflictive output stage. A cooperative's membership

policy and membership education effort may depend very strongly on the

particular stage in which it is operating (Croteau, pp. 9-10).

Conclusions for the Coonerative MonoDolv Model--This section on cooperative

objectives under monopoly conditions concludes with three general points.

First, the supply cooperative objective that is consistent with cooperative

equilibrium, when farmers expect patronage refunds, is to minimize the price

of the product subject to covering the cooperative's costs. This price

occurs where the demand curve for an open or restricted membership

195
cooperative intersects the long-run average cost curve. Therefore, a

monopoly cooperative that pays patronage refunds acts as a competitive

yardsbick against itself. In the long run, cooperative price equals average

cost. This generalization of the competitive yardstick concept is novel

and potentially quite important as a guideline for antitrust analysis of

cooperative business practices. Even monopoly cooperatives may attain

desirable social welfare norms such as allocative efficiency.

Second, the allocation of cooperative benefits between the transaction price

and the patronage refund per unit cannot be used as an instrument by

management to maximize member welfare, and it need not be used to minimize

the price subject to covering costs. No matter how the allocation is set,

the cooperative will attain long-run equilibrium.

Third, a cooperative that retains earnings has the flexibility to select any

price-output combination on the demand curve facing it. This includes the

net margins (retained earnings) maximizing point. Retained earnings,

however, cannot be used to earnings maximize member welfare. These results

also hold for cooperatives that are not monopolies.

Fourth, controlling the size of the membership can benefit those who are not

excluded, but such policies are not socially optimal. One might, however,

correctly point out that a restricted membership cooperative may be able to

move the economy toward a more efficient allocation of resources if entry is

not blockaded. The existence of several potential or established farmers who

do not have access to this input might signal a private firm to enter or

provide incentive for excluded farmers to organize a second cooperative. If

a second cooperative was established and demand in figure 5 was shared

between them, the result would be that all farmers would enjoy price near the

level minimum average cost level. Member and social welfare would be even

higher than it was at the unattainable price output point (P3,Q3).

Whether social welfare would be higher if an IOF enters takes us into an

analysis of how cooperative objectives are influenced by market structures

where the cooperative has investor-owned rivals.

Relaxing the Independence AssumDtion --Analyzing cooperatives as if they were

monopolists with blockaded entry essentially assumes that they are unaffected

by and do not have an impact on other firms in the market environment. This

independence assumption is now relaxed to examine what different competitive

environments can tell us about a cooperative's objective and its

performance. The fourth objective in table 3 now has content because there

is a market price and the cooperative can choose it or some other price level

as its transaction price. The competitive yardstick concept, as Nourse

envisioned it, also becomes operative. Previously a cooperative was only

working against itself or, more accurately, its members. Now it is working

against other firms as well, and one can ask whether it pulls rivals as well

as members toward a more efficient allocation of resources. Continuing the

example of a purchasing cooperative, there are three structural

configurations that merit analysis--perfect competition, monopolistic

competition and oligopoly.

196
The first two, perfect competition and monopolistic competition, can be

dismissed as trivial for cooperative theory. In a perfectly competitive

market, entry is easy, firms are numerous, and they are price-takers. No

firm, including a cooperative, has discretion over price so the objective

must be to charge the market price and refund any net margins to members. In

long-run equilibrium, market price equals minimum average cost. Net margins

are zero, and members receive no patronage refunds. Member and social

welfare would be at a maximum because price equals marginal cost. With

regard to monopolistic competition, it is sufficient to note that long-run

equilibrium occurs for each firm where its demand curve is tangent to the

long-run average cost curve (Ferguson, p. 299). Therefore, as in the

perfectly competitive situation, it makes no difference which objective a

cooperative pursues. Each produces the same equilibrium price-output result.

Oligopoly is the most relevant real-world, theoretically interesting

environment for most cooperatives. Assume that all firms, including the

cooperative, have symmetric costs, IOFs recognize their interdependence, and

they jointly maximize profits as in Chamberlin's small-numbers case

(Chamberlin, pp. 46-51). To analyze this joint profit-maximizing solution,

industrial organization economists have defined followship and nonfollowship

demand curves (Greer, pp. 257-61). A followship demand curve for a firm is

that amount of industry sales that it receives when all firms raise or lower

prices in tandem. Assuming that farmers do not switch among firms when all

firms change prices at the same time, the followship demand curve construct

is equivalent to the closed membership demand curve. As all firms in the

industry raise or lower prices in tandem, they keep the same set of

customers. Thus they are moving along what has heretofore been called a

membership curve. A nonfollowship demand curve is analogous to the market

demand curve of the monopoly cooperative case in that it is predicated on the

assumption that changes in a firm's price are not followed by (are

independent of) rival firms. The nonfollowship demand curve therefore is

considerably more elastic than the followship curve.

Figure 6 illustrates how the followship and the nonfollowship demand curve

can be used to analyze cooperative equilibrium in an oligopoly. Given

initially the followship demand curve FIFl and that the IOFs maximize

profits by charging Pl, the cooperative has some important choices.

oli~ovolv: Closed Membershin Cooperative Eouilibria--If it is a closed

membership cooperative, it can price at Pl and pay a per-unit patronage

refund equal to PlP2. Ultimately membership demand will attain

equilibrium at Q2. The cooperative will continue to charge Pl, but it

will pay a per-unit patronage refund equal to PlP4. A very important

result follows. A closed membership cooperative equilibrium will not disturb

the oligopolistic joint profit-maximizing equilibrium.

There will be no competitive yardstick effect on the market price. This case

occurs because the cooperative captures no customers from the proprietary

firms. In essence, the closed membership cooperative structure allows the

cooperative to move down its followship demand curve while the other firms do

not. If it prefers, a closed membership cooperative could lower price from

Pl to P4 rather than charge market prices and pay patronage refunds.

197
Figure 6--Supply cooperative equilibrium in an oligopolistic industry

DOLLARS

pl

F

I

\\

Ql Q2 Q, Q, QUANTITY

198
Again, in theory, there would no impact on other firms in the market because

buyers could not switch to the cooperative.

This theoretical result may describe reasonably well the impact of

agricultural supply cooperatives that have integrated into oil refining.

Because these cooperatives sell primarily in rural areas to agricultural

producers, they are essentially closed membership organizations. Urban

consumers cannot switch their patronage to farm cooperatives. Therefore, any

benefits from cooperatives entering the oligopolistic refining industry

accrue to cooperative members (rural areas) rather than the general public

(urban areas).

Oligovolv: Onen Membershin Coonerative Eauilibria--The situation is quite

different for an open membership cooperative. First it could refuse to go

along with the joint profit-maximizing price and charge Ph. Rivals would

follow by charging P4 to produce cooperative equilibrium at output Q2.

This is a competitive yardstick result. All farmers now can purchase the

input from all firms at price Ph.

An open membership cooperative, however, has what may be a superior

alternative. It can pursue objective four from table 3, which is charge

market prices and pay patronage refunds. A cooperative would do this even if

it had no fear of a price war because it benefits members most. The open

membership cooperative would charge P , sell Ql, and pay a per-unit

patronage refund equal to PlP2. Unti i nonmembers became aware of the

benefits to cooperative membership, established members enjoy benefits just

like a closed membership cooperative. However, as the patronage refund

becomes common knowledge, membership would expand to Q4 if IOFs do not

respond. Assuming no response by rivals, equilibrium would occur at

(P4,Q3) where the membership demand curve intersects the average cost

curve. The IOFs have exited the market and the cooperative output Q3

accounts for 100 percent of industry sales. This is because no one would buy

from the higher priced rivals.

Even if rivals respond by matching the net price in the next market period,

and they most certainly will rather than see their market shares fall to

zero, some farmers who are upset that they did not share in the already

awarded patronage refund may join the cooperative. Although IOFs match the

expected net price of the cooperative P2, these farmers have revised their

expectations to reflect their lack of trust in the proprietary firms'

performance. Thus the cooperative's market share might increase, and its

followship demand might now be F2F2. The cooperative also would charge

P2 in period 2. At (P2,Q5L the cooperative pays a patronage refund at

the end of period 2. The process continues in period 3. More farmers would

shift patronage to the cooperative, causing the followship demand curve to

shift to F3F3 (not shown). Equilibrium is at P4 and a quantity between

45 and Q3. This is a competitive yardstick result. All firms offer the

input at a price equal to long-run average and long-run marginal cost.

Of course, these results change if the firm eventually experiences size

diseconomies, which cause the long-run average cost curve to be U-shaped.

The cooperative then may or may not move the industry toward an efficient

199
allocation of resources. As with a monopoly cooperative, if entry is

possible, adding one or more additional firms may shift the cooperatives

followship demand curve until it intersects the long-run cost curve at its

minimum. The entering firms do not necessarily have to be cooperatives.

Comoetition Among Cooperatives --Recently Rhodes and Ratchford have

rejuvenated concerns about the sixth Rochdale principle by looking at its

negation, competition (not cooperation) among cooperatives. The theory

presented here addresses the issue. First, consider an oligopoly market

where economies of size are not the major determinant of market structure.

Where long-run average cost curves are U-shaped (diseconomies of large scale)

and minimum efficient scale occurs at or below 50 percent of the market, two

or more cooperatives may produce lower prices for farmers than a single

dominant cooperative. If, however, the result is several cooperatives and

each has a relatively small share of the market, individually they may not

have sufficient market power to influence IOFs that have amassed larger

shares through multiplant operations (combinations of two or more units each

operating at efficient cost levels). The solution, which may at first seem

unorthodox, is collusion, i.e., cooperation, among the cooperatives in the

market. If they set price strategies as a group, they may be able to lower

prices farmers pay toward the competitive price level. If IOFs in

oligopolies can tacitly collude to raise price above the competitive levels,

cooperatives in that industry should certainly be allowed to collude, even

openly collude through joint marketing efforts and price discussions to

provide a competitive yardstick. Of course, an alternative that is often

preferred to open collusion is merger.

A second situation, which is more relevant in many midwestern market areas,

is that two or three cooperatives currently make all sales. There are no

IOFs. If further cost efficiencies can be gained by consolidation, i.e.,

these cooperatives are in the complementary output stage, then these

cooperative should merge. A monopoly cooperative would increase social

welfare as well as benefit farmers. Competition among cooperatives would be

wasteful.

The Multioroduct Case: A Solution to the Joint Cost Allocation Puzzle--This

analysis of a farm supply cooperative can be generalized to address a

multiproduct cooperative. Some other researchers have not fully appreciated

this fact. When arguing for the "maximum member welfare objective," Ladd

dismissed the "minimize price subject to covering costs" objective. He

reasoned one cannot add up the prices across commodities to produce a single

measure of cooperative performance (Ladd, p. 18). He prefers to add the two

measures of welfare, producer and consumer surpluses, across commodities.

Yet a cooperative does not need to have a single measure of performance. Its

decision rule can be to set market level prices in each market and refund net

margins as they materialize. Cooperative equilibrium will be attained. If

the cooperative wishes, it can limit membership until expected net price

equals minimum long-run average cost for each product.

Methods exist and are regularly used by multiproduct cooperatives to compute

patronage refunds (Davidson). The allocation of joint (overhead) costs to

individual products is a problem the equilibrium theory developed here can

200
address. Consider a purchasing cooperative that sells two products in

oligopolistic markets. If it allocates all of the overhead cost to one

product, that product's cost curve shifts up and the favored product's cost

curve shifts down. How will this affect equilibrium in the two markets?

Costs in the favored market are not only lower, they are lower than the costs

of single-product rivals that do not have the ability to shift costs.

Therefore, the cooperative's expected net price will be lower than the price

that rivals require to earn a competitive return on their invested capital.

They will exit the market and the cooperative market share will rise. Joint

cost allocation practices in a cooperative are analytically equivalent to

price cross-subsidization in a conglomerate IOF (Greer, chap. 17).

Cooperative performance in the unfavored market also will change. Because

the joint costs are being charged to users of this product, the cost curve

shifts up. In cooperative equilibrium, the expected net price will be higher

and rival joint profit-maximizing firms will enjoy positive profit levels.

Note that this approach finesses the issue of how to allocate joint costs

across several products- -a theoretical puzzle that continues to baffle

microeconomists. Here only the deviation from the historical norm matters.

The norm may be set by tradition, custom, happenstance, or collusion.

This analysis suggests an empirical test for the direction and extent of

deviation of joint cost allocation from industry norms. A complete model

would be more complex than what is suggested here. However, the current

purpose is only to show the direction that research can proceed. Note that

in cooperative equilibrium, the net margin for each product will be zero,

regardless of how joint costs are allocated. The cost allocation effect

registers on market share, measured as the percent of quantity sold.

Examining the unfavored market first, if rivals follow the cooperative up the

followship demand curve, the cooperative's market share will not change.

Market share variation for the favored product depends on the shape of the

long-run average cost curve. If it is L-shaped, the cooperative's market

share would expand to 100 percent. All rivals would be forced out of the

market. On the other hand, if unit costs rise at larger volumes, market

share would only expand until the increase in unit costs equals the amount of

the excess joint cost allocation. At that point, the cooperative's expected

net price would equal the minimum long-run average costs of IOFs. Market

shares would stabilize with the cooperative having a larger share than

before. Because both the cooperative and the remaining IOFs charge the

competitive price, one might think that the equilibrium is socially optimal.

It is not. The cooperative's market share is too large. Members who buy the

favored product gain at the expense of farmers who must pay a higher price

for the unfavored product.

Marketing Cooperative Theorv

There are two major types of agricultural marketing cooperatives: bargaining

and processing cooperatives. Bargaining cooperatives act as the common

selling agent for members. They may or may not take title to the farm

commodity. The Michigan Agricultural Cooperative Marketing Association is an

201
example of a bargaining cooperative. It negotiates with processors to

establish contract terms for fruit and vegetable growers in Michigan. Some

bargaining cooperatives act on behalf of only their members. Others are

exclusive agency bargaining associations. By law these cooperatives

establish the terms of trade for all producers, members and nonmembers alike

in a market area. Exclusive agency bargaining cooperatives are analogous to

a closed union shop situation. As such, they are in a much stronger

bargaining position with processors. When farmers bargain collectively, they

are attempting to exert market power (monopoly power) to offset the buying

power (monopsony power) processors possess due to control over market

information, processing facilities, market access, or other resources.

Galbraith explained that farmers who bargain collectively are developing

countervailing power. The price-quantity equilibrium resulting from this

bilateral monopoly situation, he concluded, depends on the relative

bargaining strength of the two sides. Nonetheless, he felt it could be

closer to the competitive (efficient) equilibrium than if there were no

farmer bargaining.

Processing cooperatives procure raw product from members, transform it, and

sell the processed product to wholesalers and retailers. Land O'Lakes and

Ocean Spray are examples of such marketing cooperatives. The theory

developed here is most pertinent for processing cooperative activities.

However, it also can provide insights for bargaining cooperatives. An

exclusive agency bargaining cooperative would, for example, seek to move an

investor-owned monopsonist toward one or more of the equilibrium points

discussed for cooperative monopsony.

Marketing cooperatives often have special payment arrangements that are

related to the pooling of products and the timing of sales over a market

period. Growers receive several installment payments as the marketing

process continues. Those that deliver products that go into higher quality

pools also receive higher prices. To facilitate the examination of the

general price-output behavior of marketing cooperatives the complex timing of

payment and pooling arrangements will not be included in this analysis. Here

it is assumed that members receive a transaction or market price when the

product is delivered to the cooperative. Any net margins remaining at the

end of the market year are refunded as cash patronage refunds at that time.

Per-unit capital retains, a financing arrangement that often is used by

marketing cooperatives instead of allocated patronage refunds, will not be

analyzed. It also will be assumed that the cooperative markets only one

product for members and the processed product market in which it sells is

perfectly competitive.

At the outset of the analysis, this marketing cooperative is assumed to be a

monopsony with blockaded entry. The only marketing alternative available to

growers is to sell product through the cooperative. This assumption will be

relaxed at a later point to examine cooperative conduct in oligopsonist

markets.

Deriving Net Revenue Curves for a Marketine: Cooperative--A marketing

cooperative that processes raw farm product and then sells it is an

intermediate stage firm in a food marketing channel. Figure 7 conceptualizes

202
Figure 7--Derivation of net revenue product curves for a marketing

cooperative

DOLLARS

Processed

Product

Market

DOLLARS

Raw

Product

Market

Marginal Cost of Processing

Processed

Product

Price

Average Cost of Processing

Q-l 92 83 44

Processed Product Quantity, Q

Raw Product Processed

203
this activity in a useful fashion. It helps us determine how much revenue

net of processing costs is left to pay the farmer for delivery of the raw

product. First we assume it takes exactly one unit of raw product to produce

one unit of processed product. This is not necessary, but it makes the

graphical presentation easier. It allows us to derive net revenue product

directly from the price and cost conditions displayed in the processed

product market.

Because we have assumed the processed product market is perfectly

competitive, the demand curve for processed product is perfectly elastic and

is the processed product price line in figure 7. Introducing imperfect

competition in the processed market, such as product differentiation of the

Land O'Lakes butter or Ocean Spray cranberry juice type, would produce a

negatively sloped processed product demand curve. That will not be done

here. However, the extension of the theory is straightforward and important

for analysis of many real-world situations.

The average marginal cost of processing curve in figure 7 includes all costs

extent the cost of raw product supplied by members. Subtracting these unit

costs from the price received for the processed product produces the net

average revenue (NAR) and the net marginal revenue (NMR) product available.

The NAR indicates for each quantity of product processed net revenue per unit

or price the cooperative can pay the farmer for raw product.

Representative NAR and NMR curves are displayed in lower part of figure 7.

Note that NAR equals zero at Ql and Q4 because processed product price

equals the average cost of processing at these output levels. NAR attains at

maximum value at Q2 where the vertical distance between processed product

price and its average processing cost is greatest.

because for output levels above Q3

NMR equals zero at Q3

the marginal cost of processing is

greater than the marginal revenue (processed product price) gained from

selling the product.

The exposition of marketing theory that follows will use only the NAR and NMR

curves displayed in the bottom section of the figure. Before analyzing how

raw product prices and quantities marketed actually are determined, we must

first describe in a specific fashion the raw product supply conditions the

cooperative firm faces.

Partitioning the Raw Product SUDD~Y Curve of a Marketing Cooperative--As in

the case of a supply cooperative, partitioning the offer curve a marketing

cooperative faces provides powerful insights into price-output performance.

For a marketing cooperative, the relevant offer curve is the supply curve.

It is partitioned in figure 8 into supply arising from changes in output from

a set of members and supply arising from changes in the number of members in

the cooperative. Because at this stage of the analysis the marketing

cooperative is assumed to be the only buyer of the farm product (monopsonist)

S in figure 8 is the market supply curve for raw product. At price PC, no

farmer will produce the product. As price increases from PC, the market

supply curve S indicates that the quantity of product forthcoming from all

farmers increases. At price Pl, the amount supplied is Ql. At this

point, some number Ml of farmers are member-patrons of the cooperative.

204
Figure 8-- Partitioning the raw product supply curve faced by a marketing

cooperative into supply from a set of members and changes in the set of

members

Raw Product

Price

P,1

Raw Product Quantity

205
The curve Sl is the supply curve for that given set of members. Thus it is

a supply schedule for a closed membership marketing cooperative with Ml

members. In such a closed membership cooperative, a price increase to P2

would increase raw product supplied to the amount 412. This is a move up

the Sl curve. If the cooperative were an open membership organization with

membership Ml at price Pl, a price increase to P2 also would increase

supply because new members would join the cooperative. The quantity supplied

at P2 would be amount Q2. The market supply curve S is the combination

of these two separate price responses. S2 is a second membership supply

curve. The number of members M2 is greater than Ml, the number of

members associated with curve Sl.

If there are no real or perceived barriers to exit in a closed membership

cooperative, the cooperative faces a kinked supply curve for raw product.

For example, if the cooperative has Ml members and price is at level Pl,

increases in price will produce output increases along the membership supply

curve Sl. For price decreases from level Pl, however, the relevant

supply curve is not Sl. It is s. Some members free to exit the

cooperative will do so, and supply reductions are larger for this reason.

Analysis of Marketing Cooperative Obiectives--The revenue product curves and

supply curve constructs previously developed can be used to analyze

desirability and feasibility of the four cooperative objectives listed in

table 3. The analysis is analogous to that presented for a supply

cooperative, so it will be abbreviated here. Because at this stage we are

analyzing a monopsony marketing cooperative, only the first three objectives

of table 3 are relevant: (1) maximize net margins, (2) maximize member

welfare, and (3) maximize the price farmers receive for raw product. At the

outset, assume the cooperative has an open membership policy. Any grower can

market product through the cooperative. Given this assumption, a monopsonist

cooperative in figure 9 faces the market supply curve S for raw

product. Also assume cooperative net margins, if any, %?not returned to

members as patronage refunds. However, assume farmers consider only the

price paid at delivery when making production decisions. They regard

patronage refunds as windfall gains.

In figure 9, the three objectives are illustrated by the corresponding

price-output points 1, 2, and 3. At point 1, the cooperative behaves like a

profit-maximizing monopsonist and maximizes net margins, area Pllab, by

processing raw product Ql and paying farmers price Pl. At point 2,

member welfare is maximized, as explained in the supply cooperative

discussion, because net marginal revenue equals the supply price at output

level Q2. The price farmers receive is P2 and cooperative net margins

are lower than they are when the first objective is pursued. At point 3, the

price farmers receive is maximized subject to covering processing costs. The

cooperative has zero net margins. As was shown for a supply cooperative, if

members of this marketing cooperative base their production-supply behavior

on the expected raw product price, which is the known transactions price at

delivery plus any expected patronage refunds at year-end, the only

sustainable equilibrium is point 3 in figure 9. In other words, a

monopsonist marketing cooperative with an open membership policy will process

more of the product and pay producers a higher price (point 3) than an

206
Figure g--Alternative microeconomic objectives for an agricultural marketing

cooperative that is a monopolist with an open membership policy

ME1

Raw Product Quantity, Q

207
investor-owned monopsonist firm (point 1). This is a generalization of

Nourse's competitive yardstick theorem.

How, one might ask, do these results change if the cooperative pursues a

restrictive, closed membership policy? Figure 10 illustrates the impact of

closed membership. The price-maximizing equilibrium for an open membership

occurs at point 3. If the cooperative restricts membership to a number

smaller than the number of producers at point 3, the relevant supply curve

will be a closed membership supply curve such as Sl. Equilibrium will

change to point 3'. Those producers who continue to sell to the cooperative

receive a higher price, and the amount of raw product processed is reduced.

Note that consumers do not suffer from this output restriction because the

price for the processed product does not change. The losers are the excluded

growers who no longer have a market for their product.

Relaxing the Indeoendence ASSUmDtiOn: Oligoosonv--When the assumption the

marketing cooperative is a monopsony is relaxed, the most relevant market

structure to analyze is oligopsony. The cooperative no longer faces the

market supply curve. Instead, it competes for raw product with a small

number of investor-owned processors.

To facilitate the analysis, assume all firms, including the cooperative, have

symmetric processing costs and face the same processed product price line,

i.e., there is perfect competition in the processed product market. Then all

processors have the same net average revenue and net marginal revenue

curves. Also assume that the investor-owned oligopsonists recognize the

interdependence in the raw product market and jointly maximize profits as in

the Chamberlin small-numbers case for oligopolists (Chamberlin, pp. 46-51).

To analyze industry equilibrium and the impact of a marketing cooperative on

it, define the analogues to the followship and nonfollowship demand curves

introduced in the supply cooperative discussion. These are the followship

and nonfollowship raw product supply curves. A firm's followship supply

curve is the amount of raw product that is offered when all buyers raise or

lower their prices in tandem. Because farmers would not switch among firms

when all firms follow each other's price changes, the closed or set

membership construct is equivalent to the followship supply curve. As all

firms raise or lower prices at the same time, they keep the same set of

customers, thus they are moving along what has heretofore been called a set

membership supply curve. A nonfollowship supply curve is analogous to the

market supply curve of the monopsony cooperative case in that it is predicted

on the assumption that changes in a firms price are not followed by (are

independent of) rival firms. The nonfollowship supply curve is considerably

more elastic than the followship supply curve because the price mover

receives increased supply from producers that switch to take advantage of the

higher price as well as increased supply from its prior customers who

increased output.

Figure 11 illustrates how the followship and the nonfollowship supply curve

can be used to analyze cooperative equilibrium in an oligopsony. Given

initially that the IOFs maximize profits by charging Pl, i.e., all firms in

208
Figure lo--Impact of a closed membership policy on monopsony marketing

cooperative equilibrium when members recognize the value of expected

patronage refunds

DOLLARS

NAR

Raw Product Quantity, Q

209
Figure ll--Marketing cooperative equilibrium in an oligopsonistic industry

DOLLAR.S I

FS

(

/

NFOS

/

!2 3

NAR

Raw Product Quantity, Q

210
the market are following objective 1, the cooperative faces followship supply

curve Sl and some important strategic choices.

Olizonsonv: Closed Membership Coonerative Eouilibria--If the cooperative is

a closed membership organization, it can price at Pl and pay a per-unit

patronage refund equal to Pla. Ultimately membership supply will attain

equilibrium at Q2. The cooperative will continue to charge Pl but it

will pay a per-unit patronage refund equal to Plb.

A very important result analogous to that for a supply cooperative follows.

This closed membership cooperative equilibrium will not disturb the

oligopsonistic joint profit-maximizing equilibrium of the industry. There

will be no competitive yardstick effect on the market price. This is the

case because the cooperative captures no customers from the proprietary

firms. In essence the closed membership cooperative structure allows the

cooperative to move up its followship supply curve while the other firms do

not. If it prefers, a closed membership cooperative could raise price from

Pl to b rather than charge market prices and pay patronage refunds. Again,

in theory, there would be no impact on other firms in the market because

suppliers could not switch to the "closed" or "waiting list" cooperative.

Olizonsonv: Onen Membershio Coooerative Eauilibria--The situation is quite

different for an open membership marketing cooperative. First, it could

refuse to go along with the joint profit-maximizing price and pay amount b as

a transactions price to farmers when they deliver product. Rivals would

follow by paying b to produce cooperative equilibrium at output Q2. This

is a competitive yardstick result. All farmers now can sell this product to

all firms at price level b.

A second possibility is that the IOFs, for whatever reason, do not follow the

cooperative's price increase. Then the relevant supply curve is NFOS. The

cooperative would not only receive increased product from existing members,

but producers would switch from other firms, increasing the cooperative's

market share and producing equilibrium at price level c and output level

Q3* This also is a competitive yardstick result. Although it does not

force other firms to raise their prices, it does reduce their market shares.

If they continue to refuse to raise price the cooperative conceivably could

expand to supply 100 percent of the market.

A Closing Comment

Perhaps an appropriate closing for this section is to recall that open

membership cooperatives in oligopolistic markets that are in equilibrium pay

no patronage refunds. This is contrary to what is commonly observed. Some

agricultural cooperatives do pay patronage refunds on a regular basis. It is

unattractive to conclude that this is because they are in perpetual

disequilibrium. Other factors obviously are at work. One of the assumptions

in this paper has been that cooperative capital earned it opportunity cost

rate of return. This amount is built into the cost curves. In the'real

world, members furnish equity capital to their cooperatives and the fixed

dividend rate they are paid often is below the opportunity cost rate. Thus a

211
cooperative in equilibrium may have positive patronage refunds to cover fully

the opportunity cost of invested funds. In fact, this point is central to

the analysis of the next two sections of this paper.

Coooerative Eouilibrium with Investment;

The Certaintv Case

Market values for corporation stock can appreciate. This value is

related to capitalizing a stream of anticipated future earnings by the

opportunity cost of the investor. A nice neat package. No such package,

however, exists for cooperatives. There is no standard way to measure

performance of a cooperative in terms of making the member-patron better

off. (Fenwick, p.208)

Introduction: Basic Concepts

This section develops a unified theory of cooperation that seeks to meet the

cogent need for performance measures described in the opening quote.

Fenwick; Beierlein and Schrader; and others have pointed out that, unlike an

IOF, a cooperative cannot examine ex post changes in its value in the capital

market to evaluate investment performance. The analysis presented here

demonstrates that for ex ante evaluation of potential investments and ex post

evaluation of investment performance cooperatives must measure the flow of

benefits to members via the product market if any product price adjustments

occur. In such cases, one must analyze more than cash flows to the

cooperative.

This section proceeds by generalizing the supply cooperative equilibrium

models of the last section to include investment and its related concern, the

financing of investment. The resulting theory will be used to analyze

several important issues including the following: (1) the impact of

unallocated retained earnings on cooperative equilibrium performance, member

welfare, and cooperative investment analysis; (2) the appropriate form of

investment analysis models for cooperatives in differently structured markets

and with different operating procedures; and (3) the significance of the

free-rider problem to cooperative performance.

This section is divided into several subsections. Each covers a distinct

topic. For convenient reference, table 4 identifies all the variables used

in the mathematical analyses in this section.

The Risk-Free Rate of Interest--Investment, by definition, is the outlay of

funds today to obtain an income in the future. Investment activity makes

economic analysis more challenging. This is true for cooperatives as well as

IOFs. One must analyze how a cooperative makes and finances investment

choices today that will generate income in the future. The economic problem

not only gains an intertemporal dimension, but investment links present and

future economic activities.

The counterpart of investment, savings, performs a similar function.

Cooperative members, for example, will reduce consumption and save money if

212
Table 4.- -A Key to Symbols Used in the Analysis of Cooperative Equilibrium

with Investment (Equations (2) Through (28))

Equation

where first

introduced Symbol Definition

(2) VO

CO

net present value of cooperative at time to

cash payment to cooperative members at time

t0

Cl cash payment to cooperative members at time

t1

il risk-free rate of interest

(3) KO net cash margins from operations at time to

F equity capital paid in by new members at time

t0

B amount of funds raised by selling debt

securities or preferred stock at time to

(4)

IO

fi

investment by cooperative at time to

ith member's share of equity capital paid in

by new members at time to

m number of farmers that join at time to

(5) a-l

ith member's share of total cooperative sales

at time to

It total investment of cooperative at time to

(6) 'i ith member's purchases at time tl

Sl total cooperative sales at time tl

(7) IP

investment in cooperative prior to time to

IO investment in cooperative at time to

(8) c.1

ith member's cash payment at time tl

(Continued)

213
Table 4.- -A Key to Symbols Used in the Analysis of Cooperative Equilibrium

with Investment (Equations (2) Through (28)) (Continued)

Equation

where first

introduced Symbol Definition

(11)

(12)

(14)

(15)

(19)

(23)

(25)

(26)

(27)

(28)

Xl

Ql

Pl

QT

Q?

CO1

KEl

Kl'

AV;

V

AV

cooperative's net cash margins, including net

cash from dissolution, at time tl

total cooperative sales at time tl

cooperative transaction price (market price)

at time 

tl

tl

tl

tO

tl

tl

IO

change in net margins at time tl

IO

tOIO

timel

to

IO
the interest rate is high enough to reflect their rate of time preference for

consumption (Samuelson). Such savings are loaned to other consumers, who

wish to borrow against future income to increase their current consumption,

and to firms, such as cooperatives, if the rate of return on investment is

high enough. In equilibrium, the supply of funds from savers and the demand

for funds from borrowers determine the interest rate in the capital market.

There are, of course, more powerful models of interest rate determination

than this classical supply demand analysis which has been attributed to

Fisher. One class of models recognizes that savings preferences also vary by

age (Friedman's life-cycle consumption function (1957)). Another class of

models recognizes that monetary authorities can influence the rate of

interest and thereby influence aggregate investment and consumption patterns

to manage the level of aggregate economic activity (Keynes). This later

theory of course, is an important component of macroeconomics. For current

purposes it is not as important to know how the rate of interest is

determined as it is to know that it exists and all economic agents can lend

and borrow freely at that rate.

Under the certainty assumption of this section, decisionmakers know all

economic facts. This includes how much income an investment will generate

over its useful life as well as all aspects of current economic conditions.

Nothing is unknown or risky, so the equilibrium interest rate is called the

risk-free rate.

Superiority of the Cash Flow Based Net Present Value Analysis--Firm

valuation, investment, and finance questions have been analyzed for IOFs by

using net present value analysis based on cash flows (Copeland and Weston).

Nearly every undergraduate text in finance explains why net present valuation

is superior to other investment analysis methods, including internal rate of

return and payback. The primary alternative to analysis of cash flows is

analysis of reported earnings. The two approaches are sometimes described as

measuring economic as opposed to accounting profits (Copeland and Weston, pp.

22-25). Accounting measures of earnings capitalize investment and then write

off that amount as depreciation over the life span of the investment.

Depreciation is a noncash expense. Cash flow analysis records the receipt of

funds from equity holders or other finance sources and the actual payments of

cash to equity holders when they occur.

Bodenhorn emphasizes three desirable properties of cash flow analysis for

IOFs (p.16). First, cash flow analysis can be used in decisionmaking because

maximizing the net present value of cash flow increases the value of the firm

and thus is in the best interest of stockholders. Second when profits for an

IOF are measured with cash flow techniques, they are identical to income on

investment. Third, cash profit for an IOF can be measured from market

values, so it is an objective measure. Accounting profits are more

susceptible to manipulation by management.

None of these properties hold unequivocably for a cooperative. Maximizing a

cooperative's cash flow does not necessarily increase the value of the firm

to members. Cooperative net margins, even when measured by cash flow rather

than accounting methods, are not necessarily identical to benefits

215
attributable to investment. Finally, measures of cash flow benefits are less

subject to manipulation by management than accounting measures, but the cash

flow from a cooperative investment can accrue as product price reductions as

well year end margins. These points suggest that cooperatives demand more

careful examination.

Cooperative Valuation Theorv: A Useful Partition--Cooperatives have not

adopted net present value analysis of investment alternatives as rapidly as

IOFs (Street, p.1). Perhaps one reason for reticence has been the lack of a

clear theoretical exposition of when and how net present value analysis can

be applied to cooperatives. The unified product capital market theory

developed in this section helps to overcome a major stumbling

block--identifying exactly what it is that observed cooperative cash flows

measure.

When evaluating investments for an IOF, the primary question is whether the

commitment of funds will increase the value of the firm, i.e., increase the

value of the stock stockholders own. Let us begin our analysis of the value

of a cooperative firm to its members by noting that the value of any firm can

be partitioned into two parts, its core value and its global value. The core

value of a firm is the value it would command if it were in a competitive

industry that is in long-run equilibrium. Industry equilibrium price equals

long-run average cost and the firm earns the competitive rate of return.

Global value can be equal to or larger than the core value of a firm. For an

IOF, it is defined to be the long-run equilibrium value of its stock as

determined by the capital market. It is the total amount investors are

willing to pay the for the firm. When an IOF possesses market power, for

example, it can increase its net cash flow by charging prices above long-run

average cost. The global value of the firm increases as investors bid up the

stock price until the rate of return decreases, given the certainty

assumption of this section, to the risk-free interest rate. This is the

equilibrium adjustment mechanism that Fenwick referred to when pointing out

that "no such package" exists for cooperatives.

Turning to the cooperative firm, its global value is similarly defined as the

amount its members-owners are willing to pay rather than do without the

cooperative. The difference is that, for a cooperative, long-run equilibrium

is achieved through adjustments in the product market rather than the capital

market. Moreover, how global value is measured depends, among other things,

on the market structure of the industry and the membership and pricing

practices a cooperative follows. Consider a supply cooperative with an open

membership policy in an oligopoly. The analysis of this type of cooperative

in the previous section indicated that, in equilibrium, it would charge a

price equal to long-run average cost. Long-run average cost includes the

cooperative cost of capital as well as other input costs. As a result, the

net cash margins that remains after paying for other input costs measures

only the cooperative's core value.

Two important corollaries follow. First, the cooperative's reported net

margins, on a cash flow basis, can be used to measure the required return on

cooperative capital. Given the certainty assumption, the issue is somewhat

216
trivial because the required rate is the risk-free interest rate and can be

determined elsewhere. This feature becomes more important when risk is

introduced to the analysis in the next section. The cooperative's required

rate of return then would include a risk premium and be higher than the

risk-free rate. Second, to measure the cooperative's global value, one must

add to cooperative cash margins the increased cash flow to members that

materializes because they pay lower prices than they would if there were no

cooperative in the market. This second component of cooperative benefits is

known as the security return. In general, the

9&

obal value of a cooperative

equals its core value plus its security return.

Now consider a second type of cooperative. A closed membership cooperative

in an oligopoly. Because IOFs do not fear losing customers to the

cooperative, they will continue to charge the shared monopoly price no matter

what the cooperative does. If the cooperative charges the same price as they

do and refunds all net cash margins to members, those net margins reflect the

global value of the cooperative to members.

These two cases make it clear that the observed net cash flows of a

cooperative must be interpreted carefully. Exactly what net cash flow

measures depends on the structure of the product market as well as the

structure and conduct of the cooperative. If a cooperative prices at the

industry price level, has no impact on it, and that price level is above

long-run average cost, net margins measure the global value of the firm to

members. Standard investment analysis procedures are appropriate. A

different approach, however, is necessary when a cooperative has a

competitive yardstick effect, bringing other firms as well as itself to an

equilibrium where industry price equals long-run average cost. Then the

observed net cash flows measure only the core value for the cooperative.

This latter type of equilibrium is the one that requires a different approach

to valuation. Thus attention is focused primarily o

r1

its properties in the

remainder of this section and the following section.

A Sinzle-Period SUDD~V Coonerative Model

To keep the analysis of cooperative finance and investment behavior under

certainty reasonably rigorous,

it is necessaryl5

o specify the structure of

the cooperative and its environment in detail. First the analysis will

be discrete rather than continuous, and it will be for a single period. The

future consists of only a single point one period from now. Thus the

analysis concerns cooperative activity at time to and at time tl. One

might, consider the analysis to be an examination of a cooperative on January

first of two successive years with the cooperative dissolving on the second

date. When mentioning flow variables at a point in time, they will be for

the preceding period. The terms "sales at tll' and "sales during period

tl" are equivalent. Stock variables such as investment will be at point

to or tl.

The cooperative's financial structure is assumed to be as follows.

Investment funds, if supplied by members, are supplied proportional to

planned patronage in tl at time to. One might regard this as a base

capital finance plan. Members provide equity capital in proportion to their

217
planned patronage when they join. Cooperative net margins at t0 are

distributed in proportion to patronage. They are distributed as cash or, if

necessary, they are allocated to patrons' equity accounts to bring their

investments up to the required amount for planned patronage in period tl.

Equity capital invested by members is assumed to earn no interest. There are

no taxes of any sort to be paid by cooperatives or IOFs.

The structure of the cooperative is defined further as follows. It is a

supply cooperative that sells one product in an oligopolistic market, and it

sells only to members. Finally, its transaction price always is equal to the

market price. This last assumption is necessary because the resulting cash

flow identifies the spread between the industry price and the cooperative's

net, operation-at-cost price. If this magnitude is positive, farmers have an

incentive to join the cooperative. This is the adjustment mechanism that

produces cooperative equilibrium. The assumptions of this section are listed

in table 5 for easy reference.

Examining an open membership cooperative in an oligopoly, how does

cooperative equilibrium come about when a new investment is undertaken? One

can use valuation and cash flow equations to specify an equilibrium

adjustment model. In a one-period model the net present value, V. of a

cash stream that pays CC at time tO and Cl at time tl when the risk-free

interest rate is il is

(2) vo - co +

cl

1 + il.

If Co and Cl are cash payments to members of the cooperative, V. is the

value of the cooperative at to.

The cooperative's cash flow equation at to can be written as

(3) X0 + F + B = Co + IO.

The left side of (3) identifies sources of cash at to. X0 is net cash

margins from operations that belong to old members, i.e., those who

patronized the cooperative during to. F is equity funds paid in by new

members who join the cooperative at to. B

taking on debt or selling preferred stock. 13

's the amount of funds raised by

Because certainty is assumed

there is no difference in risk level among member equity and all types of

funds secured from outside sources. No risk premiums are demanded or

offered, so all funds earn the risk-free rate of interest il. The right

side of (3) identifies the cooperative's uses of funds. C is cash paid to

old members-patrons. IO is investment made at to that wilP increase net

margins in tl.

An initial component of the equilibrium adjustment model is an equation that

determines the magnitude of cash paid in by new members at to. F is the

sum of the paid-in capital of M new members. fi in equation (4) is the

paid-in capital of the ith new member:

218
Table 5.--Basic Assumptions for Analysis of Cooperative Price Equilibrium

with Investment

Financial Model Assumntions

1. Certainty.

2. The analysis is discrete rather than continuous in the time

dimension.

3. All economic activities occur at two successive points in time tO

and tl (a one-period model).

4. There are no taxes of any sort.

CooDerative EnterDriSe ASSUIIIDtiOnS

5. Investment is proportional to patronage.

6. No dividend is paid on equity capital.

7. The cooperatives sells only to members.

8. Patronage refunds may be made in cash at to or allocated to

members investment accounts and returned in cash at tl.

219
(4) F - iElfi.

As expressed in equation (5), each farmer's investment is a proportion i of

total investment I,. Equation (6) indicates that Qi is the proportion of

total cooperative sales Sl that the ith member provides. Equation (7)

indicates that total investment equals the level of investment prior to t0,

which is Ip, plus current investment IO.

(5) fi - oi1, where

(6) ai - 2 and

s1

(7) It - Ip + IO.

Each member will receive at tl a cash refund ci, which is the same

proportion CYi of the cooperative's net margins Xl. Because this is a

single-period model, the cooperative is dissolving at tl. No cash is

allocated to investment at that time because there is no future. Thus tota

net margins Xl includes liquidation of all investments, and it equals total

cash refunds to members Cl. A member's dollar return for investment at

t0 and patronage during tl is

(8) ci = aiX1.

Dividing (8) by (5) gives a member's rate of return on investment,

aiXl '1 (9) ;=,_-*

i i t It

Equation (9) indicates the rate of return will be the same for all members

and it will equal the average rate of return of the cooperative. New members

will join the cooperative if the average rate of return is greater than or

equal to the risk-free rate of return. This decision rule can be expressed

as

(10) join if: - 1 1 + il.

It

The investment in the cooperative must earn enough to return the original

amount invested plus interest at time tl. Assuming the cooperative is in

equilibrium at to, i.e., old members have been receiving the risk-free rate

of return on I , a new investment IO that pays a higher rate of return

than il will rgise the cooperative's average return above il. Unless

there is a decrease in the return on the new investment as new members join

the cooperative, cooperative equilibrium is indeterminate. An infinite

number of new members would join. Recalling the analysis of membership

220
changes on cooperative equilibrium in the previous section, the net margins

generated from investment IO

purchased by old members Qy,

is in fact dependent on the quantity of product

members Qy,

the quantity of product purchased by n w

and the market price Pl that prevails during period tl. f4

Because the sum of old and new members' purchases equals total purchases

Ql, net margins at tl are

(11) x1 - Xl(Ql,Pl) where

(12) Ql - Q; + Q;.

As new members join the cooperative, its output in tl increases; this

reduces net margins if the cooperative experiences rising average costs of

production or if rivals respond to the cooperative's gain in market share by

undertaking similar investments and lowering the market price. Either way,

once equilibrium is regained, the cooperative's average return on investment

will have returned to the risk-free rate il. To summarize, this product

market adjustment mechanism is the cooperative analogue to stock market

adjustments in the value of an IOF's stock for regaining equilibrium in both

the product and capital markets.

The Core Value of a Coonerative Firm--If a cooperative prices at long-run

average cost,

market, it is

valuation and

are now clear

both sides of

(13) CC -

as it does when it has a competitive yardstick effect on the

possible to estimate its core value. Returning to the

cash flow equations (2) and (3), the cooperative's cash flow

measures of its core value.

the equation (3) gives

Note that subtraction IO from

X0 + F + B - IO.

Current cash patronage refunds are determined by the difference between

cash inflow and current investment. If F and B are not sufficient to cover

IO' some of X0 will be retained as allocated patronage refunds and cash

patronage refunds will be lower.

The cash flow equation for old members at tl is

(14) C; - Xl(Ql,Pl) - i_lE C i - (1 + il) B.

Old members cash flow equals net margins minus cash paid out to m new members

minus cash that repays outside capital suppliers plus the interest on that

capital. Substituting (13) and (14) into (2) allows an analysis of how the

core value of old member investment Vg in the cooperative changes

when investment IO is undertaken:

221
x1 EC -B

(15) v; - CC + c;

i-1 i

-XC+F+B-IO+

l+i,- 1 + i,

EC

i=l i xl

- xo

- 10+F- +

1 + il 1 + il'

But in equilibrium, the following conditions hold:

m

(16) F = 1 + i and

1

Xl

(17) It = Ip + I() = 1 + i *

1

New members join only if they earn the risk-free rate il or more on their

investment, and in equilibrium all providers of capital earn il. This

establishes (16). Similarly, (17) is based on the fact that in equilibrium

the cooperative's average return on investment will equal the risk-free rate

il.

Substituting (16) and (17) into (15) gives

(18) v; - Ip + XC.

The core value of the cooperative firm to old members equals the prior

investment they have paid in plus the net margins available at to. This

result is so fundamental to the cooperative enterprise structure that its

implications may be overlooked. Any cooperative benefits beyond those

necessary to compensate capital at the competitive rate of return are

distributed via the product market. Also, the financial decisions of

management to go outside for capital, amount B, the decision of m new members

to join the cooperative and provide F in capital, and the split of patronage

refunds between cash and allocated refunds do not affect the core value of

old members' investment. This analysis, however, says nothing about how

investment or financing strategies affect the global value of the cooperative

members. Investment impacts on global value are addressed in a later part of

this section.

A New Insipht on the Alleged Tax Advantage of Cooneratives--The fact that

cooperatives provide no vehicle for capital gains on cooperative investment

sheds new light on the issue of cooperative taxation. Some have decried the

tax status of patronage refunds, claiming that because allocated refunds

escape the corporate income tax, cooperatives receive a hidden subsidy from

the government. This theory can be used to analyze the capital market as

well as the product market aspects of this proposition. Examining the

222
capital market aspects brings to the surface the fact that shareholders in

investor-owned corporations can receive benefits from their investment as

capital gains, which are taxed at the investor level at 40 percent of the

ordinary income rate. But in a cooperative, all benefits a member-investor,

and any marketwide benefits nonmember farmers receive as a result of the

cooperative's impact on price, are ordinary income and taxed accordingly at

the patron level. The capital gains treatment investors in an IOF enjoy

suggests there is less incentive for a farmer to patronize and invest in a

cooperative for tax reasons than heretofore thought. With regard to total

tax treatment, cooperatives actually may be disadvantaged relative to IOFs.

An example can illustrate this. First consider a farmer who buys an input

for $1,000 from a cooperative at to. The cooperative solicits $100 at to

from the farmer for a new investment project and pays the farmer the

competitive rate of return, 10 percent, for use of that money at tl. As a

result, the farmer can buy the input for $800 because of the cost-saving

investment. Because the input costs on the farm at tl are $200 lower, the

before-tax increase in income is $200. If the farmer is in the 40 percent

tax bracket the farmer's after-tax gain is $120 at tl. Discounted at 10

percent to to, this value is $109.

Compare this result to the net wealth gain if the firm were investor-owned

and the farmer purchases $100 dollars of stock at to to finance the new

investment. The IOF continues to charge the farmer $1,000 for the input at

t1. However, the value of the farmer's stock appreciates in the stock

market until the farmer's investment returns the competitive 10 percent rate

of return. That value is computed as follows. The increment to IOF income

is $200. Assuming the effective corporate income tax rate after investment

tax credits and other write-offs is 20 percent, the new cash flow available

to investors is $160 plus the $10 plus the original $100, which equals $270

at tl. Thus the farmer's stock appreciates to $245 ($270 divided by 1.1)

at to and the farmer experiences a capital gain of $145.

Under capital gain taxation rules, 40 percent of this gain is taxed at the

farmer's ordinary income tax rate, which is 40 percent in this example. Thus

the after-tax income gain for the farmer is $122. The farmer increases

income more by patronizing and investing in the IOF than joining the

cooperative.

This tax problem can be analyzed in a more general fashion. Space limits

that option. However, the relative position of the cooperative improves,

ceteris paribus, as the effective corporate tax rate increases and the

farmer's personal tax rate decreases. For some tax rates the cooperative is

preferred over the IOF. This analysis suggests farmers in higher tax

brackets will have less incentive to join a cooperative.

The Case of Unallocated Retained Earnings--How does its retained earnings

policy affect the value of a cooperative firm to members? Retained earnings

are net margins that cooperative management, with approval of the board of

directors, decides to declare as income to the cooperative. Retained

earnings are not allocated to patrons' equity accounts. If the cooperative

does not dissolve while a person is a member, the cooperative never pays the

223
member a pro rata share of retained earnings. Some very different

cooperative groups have advocated the use of retained earnings. Amway, a

very large and professionally-managed farmer cooperative, makes substantial

use of them in its finance mix. Compare this organization to Lambert, one of

the more visionary social philosophers on cooperatives. He argued for

retained earnings financing and for not paying them out to members at

dissolution (p. 63). Lambert and others who would establish a cooperative

commonwealth--an entire economy of cooperatives--have regarded this

dissolution caveat as necessary to prevent current members from dividing up

the accrued capital of previous cooperative members. They have regarded

retained earnings as social capital owned by the group in common. Although

farmer cooperatives that use retained earnings do not regard themselves as

compatriots of cooperative commonwealth advocates, such financial policies do

suggest a community or socialist orientation. A retained earnings program

indeed can be described as voluntary socialism. Cooperative members abnegate

private ownership of cooperative capital at least until cooperative

dissolution, which usually is not a goal of the membership or management.

Cooperative capital is owned in common. To analyze retained earnings in the

one-period model, one must assume they are not returned to members at time

t1. Otherwise they are identical to allocated patronage refunds. For

purposes of analysis, make an additional assumption that will be relaxed

later. Assume that the following relationship holds:

(19)

xl - REl

It

= 1 + il.

The cooperative withholds retained earnings of amount REl at tl so that

the projected average return on investment equals il. As a result, there

is no increase in membership and old members do not increase their output.

Due to (19), F in the cash flow equation (3) is zero. The old members' cash

flow equation at tl is as follows:

(20) C; = Xl - REl - (1 + il) B.

Cash flow to old members at tl qe uals cooperative net margins at tl minus

retained earnings at tl minus payments to bondholders at tl. Substitute

equation (13) into (2) for cash flow to old members at to, and substitute

equation (20) into (2) for cash flow to old members tl. This gives

valuation equation (21) for old cooperative members at to:

(21) v;

xl - REl Xl - REl

-Xo+B-IO+

l+i1 -B

- x0 - 10 +

l+il'

Solving (19) for I, and substituting the result into (21) gives

(22) v; - x0 - 10 + It - x0 + I

P'

224
Equation (22) indicates that the value of the cooperative to old members

equals their prior investment plus net margins available at to. This

result differs from the previous valuation analysis because it now represents

the global value as well as the core value. Because no members receive

retained earnings and because according to (19) the cooperative siphons off

all earnings in excess of the amount necessary to pay a competitive return,

the global value of the cooperative to a member equals the core value. The

retained earnings policy therefore can be used as an alternative adjustment

mechanism to attain cooperative equilibrium. When a cooperative retains less

than the amount of retained earnings necessary for equation (19) to hold,

part of the adjustment to the new equilibrium occurs through price-quantity

adjustment and equation (22) measures only the core value of the cooperative

to old members at to.

Another interesting fact is that if a cooperative decides to retain earnings

above opportunity cost payments, as in equation (19), the value of the

cooperative, defined as the sum of its value to members plus retained

earnings, will vary with investment acumen. Changes in this magnitude

reflect how profitable investments have been. Maximizing this measure will

lead the cooperative to behave as an IOF. In an oligopoly, for example, it

would have no competitive yardstick effect on rival firms, and members would

receive no economic benefits above their opportunity cost rate of return from

the cooperative. This produces the startling conclusion that voluntary

socialism is consistent and can coexist with monopoly capitalism. One

wonders if the cooperative commonwealth philosophers realized that their

grand strategy would have so little impact on private economic power.

Core Value Analvsis of Investments--In many situations, a cooperative's cash

flow to members measures only the core value of the firm. Two important

cases are a cooperative that performs as a competitive yardstick in an

oligopoly, and a cooperative that appropriates all net margins above the

amount necessary to pay members the opportunity cost of capital.

Appropriated net margins are retained as unallocated earnings. What might

one say about cooperative investment analysis in these cases? Consider the

competitive yardstick case first. Using equation (15) and (16), one can

express the core valuation equation as follows:

(23) V; = X0 - IO +

Xl' + AX1

1+i1-

Xl' in (23) is net cash margins at tl without investment IO, and

AX1 is the change in the net cash margins due to the investment.

Rearranging terms gives

Xl'

(24) Vi - X0 + 1 + i

1

ml

+1+i1

- IO.

225
The change in core value with respect to the investment is the last two terms

of (24); and because it was shown earlier that the change in core value is

zero, one obtains

A%

(25) AV; - 1 + i - IO - 0.

1

Stated another way, investment in a competitive yardstick cooperative, as

measured by observed cash flows, always will yield a net present value equal

to zero.

Before commenting on this result, let us consider the case for a cooperative

that uses unallocated retained earnings and seeks to maximize retained

earnings plus the core value of the cooperative to members. Equation (23)

still is a good starting point. However, now the subscripts will be removed

from V to recognize that this is a different valuation problem. Also, the

change in net margins at tl due to the investment is now partitioned into

two parts --the change in net cash margins that is needed to sustain the

competitive rate of return on all cooperative investment AXl' and retained

earnings REl. Thus one has

(26) ml

Substituting (26) into (23), one obtains

(27) V =

The analysis

terms on the

x1 A%' REl

x0 + 1+i1+ 1 + il

- I() +

1 + il.

without retained earnings indicates that the third and fourth

right side cancel each other, so when management seeks to

=AXl' +REl.

maximize retained earnings plus the value of the firm to members, the change

in the value of the firm due to the investment is

(28) AV = I :E; .

1

The increase in value is equal to the net present value of retained earnings.

These results suggest that in competitive yardstick equilibrium, the standard

net present value analysis of cooperative cash flows is useless. The

computation should produce zero net present value for every investment

project. Obviously, what is needed is a measure of global rather than core

value. A supply cooperative in an oligopoly that retains earnings in excess

of the amount needed to pay members the competitive rate of return on equity

capital can use changes in the level of retained earnings to measure the

value of a proposed investment.

~--This discussion illustrates how global

value analysis of cooperative investments can be done. The example analyzed

226
here is an investment that reduces the average cost of producing the

cooperative's product in all levels of output. Farm product market prices

are assumed to remain constant at tl so that benefits

can be measured by areas under the input demand curve. fr

om an investment

Cooperatives must

look to benefit measures of this type as well as cooperative net margins when

the investment affects the farm supply market price level. This investment's

impact on the average cost curve of the cooperative is illustrated in figure

12. The average cost curve prior to the investment AC, accounts for the cost

of the cooperative's prior investment I as well as other factor costs. The

price of that capital is the risk-free gate

been made,

il. Once the investment IO has

the average cost curve shifts down to ACl. This curve accounts

for the cooperative's new investment level, I, - Ip + IO, as well as

other factor costs. Again, the price paid for this capital is the risk-free,

opportunity cost rate il.

The cooperative is in equilibrium before the investment at point A, charging

price Pp.and selling Qp. It has exerted a competitive yardstick effect on

oligopo istic rivals,

price PO.

arcing them down the followship demand curve FIFl to

Net margins are positive only because the cooperative charges the

equilibrium price and distributes the competitive rate of return il to its

equity holders via patronage refunds.

After investment, the cooperative will move to a new equilibrium. Two

possible equilibria are illustrated. They are points B and D. Regardless of

where equilibria is attained, the cooperative's cash flow only will be

adequate to pay equity holders return il

However,

on their capital at time tl.

it is fairly obvious that different equilibrium points produce

different benefits in the form of lower price and expanded quantity of Q

sold. Figure 13 illustrates total benefits to all farmers that use Q, i.e.,

it measures the social welfare value of the competitive yardstick effect.

Although it is assumed that the cooperative is the innovator, this is not

absolutely necessary. Rivals may have adopted the investment and the

cooperative may have moved rapidly to imitate it. Here it is assumed that

they both adopt the cost-saving innovations at time t0. Rivals may or may

not match cooperative price reductions. If they do, the cooperative moves

down followship demand curve FIFl in figure 12 to a new equilibrium at

Membership remains constant but old members expand their use of Q from

:' to Ql. Old members receive benefits over the opportunity cost returns

e&al to the change in their consumer surplus,

Consumer surplus discounted to time tO

which is area PoABPl.

is the net present value of the

investment to cooperative members. If net present value is greater than

zero, i.e., the investment lowers the cost curve, the cooperative should

undertake the investment.

Because the cooperative has played a yardstick role and lowered the market

price, nonmember farmers also benefit. Figure 13 illustrates the total

market demand curve DD for Q. Price has declined from PO to Pl so the

aggregate consumer surplus of all farmers is the area PoMOPl.

Reconsiderinp the Free-Rider Problem in Cooperative Theory--The fact that

total social welfare benefits are greater than the global benefits enjoyed by

227
Figure 12--Measuring member benefits from a cost-reducing investment for an

open membership purchasing cooperative in an oligopolistic industry

DOLLAR

pci

p2

p1

\

-

/

\

\

2

1

Ql Q2 QUANTITY

228
Figure 13--Measuring total benefits from a cost-reducing investment in an

industry

Total Market @amity, Q

229
members has led some analysts to suggest that there is a free-rider problem.

This contention needs to be analyzed carefully. A free rider is an

individual who benefits from a collective action but does not pay his or her

share of its costs. Free-rider behavior materializes when benefits are

nonappropriable. The competitive yardstick effect of a cooperative on market

price is an example of a nonappropriable benefit. All farmers who use the

product sold by the cooperative enjoy it--members and nonmembers alike. Does

the fact some farmers are free riders, i.e., not members of the cooperative,

result in economic inefficiencies? Does it mean members somehow are unfairly

shouldering the cost of ensuring desirable performance? The ghost of Sapiro,

the advocate of industry-wide cooperation, reappears on the scene when these

questions are raised.

Although in specific situations the free-rider problem may lead to

inefficiencies or inequities, in general this is not true. Consider how the

benefits and costs of a cooperative that has a competitive yardstick effect

on the market are distri

!iZ

ted. Members and nonmembers receive benefits from

market price reductions. For members, this is the security value

component of their global value. Members, of course, must provide the equity

capital for the cooperative. This is a cost they bear, but they are

compensated at the market rate of interest. A member would be no better off

if he or she exited the cooperative and invested his or her money elsewhere.

Conversely, a nonmember would be no better off if he or she disinvested

elsewhere in the economy and joined the cooperative.

The example illustrated in figure 12 proves that the free-rider problem is

not a general tenet of cooperative theory. If some farmers join the

cooperative, possibly because of a belief in Sapiroism, the followship demand

curve shifts out to F2F2. The cooperative's market share expands--rivals

react and follow the cooperative to equilibrium at point D. The cooperative

and other firms now charge P2 in equilibrium, which is higher than Pl.

Old member benefits are less, amounting only to area PoAHP2. Total

member benefits are area P,CDP2, which may be greater or less than member

benefits when equilibrium was established at B. Total benefits for all

farmers in figure 13 are measured by area PoMNP2, which is clearly less

than before. Therefore, there is no free-rider problem. In fact, the

cooperative would enhance member and nonmembers alike if it aided another

firm, preferably a cooperative, to enter and serve approximately one half of

its members.

If the cooperative's cost curve is L-shaped, expanded membership does not

raise the price and the cooperative still does not encounter a free-rider

problem. This situation is illustrated in figure 14. Without expanded

membership, equilibrium occurs at B, and member benefits are area

P,ABPl. Total marketwide benefits still are P,MOP

1

in figure 13.

Now, if the cooperative's membership expands to fo lowship demand curve

F F2 before rivals respond,

o 1

equilibrium is attained at point D. Note the

d member benefits and total market benefits are the same as before.

Increasing cooperative membership does not increase total benefits, although

it does internalize more of them in the cooperative. Do these increased

internal benefits mean that the cooperative would now undertake the

investment, whereas it would not have before the membership expanded? The

230
Figure 14--L-shaped cost curve case for measuring benefits from a

cost-reducing investment for an open membership purchasing cooperative in an

oligopolistic industry

231
answer is no because the cooperative would logically undertake any investment

that has positive net present value to old members. Because the cost curves

contain the cash flow necessary to cover the opportunity cost interest

expense of capital, old members will benefit as long as the project reduces

the equilibrium market price of Q. The project has positive net present

value, and it will be undertaken. No free-rider problem exists.

The Public Interest and Public Sunnort of Comoetitive Yardstick

Cooneratives --The results of this section point toward a fundamental

difference between competitive yardstick cooperatives and IOFs. That

difference argues for public policies supportive of such cooperatives if

increased economic efficiency and a more equal distribution of wealth are

desirable. Farming is, on the whole, a competitive industry. Over the long

run, the constant farm market price assumption used in the global value

analysis may not hold. As farm output increases, the prices of farm

products, assuming no government price support programs, will decline.

Benefits will be passed on to downstream firms in the food system. If

downstream industries are competitive and all other factors are inelastic

supply so no rents accrue, consumers ultimately receive all of the benefits

measured by this method. Of course, both of these assumptions often do not

hold in an absolute fashion. Consumers then receive only part of the total

benefit. Nonetheless, compare this result to the performance of an

oligopolistic industry without a cooperative. Most, but not all, of the

benefits of such a cost-reducing investment would flow to stockholders as

increased rents from the shared monopoly. Therefore, cooperatives not only

increase economic efficiency, but they tend to redistribute wealth toward

lower income persons. This may be a desirable result and, if it is, public

support for competitive yardstick cooperatives would help attain it.

Conclusions

To conclude this section, perhaps it is useful to stress that ex post, or

after the fact of investment, one often cannot use the observed cash flows of

the cooperative to evaluate whether cooperative management has made wise

investment decisions. If the cooperative is performing its historic role,

prices and quantities, and possibly membership, will change to ensure that ex

post the net present value of a desirable investment will be zero. Any

positive result would be due to rigidities in the adjustment process to the

new long-run equilibrium. Cooperatives must look to changes in consumer

surplus under the demand curve for its product to evaluate the ex post impact

of investment. Even then, they cannot be certain that all benefits flow to

their members if farm prices change or factors of production are in limited

supply and not owned by members.

Cooperative managers who wish to evaluate investment decisions ex ante,

(before the fact) must forecast where the new cooperative equilibrium will

occur and estimate the resulting benefit streams. As figures 12 and 13

suggest, this is a complex measurement problem for cooperatives. Nonetheless

the problem of forecasting benefits may be nearly as complex for IOFs in

oligopolistic industries. An investment may destabilize the market and cause

prices to decline. Like cooperatives, IOFs must consider these price effects

when measuring cash flows in such industries.

232
In figures 12 and 13, the benefit areas have been made very large. Under

actual conditions, they may be very small and certainly they will be negative

in some areas. These latter investments have negative net present values,

and should not be undertaken. Such borderline cases take an added importance

when risk is introduced to the theory. A cooperative may choose an

investment with positive expected net present value and large variance,

including significant chances of not returning to members the opportunity

cost rate of interest. If a cooperative's investments are this risky,

members will require a return on their equity capital that includes a large

risk premium as well as the risk-free interest rate. This is the issue

addressed in the next section.

Coonerative Eauilibrium

with Risky Investment

What if economics as a theory of efficiency opens up problems requiring

evidence not amenable to academic canons of accurate and absolute

demonstration? What does scientific procedure demand. Scientific

tactics says: "limit the study to evidence about which absolute and

accurate statements can be made." But scientific strategy says "It is

unscientific to exclude any evidence relevant to the problem in hand.

This comprehensiveness is scientific even if it involves some sacrifice

of other qualities for which science likes to strive. (Clark, pp. 74-75)

Introduction

Expanding the theory of the previous section to encompass investments for

which returns are not known with certainty is challenging. Considerable

controversy has been generated concerning the empirical measurement and

testing of the capital asset pricing model which is the starting point for

the theory elaborated here (Roll; Drymes). This section does not intend to

test as well as develop a cooperative capital asset pricing theory, but the

question of the testability and the empirical validity of the approach taken

here undoubtedly is an issue. Clark's admonition on scientific method is

thus appropriate. The focus here is developing a theory. It is admittedly

an exploratory effort.

In an economy where investment income streams are known with certainty, the

required rate of return in equilibrium is the risk-free rate of return. How

does one generalize the concept of a required rate of return to an economy

where investment income streams are not known with certainty?

Knight in his classic book completed in 1927, Risk. Uncertaintv and Profit,

was the first economist to focus on the relationship between the competitive

rate of return and two general states of knowledge about the future. In a

risky situation, future outcomes are not known but the probability that each

particular outcome will occur is known. Gambling on one's ability to pull an

ace from a deck of cards, for example, is a risky situation. Assuming the

dealer has not stacked the cards, one has 4 out of 52 chances of winning.

233
The odds are known. Knight's other general state of knowledge, uncertainty,

exists when it is not possible to compute the probability of particular

outcomes. The probability of a total nuclear war is a good example. One

reason for this is the structure of the problem is not known. Using the deck

of cards analogy, we do not know how many cards and how many aces are in the

deck. Another reason is that, fortunately, we have no prior occurrences of

the event on which to base an esi+mate of its occurrence. The theory

developed below deals with risk.

The Market Eauilibrium Anoroach

It seems plausible that if the level of risk varies among cooperatives, the

required rate of return for capital also would vary. A cooperative with

large swings in net cash flow is a riskier investment. Members would require

a larger risk premium, and this would establish a higher required rate of

return than required from a firm with smaller swings in net cash flow.

Cooperative members that seek to maximize their welfare now maximize expected

utility because cash flows from risky assets are random variables. The

variance as well as the expected (average) return on investment now matter.

Stated another way that is more operational for many analytical queries, the

opportunity cost of member equity investment in a cooperative now consists of

the risk-free rate of return plus a risk premium.

The market equilibrium approach to cooperative finance requires that the

total cash income (net cash flow) for a member farm be partitioned into two

components: cash income from farm operations and cash income from

cooperative membership. Separate degrees of risk usually will exist for each

of these economic activities. Cash income from cooperative membership must

be further partitioned. The total or global income a farmer receives from

cooperative membership is the cash flow he or she would lose if there were no

cooperative in the market place. The core income that the farmer receives is

the actual cash flow he or she would receive from the cooperative if it were

in a competitive industry that is in long-run equilibrium. Therefore, from

the member farmer's viewpoint, his or her cash income has two major

components: income from farming and global income from cooperative

membership. The latter component is further subdivided into core income and

security income just as global value was subdivided into the core value and

the security return in the last section.

Basic Assumntions--The task at hand is to provide a theory that predicts the

required rate of return for cooperative firms and investments in those firms

when they have different levels of risk. To keep the analysis manageable and

consistent with the method of the preceding section, the same assumptions

will be maintained. They are listed in table 5. In addition, it is assumed

the cooperative is an open membership organization.

Assumntions UnderlvinF Asset Pricinp Models --The fundamental insight into

risk management was made by Markowitz. An individual, including a

cooperative member, can avoid a certain amount of risk without any loss in

return by holding a portfolio of diversified assets. Using this insight,

finance theorists have developed two theories to measure the required rate of

return or price for a risky asset: the arbitrage pricing theory (APT) and

234
the capital asset pricing model (CAPM). The assumptions underlying these

theories are listed in table 6. Each will be explained with special concern

for the fact that some of the firms are now cooperatives and some of the

investors are now cooperative members. APT, the most general theory, was

developed by Ross in 1976. Both APT and CAPM rely on the first eight

assumptions in table 6. First, all individuals, now including cooperative

members, maximize expected utility of their wealth or income (changes in

wealth). Second, all individuals, including cooperative members, are assumed

to be risk-averse. Third, all individuals, including cooperative members,

are assumed to have homogenous expectations with regard to the occurrence of

future events.

Fourth, it is assumed, as it has

'la

en throughout this paper, that capital

markets are perfect or efficient. In real markets, this assumption does

not hold because there is a need for financial intermediaries. Banks and

brokers, for example, introduce transactions costs. To cover such costs,

these intermediaries lend funds at a higher rate than the rate at which they

borrow them. When rates multiply because of transactions costs, the capital

market no longer is an efficient mechanism an individual can use to borrow or

lend funds to maximize utility over time. The separation theorem proved

later no longer holds.

Corporate finance theorists commonly recognize that the efficient market

assumption is often violated.

The theory of finance is greatly simplified if we assume that capital

markets are perfect. Obviously they are not. The relevant question then

is whether the theories which assume frictionless markets fit reality

well enough to be useful or whether they need to be refined in order to

provide greater insights into reality. This is an empirical question.

(Copeland and Weston, p. 14)

At this stage, theorists in this area obviously espouse a positive approach

to theory.

The fifth assumption is straightforward for IOFs, given there are no taxes,

as assumed earlier. This assumption is not relevant for cooperatives,

because cooperatives do not generate capital gains.

The sixth assumption, a homogeneous planning horizon, is equally

straightforward. Adding cooperatives and cooperative members to the problem

creates no need for modification in the one-period model. Over a longer

period, the planning horizons of cooperative members may differ. However,

the length of an individual's planning horizon should not be confused with a

member's decision to exit the cooperative. Such decisions may be made at any

time during the planning period. When members exit the cooperative, it is

assumed they receive all monies due them at that time. In fact, many

cooperatives do not redeem equities this promptly.

The seventh assumption, that everyone in the market has the same opportunity

to invest, also requires extra consideration when agricultural cooperatives

are added. Its purpose is to ensure no one can corner the market by

235
Table 6.- -Assumptions Necessary for Estimating the Required Rate of Return

for a Risky Asset: The Abritrage Pricing Theory and Capital Asset

Pricing Model Approachesa

APT and CAPM

1.

2.

3.

4.

5.

6.

7.

8.

Individuals

Individuals

Individuals

probability

The capital

Individuals

maximize expected utility.

are risk-averse.

have homogenous expectations with regard to the

distributions of future returns to assets.

market is efficient.

are indifferent between equal dollar

or capital gains income (because they can always

bonds).

All individuals have the same horizon period; in

assumed to be one period.

amounts of dividend

their shares or

this paper it is

Everyone in the market has the same opportunities to invest although

the amounts invested may differ from person to person.

The stock of risky securities in the market is given, all securities

that were to be issued for the coming period have been issued, and

all firm financial decisions have been made.

Additional AssumDtion for CAPM

9. Individual utility functions are quadratic or the distribution of

assets' returns is joint-normal.

a These have been assembled from Haley and Schall, p. 144, and Copeland and

Weston, chap. 7.

236
excluding investors. As such, it is an extension of the efficient market

assumption. One might think that agricultural cooperatives, and especially

closed membership ones, would violate this assumption. They do limit

membership to farmers who use their product or services. Nonetheless, as

long as the membership can expand or as long as members can expand output,

i.e., there are no quotas or other output restrictions, the investment

necessary to ensure equilibrium at the capital market's level of return for

firms of the cooperatives risk level will be forthcoming.

Assumption eight ensures the problem's boundaries are defined. It does this

by fixing the stock of securities and the financial decisions of the firms.

For a cooperative, financial decisions also include farmer decisions to join

or leave the cooperative, the decision to allocate patronage refunds to

members' investment accounts, and the decision to use unallocated retained

earnings. Given such decisions have been made, the theory analyzes their

impact on the required rate of return and other performance variables.

Assumption nine is required only for the CAPM approach. If utility functions

are quadratic, investors are concerned only about expected value and standard

deviation or variance of their portfolio performance. This means that the

theory can be reduced for trade-offs in these two dimensions. One can obtain

the same attractive feature by assuming that the distribution of asset

returns is joint-normal. The multivariate normal distribution can be

described completely by its first two moments, the expected value vector and

the variance vector. Because all higher moment vectors are zero, it does not

matter whether individuals actually consider them in their utility

functions. They do no vary. Adding cooperatives to the problem requires no

changes to this assumption.

The following analysis focuses on a market economy with two types of firms,

cooperatives and IOFs. Individuals differ in their attitudes toward risk and

the amounts they will be investing, but they agree on the characteristics of

securities available. All individuals are averse to risk and agree on what

constitutes risk. Except for the restrictions imposed by agricultural

cooperative membership policies, individuals can freely invest in any

combination of securities desired and can borrow and lend at the same

risk-free rate of interest.

Comnaring the Arbitrage Pricing Theorv and Caoital Asset Pricing Model--The

essential concept of the arbitrage pricing theory is the market is not in

equilibrium if a portfolio holder can for a given risk level increase his or

her return by redeploying wealth. In equilibrium, no arbitrage opportunities

exist in the market. From this equilibrium condition, one can derive the

required rate of return for each asset as a function of several risk factors

(Copeland and Weston, pp. 211-20).

CAPM is a special case of the more general APT. Under CAPM, the required

return is a function only of risk defined as a single factor that shifts the

value of the market portfolio up and down over time. This is termed

systematic risk. Risk that can be avoided through diversification is called

unsystematic risk. The APT model decomposes the single risk measure of CAPM

237
into several statistically independent subcomponent risk variables. It then

analyzes how asset prices vary as each of these specific risk levels vary.

Empirical studies have found that APT explains observed returns on equities

more accurately than CAPM (Copeland and Weston, chap. 7). From an econometric

standpoint this should not be surprising. A theory that admits multiple

explanatory factors usually will explain more variation than a theory that

relies on a single explanatory variable. However, for the expository

purposes of this section, the focus will be on the single-risk-factor CAPM.

The Capital Asset Pricing Model--Applying a capital asset pricing model to a

cooperative may seem useless. If the asset is equity investment in a

cooperative, its market value does not change over time. Its market value is

its face value. Thus it may seem odd to develop a pricing model for

cooperative equity. The purpose, however, is not to determine the value of

equity. It is to use the CAPM theory to determine the risk-adjusted rate of

return members require on equity investments in the cooperative. Because of

a cooperative's unique business structure, equilibrium is attained through

adjustments in price and quantity in the product market rather than

adjustments to the value of cooperative equity. This difference in

equilibrium adjustment mechanisms does not preclude the measurement of

members' required rate of return. For the reader's convenience, table 7

identifies all of the symbols used in the following analysis.

An approprlate place to begin the analysis of the value of an asset, be it a

firm or an investment project contemplated by a firm, is the definition of

the rate of return rj for an asset in the one-period model. It is

Yl

(2g) rj - VJ - l*

where Yl is the dollar return at tl and includes any cash distributions

made at that time plus the market value of the asset at tl. The tilde will

be used to designate random variables. In equation (29), dollar return at

tl is random so the rate of return also is random. Equation (29) also can

represent a set of assets, i.e., a portfolio.

The current value of the investment, V , is known with certainty so it is

not random. Computing the expected va ue I and standard deviation of rj gives

Yl

(30) rj - 7 - 1 and

j

(31)

OY

(Ij-vj*

Throughout this section a bar over a variable denotes its expected value,

oj denotes the standard deviation of j, and 09 denotes the variance of j.

238
Table 7 .--A Key to Symbols Used in the Analysis of Cooperative Equilibrium

with Risky Investment (Equations (29) Through (53))

Equation

where first

introduced Symbol Definition

(29) r.

J

y1

'j

U.

J

(31)

(32)

(33)

(39)

(40)

(41)

i

X'

um

rm

Bj

2

*m

x

CO

rate of return on jth asset

dollar return of jth asset at time tl

value of_jth asset at time to

standard deviation of jth asset's rate of

return

standard deviation of dollar return of jth

asset

risk-free interest rate

slope of capital market line (CML)

standard deviation of market portfolio rate of

return

market portfolio's rate of return

beta volatility coefficient for jth asset

variance of market portfolio rate of return

risk parameter (slope of capital market line

X' divided by standard deviation of market

portfolio om.

expected net present core value of

cooperative activity during tl

expected net present core value of

cooperative at time to

cash patronage refunds at time to

(Continued)

239
Table 7.- -A Key to Symbols Used in the Analysis of Cooperative Equilibrium

with Risky Investment (Equations (29) Through,(53)) (Continued)

Equation

where first

introduced Symbol Definition

(42) It

IP

IO

(43) on

rC

(44) Xl

Ql

Fl

(45) KO

F

B

(46) Cl

YF

YB

total equity investment in cooperative at time

t0

equity investment in cooperative prior to time

t0

equity investment in cooperative at time to

nth member's share of cooperative sales at

time tl

required rate of return for an investment with

cooperative's riskiness

cooperative's net cash flow at time tl

sales volume of cooperative at time tl

transaction price of cooperative at time tl

cooperative's net cash flow at time to

amount of equity capital provided by new

members at time to

amount of outside financing undertaken at time

t0

cash flow to old members at time tl

cash flow to new members at time tl

cash flow to outside suppliers of funds at

time tl

240
Given assumption 9 in table 6, the only characteristics of portfolios that

matter to the individual are the expected returns and standard deviation (or

variances). Thus one can display capital market equilibrium on a two

dimensional graph as in figure 15. EE' is the efficient frontier.

Portfolios that lie on it are efficient in that they pay the highest expected

return for a given level of risk. Alternatively, they have the least risk

for a given expected rate of return. Inefficient portfolios are located to

the right of EE'.

The risk-free rate of interest i combines with the market portfolio M to

produce the capital market line (CML). The construction of the CML will be

explained in the proof of the separation theorem. First, however, note that

a single portfolio M will be held by all individuals. It may seem

counterintuitive that individuals with different risk and income preferences

hold the same portfolio of securities. The separation theorem proves that it

is not. It states:

The individual's choice of a portfolio of risky securities to hold is

independent (separate) of the individuals attitude toward risk. (Haley

and Schall, p. 132)

To prove this, note the indifference curve sets for two individuals A and B

in figure 15. By construction, indifference curves for an individual cannot

cross. Moreover, given all individuals are risk-averse, each curve has a

concave shape. For individual A, indifference curve IA' indicates a higher

level of expected utility than indifference curve IA' Similarly IB'

provides more expected utility than IB for individual B. Only two

indifference curves for each individual have been drawn, however, each has an

infinite number of such curves, essentially one for each level of

satisfaction. The indifference curve set for each person covers every point

in figure 15, and it is the goal of each person to attain the highest

indifference curve possible. This expected utility maximization goal, along

with the indifference curve set and the boundary of possibilities offered by

the capital market, determines each individual's risk-rate of return choice.

Without access to funds at the risk-free rate i, individuals A and B would

make two distinctly different portfolio choices because their preferences

toward risk differ. The particular portfolio each would choose would be

determined by the tangency of the efficiency frontier with their highest

attainable indifference curve, The location of their indifference curves in

the figure indicate that individual A prefers less risk with corresponding

lower expected returns than individual B.

Access to funds at the risk-free rate i establishes the capital market line.

Individuals can attain an expected rate of return-risk combination on the CML

between i and M by investing a proportion of their assets at the risk-free

rate i and the remaining proportion in the market portfolio M. Individuals

can move up the CML beyond M by borrowing funds at the risk-free rate i to

invest more in the market portfolio M. This financial leverage increases the

expected rate of return as well as the risk. In figure 15 individual A

maximizes expected utility at point A by investing approximately 50 percent

of his or her assets in M and 50 percent in risk-free assets. Individual B

241
Figure 15--Equilibrium in the capital market

5

T

f

m

0

m

0

242
borrows money at interest rate i to leverage his or her funds and attains

maximum expected utility at point B. Note that although their attitudes

toward risk are different, both in their drive to maximize satisfaction

desire to hold only the market portfolio M rather than some other portfolio

such as M'. This proves the separation theorem.

For the capital market to be in equilibrium, all securities must be held by

someone, i.e., they must be in portfolio M. This requirement implies a

pricing process for each security, including equity securities of

cooperatives held by members. If the expected return on a security of an IOF

is too low given its riskiness, more individuals will wish to sell rather

than buy it. The current price (value) of the security will fall until the

expected rate of return as computed with equation (30) equals investors'

required return for a security of that risk class.

The equilibrium adjustment process for a supply cooperative is different, but

it produces the same result. As explained in the previous two sections, when

patronage and the associated investment imply an expected return above that

earned by investments with similar risk levels, demand for the cooperative's

output will expand and the price will fall to reduce the cooperative's

competitive advantage until members earn only the rate of return required for

assets of that risk class. Thus the equity security's net cash flow rather

than its market value changes to reestablish the required rate of return.

The derivation of the asset pricing equation from the capital market

equilibrium condition is reasonably complex, but readily available in

advanced corporate finance texts (Haley and Schall, chap. 7; Copeland and

Weston, chap. 7). The pricing equation,

(SML), for the jth asset is

called the security market line

(32) rj = i + x cov(r

am

-j,rm)

where

r. is the expected price of asset j;

J

i is the risk-free interest rate;

X' is the slope of the CML;

a, is the standard deviation of the market portfolio M; and

is the covariance of the return on j with the return

portfolio M.

Graphically one can represent the SML as in figure 16. Note that the

expected rate of return is not a function of the asset's variance. Because

the unsystematic or idiosyncratic portion of an asset's variance can be

avoided through diversification, only systematic risk as measured by the

covariance term matters.

243
Figure 16--Security market line for jth asset using covariance

r.

J

SML

i

_ -

cov(rjVr,)

244
An alternative form of the SML often appears in t

P%

literature because it

suggests a direct empirical method to compute F..

J

Define the following

volatility coefficient:

I ..,

cov(rj*'m)

(33) Bj a ,2 *

m

Solving (33) for cov(? ,c ), substituting it into (32), and using the

point-slope formula fo1-Rt e slope of a straight line to eliminate X', one

obtains

(34) ;j - i + pj(rrn - i>.

_r. is computable from observed data (Copeland and Weston, pp. 204-g).

14 illustrates this second form of the SML.

Figure

Note when the beta equals one,

the asset has the same risk as the market portfolio. As a result, the

expected rate of return on j equals the expected market rate of return in

equilibrium. If the beta is greater than one, the jth asset is more volatile

than the market and its rate of return is higher. The converse holds for a

beta less than one.

Deriving the Valuation Eauation--The CAPM enables a parallel examination in a

risky world of the valuation, finance, and investment issues covered in the

previous section under certainty. The first step is to derive the valuation

equation for a risky asset. Equating equations (30) and (32), one obtains

I -

y1

(35) - - 1 - i +

X' COV(rj , rm)

'j *m

Substituting equation (29) for Ej into (35) gives

y1

(36) - - 1 = i + $m y1 -

vj

cov(- - l,r,).

vj

Because Vi and 1 are constants, the covariance term simplifies to

J

y1 cov(Yl,rm)

(37) cov(- - l,r,> - .

“j “j

Substituting (37) into (36) and solving

- -

(X'/a,) cov(Yl,r,)

(38) Vj - Yl l+i ’

for Vj gives

245
Figure 17- -Security market line for jth asset using beta

r.

J

SML

i

B

246
The standard deviation of the market, am, is a constant in equilibrium.

Therefore, one can define a new "price of risk," X - X' / a,. Also,

dropping the subscript j, one obtains the following general equation

valuation equation;

yl x cov(Yl,rm)

(39) V = l+i -

l+i *

Note that if the covariance between an asset's period one income P and the

market rate of return is zero, the valuation equation reduces to t&e first

term. Such an asset is equivalent over time to a risk-free investment. No

risk premium is subtracted from the net present value of its expected return.

Alternatively Pl - X cov(P,,r,) is the-cash or certainty equivalent of the

random cash payment P,.

Aoplvinp CAPM to Cooneratives: The Core Value of an Onen Membership

Coooerative- -The general valuation equation can be used to analyze the core

value of a cooperative. As explained in the previous section, if we are

examining an open membership cooperative and the cooperative prices at the

industry level, the cooperative's observed net cash flow can be used to

determine the cooperative's core value. That example is continued here.

Assume that at tl the cooperative liquidates by paying a cash patronage

refund Cl to old members. It is a random variable. Old members are members

who were members during tO. Also assume that the cash patronage refund at

t0, CC' is known and has been paid. Then the expected net present core

value to old members at to

dissolution at tl, Vy, is

of the cooperative's activity during tl and

I e

Cl

(40) v; = --

cov(Cl,r,)

x

l+i l+i -

The total expected net present core value of the cooperative to old members

at to is

(41) V; - co + v;.

It is the sum of current patronage refunds plus the expected net present core

value of period tl activity and dissolution.

To establish cooperative equilibrium in a risky environment, recall from the

previous section the analysis of potential member's decision to join the

cooperative. Briefly, total cooperative investment is the sum of previous

investment plus current investment:

(42) It - Ip + IO.

The nth new member will receive anCl as cash patronage refund for an

investment of anIt. an is the patron's percent of cooperative volume

in period one. A potential member will join if the expected return on

247
cooperative investment is greater than or equal to the required rate of

return for an investment of the cooperative's risk level f,, that is,

_

anC1 '1

(43) aI - - 1 1 + rc.

n t It

In this example, because there is no investment in tl and the cooperative

dissolves at tl, period one cash patronage refunds cl equal period one

net cash margins plus any cash received at dissolution Xl. Moreover, the

cooperative equilibrium process implies that

(44) Xl = X1(61,&).

Period t0 cash flow is known with certainty and can be written as follows:

(45) CO - X0 - IO + F + B.

CO is current cash patronage refund. X0 is current investment. F is the

amount of capital provided by members that join at t . B is the amount of

outside financing undertaken at t0. Because risk exysts, B could be bonds,

other long-term debt, or more risky preferred stock.

Cash flow at tl is a random variable and given there is no investment, it

can be written as

(46) Xl = Cl +YF+GB.

cl is the random cgsh flow to old members, YF is the random cash flow to

new members, and Y is the random cash flow to outside suppliers of funds.

A random cash flow to outside suppliers of capital is appropriate because

most cooperatives borrow at floating interest rates.

cash patronage refunds gives

Solving for period tl

(47) Cl = Xl - YF - YB.

The expected cash flow at tl is

(48) cl - Xl - YF - YB.

Substituting (48) and (47) into the general valuation equation (40) and

simplifying, using the additive property of covariance, gives

(49) v; =

x1 - x cov(xl,;m) YF + cov(YF,im) YB + cov(GB,;m)

l+i l+i - l+i *

The expected net present core value at t

period tl and its dissolution at t

E;

to oP

of the cooperative activity in

d members is composed of three

parts: the net present value of t e certainty equivalent of cash income,

minus the present value of the certainty equivalent of payments to new

248
members, minus the net present value of the certainty equivalent of payments

to outside suppliers of capital.

Equation (49) can be further simplified by noting that the raising of outside

funds and new decisions to join occur in markets that are in equilibrium.

Thus the net present value of expected bond repayment plus interest equals

the amount of outside funds raised, B. Market equilibrium also combines with

equation (43) to establish that the net present value of expected cash

patronage refunds to new members equals the amount of capital provided by new

members, F. Therefore, equation (49) can be rewritten as

(50) v; =

Xl - cov(Xl,r,) - F - B

l+i

The total expected net present core value of the cooperative to old members

at to is now obtained by substituting (45) and (50) into (41) to obtain

(51) v; - co + v; - x0

Xl - x cov(xp;,)

- IO +

l+i *

In cooperative equilibrium, another relationship holds:

” _

(52) I,

x1 - X cov(Xl,r,)

= Ip + IO -

l+i -

Total investment in the cooperative earns only the competitive rate of return

for assets of that risk level. Therefore, the old member

equation reduces to

(53) v; - Ip + x().

The expected net present core value of the cooperative to old members equals

core valuation

the sum of prior investments I

margins X of the cooperative. P

made by old members plus the current net

Q

This result corresponds to the result

obtained In the certainty case analyzed in the previous section. There the

actual value of the cooperative to old members was equal to prior investment

plus current net margins.

Risk-Adiusted Discount Factors for Cooperative Investmont Analvsis--The

analysis of changes in global value arising from a cooperative investment

given risk also corresponds to that of the certainty case presented in the

previous section. It will not be generalized here because kt adds little new

insight. The CAPM approach does, however, provide a measure of the

appropriate discount factor for a proposed investment. It also can be used

to measure members' required rate of return on cooperative equity. The

security market line identified in equation (34) and figure 17 provides

answers. If the jth asset is a proposed cooperative investment, one would

proceed as follows. First, estimate the investment's beta. Then estimate

249
the SML of figure 17 and employ it to determine the required rate of return

on an investment of the proposed investment's risk level. If the jth asset

is the equity capital of the cooperative firm, this procedure gives the

members' required rate of return.

An important result of this approach is that two investment projects with

different levels of risk will have different risk-adjusted discount rates.

The traditional weighted average cost of capital (WACC) approach does not

adjust for different levels of risk associated with projects. It computes

one discount rate for a firm by weighting the required return for each type

of security by the proportion of total assets. If 75 percent of the firm is

financed with debt bearing an interest rate of 10 percent and equity capital

which requires a 20 percent return accounts for the remaining 25 percent of

assets, the weighted average cost of capital is

(54) WACC = .75(10) + .25(10) = 12.5%.

This discount rate is then used to evaluate all investment projects. This

approach is only acceptable if the proposed investments have the same risk

level and that risk level equals the current risk of the cooperative firm

(Haley and Schall, p. 177). In general, WACC is no longer considered to be

an appropriate method for adjusting investment analysis for risk.

Unallocated Retained Earnings Given Riskv Investment--The analysis of

unallocated retained earnings in a risky environment produces results that

correspond closely to those derived under certainty in the previous section.

A cooperative that retains all net margins in excess of the amount necessary

to meet the required return of security holders will provide members an

expected net present core value equal to prior investment I plus current

net margins X0. As in the prior analysis, this also will bg the members'

expected net present global value. The cooperative can evaluate investment

performance by noting how the amount in the retained earnings account

changes.

Under risk there is, however, one additional possibility for the

cooperative. If one assumes in the one-period model that the cooperative had

unallocated retained earnings at to, it has an extra degree of flexibility

when determining cash flow to members at tl. It can manage the benefit

flow to members, but because unallocated retained earnings are finite, the

cooperative cannot raise the cash flow to members permanently in a

multiperiod model. This suggests three testable hypotheses. First, a

retained earnings cooperative might use a buffer stock approach, drawing down

retained earnings in bad years, and adding to them in good ones, to reduce

the riskiness of the cooperative's payments to members for equity capital

furnished. The member's required rate of return on equity capital could thus

be lowered. A retained earnings cooperative could conceivably reduce beta to

zero so members would be satisfied receiving the risk-free rate of return.

In a multi-asset, efficient capital market, however, this type of

manipulation of the required rate of return may not increase members'

expected utility.

250
A second hypothesis is: Cooperatives that have accumulated a pool of

unallocated retained earnings would have more stable patronage refund streams

with, on average, a lower cash refund value than comparable cooperatives that

do not have and use retained earnings as a buffer stock. Lowering the

required rate of return also suggests these cooperatives would find more

investment projects with positive net present values. Retained earnings

cooperatives that buffer refunds may expand more rapidly than other

cooperatives.

Future Research

The theory presented in this paper is very abstract. Some may reject it out

of hand because its assumptions strip away many of the "real" world features

of cooperative pricing and finance methods. Yet for progress in the theory

of cooperative enterprise activity, perhaps more research on specific pricing

and finance methods should be conceptualized within the context of the linked

product and capital market equilibrium theory developed in this paper. In

fact, this paper suggests several fruitful avenues for research. The price

output models of the second section can be seen as the core of a set of

strategic planning models. They can be expanded by incorporating other

internal organization and policy features to complement the pricing

membership and retained earning features analyzed here (Cotterill 1987).

Specific cooperative finance plans such as the revolving fund or base capital

plans could be incorporated to produce a more detailed model of price and

finance. This would require a more complex multiple-period model. Adding

corporate and personal income taxes also would produce more refined results.

Ultimately this work could lead to empirical testing and measurement of the

parameters in these models.

Applied research along this avenue could provide cooperatives with

operational strategic planning and investment analysis models that

incorporate risk. Members' required rates of return could be estimated.

Managers and directors as a result should be able to improve cooperatives

performance.

The theory suggests several ways to evaluate the performance of cooperatives

that use tax-paid surpluses such as retained earnings or income from

nonpatronage business units. Comparing their performance to cooperatives

that use other types of financial strategies might provide useful insights.

The theory also generates insights that can serve as the basis for antitrust

analysis of cooperative activity and for member education on strategic

pricing and financial issues. Certainly this type of information would be

useful.

Notes

1. The work of Helmberger, and Helmberger and Youde on market impacts,

especially the relationship between cooperative membership policies and

the ability of marketing cooperatives to raise price to members is a

notable exception, as is the 1977 NC-117 monograph Agricultural

Cooneratives and the Public Interest.

251
2.

3.

4.

5.

6.

7.

a.

9.

10.

11.

12.

Except for the first principle, which is curiously omitted, these are

from Abrahamsen, p. 48.

See Berle and Means for a classic discussion and Cotterill (1987) for a

recent analysis of this subject in IOFs. For a discussion of the same

concerns for cooperatives, see Vitaliano and Condon.

It is worth noting that there is a difference between the political

process in an organization such as a cooperative and a country. A

member can exit a cooperative, but a citizen cannot exit a country very

easily. Citizens essentially have only the voice option.

Later Robotka (1957) retrenched toward Emelianoff's view of

cooperation. This revision was in response to Phillips's rigorous

theory of a cooperative as a "joint economic plant" operated by members

of a cooperative association without a central coordinating agent.

See Ladd for an example of this approach. His bargaining cooperative

seeks to provide services including political representation of farmers'

interests as well as to raise the prices that farmers receive.

Royer's criterion is the same as Enke's, which is the sum of producer

surplus and cooperative net margins, because producer surplus and

profits from farm operation are identical.

Recall that for the interim we are assuming that members purchasing

behavior is not a function of patronage refunds. When this assumption

is later relaxed, this pricing rule no longer produces maximum welfare.

If the long-run average cost curve is flat at the point of intersection

with the demand curve, price also equals long-run marginal cost and we

have an exact duplication of the properties of long-run competitive

equilibrium.

One also can measure the total social welfare value of the cooperative

by including the net gains in consumer and producer surplus throughout

the economy. One component of this is gains that nonmember farmers

enjoy because of the yardstick effect of the cooperative rival IOFs.

Core and global value are critical for cooperative investment decisions;

total social welfare value is not.

One may be able to view these two approaches as valid for the end points

of a price-cost spectrum that has the shared monopoly margin as one end

and the competitive price-cost margin (zero) as the other extreme. When

the equilibrium price-cost margin settles between these two values, the

cooperative has had a partial competitive yardstick effect and the

resulting net cash flow measures neither the global nor core value.

Cooperative investment analysis is even more challenging if this is the

case.

This specification and the related mathematical analysis follows Haley

and Schall. I also have tried to follow their notation. Reading

252
13.

14.

15.

16.

17.

18.

19.

chapters 1 and 2 of that book may be helpful for readers who are

unversed in mathematical finance models.

F and B are stock variables that occur at to. They could have zero

subscripts, but because this is a one-period model, no new member equity

or new debt is contemplated at time tl. As a result, there is no need

to distinguish between transactions at to and tl, so no subscripts

are used on F and B. Also, it is assumed, without loss of generality,

that prior investment is net of any prior bond financing. Only current

financing decisions are analyzed.

Changes in the cooperative's unit cost structure are implicitly included

because they occur as purchase volume Ql changes.

Cases where farm product prices remain unchanged after a cooperative

lowers an input price may not be uncommon. If the cooperative operates

in one of several production areas, the production response to lower the

cooperative input price may not affect the national market price of the

farm product. On the other hand, if farm product prices adjust

immediately to the input price, benefits over the opportunity cost of

capital are passed on to others in the food system. If all downstream

industries are competitive then consumers and the owners of productive

factors in less than perfectly elastic supply are the ultimate

beneficiaries. High quality farmland, for example, is not in elastic

supply so returns to it would be higher in equilibrium and its owners

would benefit.

Recall it is assumed that members purchase at the cooperative and

nonmembers purchase from IOFs.

See Vickers for an iconoclastic attempt to develop a theory of profit

that deals with uncertainty.

See Copeland and Weston, chaps. 1, 9, and 10, and Haley and Schall,

chap. 14, for further explanations of what an efficient capital market

is and evidence as to how lack of efficiency can be controlled in these

models.

Using the model to compute required rates of return is different than

testing the model to establish its validity.

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