RCOOPERATIVES u

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The

Nature of the

Cooperative

The

Nature of the

Cooperative

A reprint of five articles

by K. Charles Ling

The

Nature of the

Cooperative

A reprint of five articles

by K. Charles Ling

A reprint of five articles

by K. Charles Ling

R

u

r

a

l COOPERATIVES

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These five collected articles authored by USDA Rural Development agricultural economist K. Charles Ling were orginally

printed in the Rural Cooperatives magazine to examine the nature of cooperatives and their place in our free-market economy.

“What Cooperatives Are (and Aren’t)” (Nov./Dec. 2009) and “What Cooperatives Do” (March/April 2010) explain the

economic structure of cooperatives and their role in the marketplace. Together, they examine the economic theory of

cooperation as advanced, respectively, by Ivan V. Emelianoff and Edwin G. Nourse. These writings constitute a

comprehensive framework for understanding cooperatives. The third article, “Dairy Cooperatives: What They Are and What

They Do” (March/April 2011) looks at dairy cooperative practices to illustrate how well the theory fits reality, and vice versa.

“How Co-ops Do It” (Nov./Dec. 2011) analyzes marketing operations of dairy cooperatives as a means of understanding the

economics of co-op marketing. The final article “The Nature of Cooperatives” (Jan./Feb. 2012) attempts to show how

cooperatives relate to other market participants through their roles in transaction governance.

Topics discussed here are examined in greater detail in the following research reports:

n Co-op Theory, Practice and Financing: A Dairy Cooperative Case Study (USDA RBS Research Report 221, April 2011);

n The Nature of the Cooperative: A Dairy Cooperative Case Study (USDA RBS Research Report 224, forthcoming).

Cover photos: sugarbeet grower courtesy American Crystal Sugar; dairy farmer courtesy Darigold.

Foreword

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Cooperative Information Report 65

February 2012

United States Department of Agriculture
The Nature of the Cooperative 3

By K. Charles Ling, Ag Economist

Cooperative Programs

USDA Rural Development

any factors are converging to bring new

attention to the cooperative business model.

Discussions about a possible role for co-ops

as part of national health-care reform and an

explosion of interest in local foods, farmers

markets and community-supported agriculture and fisheries

— which often employ co-op business models — have added

to this attention.

During the past 10 or 15 years, we’ve also seen many

experiments with variations on the traditional co-op business

model, as have occurred with some new-generation

processing co-ops and producer-owned limited liability

corporations (LLCs), including those involved in renewable

energy production. As such, it is timely to take a fresh look at

what a cooperative is and how it differs from an investorowned business.

Emelianoff’s definition

A concise definition of a cooperative by Ivan V. Emelianoff

— in explaining the economic structure of cooperative

What Cooperatives Are (and Aren’t)

Economist says co-ops represent the aggregates of economic units

Graphic by Stephen Thompson

M
associations about 70 years ago — remains refreshingly clear

and applicable today. His work marked the beginning of a

new era in the development and evolution of cooperative

theory. The narrative of ideas presented in this article is

primarily drawn from Emelianoff’s book, and will hopefully

shed light on the nature of cooperatives.

In Economic Theory of Cooperation, Emelianoff carefully

reviewed the worldwide literature on cooperative theory from

the late 19th century until 1939. He came to the conclusion

that for economic analysis of cooperatives, the economic

structure of cooperative organizations should be clearly

defined, and that the definition should be free from the

encumbrance of sociological, legal, technical, socialphilosophical and ethical considerations.

Against this backdrop, Emelianoff established this

definition: “Cooperative organizations represent the

aggregates of economic units.” While that is more “bare

bones” than many definitions of cooperative, it crystallizes

the essence of what cooperatives should have in common.

“Aggregate” is commonly defined as: “Any total or whole

considered with reference to its constituent parts; an

assemblage or group of distinct particulars massed together.”

Further, as defined by Emelianoff: “An economic unit, or

economic individual, is an economic body admittedly

complete and sufficiently integrated for individual existence

and independent (in conditions of an exchange economy —

interdependent) economic functioning.”

Co-ops as aggregates of farms

In the agricultural context, farms are such economic units.

The nature of cooperative associations as aggregates of

member-farms is clearly discernible in the embryonic forms

of such associations. For example, a buying club of farmers

may want to purchase certain goods together, such as

fertilizer.

The buying club would have someone take orders from

member-farmers and place orders with a vendor, as well as

perform other related chores. If the vendor requires a

deposit, members may advance money to the buying club for

the deposit requirement in proportion to their respective

buying volume.

There may be an elected committee to facilitate decisionmaking if the number of members is large. Members may

each have one vote if their purchasing volumes are about the

same. Otherwise, some form of proportional voting may be

adopted to conciliate large-volume members.

When the fertilizer (for example) is delivered, members

pay the balance of their obligations. After the transactions

have been completed, payment to the vendor and other

expenses are subtracted from the sum of money paid by

members. Any surplus is returned to members in proportion

to the volume of fertilizer they have purchased.

This buying service is conducted at cost; every aspect of a

member’s transaction through the buying club is in

proportion to their patronage (buying) volume. The buying

club may be disbanded after fulfilling its joint-buying

purpose.

This scenario shows that the buying club represents the

aggregate of its member-farms, through which they purchase

fertilizer. If the buying club metamorphoses into a permanent

purchasing cooperative association, the picture may look

more complicated. However, the underlying nature of the

cooperative as an aggregate of member-farms remains the

same.

Making it permanent

In this new scenario, the person who manages buying

orders and other chores will be the manager of the

cooperative (usually a hired professional). The committee of

members becomes the board of directors. Advanced payments

by members to the cooperative become equity capital for

financing the operation and for carrying inventories and

owning facilities.

Year-end surplus is returned to members as refunds in

proportion to patronage volume, but a portion may be

retained as revolving capital. The principles of

proportionality and service at-cost remain intact, but their

practices may be less evident because the operation has

become more complex.

Although the above example is based on purchasing

cooperatives, the same line of reasoning also applies to

marketing cooperatives. The difference between purchasing

and marketing cooperatives is: instead of procuring goods, a

marketing cooperative markets products produced by

member-farms.

In either case, the member-farms coordinate their

activities through the cooperative, but each fully retains its

economic individuality and independence.

A cooperative may be described as a center of memberpatrons’ coordinated activities, or as an agency owned and

controlled by members through which they conduct their

business. In this respect, it is identical with the special

departments or branches of single member-farms.

For example, a dairy cooperative is the collective

marketing arm of its member dairy farms; a farm supply

cooperative is their supply purchasing department; and a

livestock-genetics cooperative is the breeding service branch

for its members. As some would say: a cooperative is an offfarm extension of the farming business.

Characteristics of co-ops

Being aggregates of member-farms, cooperative

associations have these characteristics in common:

a) The equity capital of a cooperative is the sum of

advances needed for financing anticipated

transactions of individual members of the

cooperative; it is not the same as the entrepreneurial

capital of an investor-owned corporation.

4 The Nature of the Cooperative
b) The member-owners of a cooperative are

independent farmers who have chosen to coordinate

certain activities via a cooperative. They are not the

same as the stockholders of an investor-owned

corporation, who are a diverse set of shareholders

joined solely by common investment.

c) The surplus or deficit of a cooperative is the account

payable to, or receivable from, the member-patrons

of the cooperative on their current transactions; this

is not the same as the profit or loss of an investorowned corporation.

d) The sum for patronage refunds to members is the

sum either underpaid (overcharged) to the members,

or — in case of a deficit — overpaid (undercharged)

to members on their transactions through the

marketing (or purchasing) cooperative; the sum for

patronage refunds is not the profit of the cooperative

or its income.

e) The dividend on capital, if any, does not represent a

profit or any income of the cooperative; it is the

interest payment for using capital advanced by

members. By contrast, investor-owned corporations

pay dividends to shareholders out of earnings.

f) All the economic functions of a cooperative are

ultimately the economic functions of the memberfarms performed through the cooperative as their

collective branch or collective department.

Therefore, all economic services of cooperative

associations are performed at cost.

Emelianoff emphasizes: “None of such traits can be

unreservedly used as an unerring test of a truly cooperative

organization, since these traits only indirectly disclose the

economic character of the cooperative aggregate....The only

comprehensive and indisputable test of the cooperative

character of organizations is their aggregate structure.”

Unique aspects of co-ops

The unique aspects of cooperative character, however, are

often not readily apparent. There are many reasons for this,

some examples being:

• Cooperatives only reflect the characters and aspirations of

their membership, which are diverse and manifest the

diversity of the population, the geographical regions and

the commodities involved. Such differences directly, or

indirectly, have a certain bearing on the character of an

association and its cooperative ideals. The variability of the

external characteristics of cooperatives is kaleidoscopic and

infinite. Differences in their external and superficial

features obscure cooperatives’ ultimate economic character

of being aggregates of their member-farms.

• Most cooperatives are incorporated. The legal vestments of

incorporated cooperative associations also cloak their

economic structure as aggregates of member-farms to such

a degree that they are often mistaken to be the same as

investor-owned corporations. This is one of the principal

sources of confusion in understanding cooperative

organizations.

• A lack of distinction between the concept of an investorowned corporation as a profit-seeking economic unit and

the concept of a cooperative as an agency of its member

farms is another factor that confuses many. Use of common

accounting terminology for both business models adds to

this confusion. As the above list of co-op characteristics

shows, such conventional terms as “profit,” “capital,”

“shareholders,” “dividends,” etc., should be used with

reservations when describing cooperatives.

• In governance, a cooperative board of directors —

including its board election rules, composition, function,

responsibilities and interaction with management — is not

the same as the board of an investor-owned corporation

(especially the publicly traded ones). Consequently, the role

of the top manager of a cooperative is also somewhat

different from that of an investor-owned corporation (even

if they have the same title).

Emelianoff’s conclusion that cooperative organizations

represent the aggregates of associated economic units

provides a clear insight into how cooperatives organize and

function. This insight is not limited to agricultural

cooperatives.

A unique mode of organizing coordination

In a paper dealing with the issue of economic coordination

some 45 years later, James Shaffer echoed (though without

citing) Emelianoff’s definition of cooperatives as aggregates

of member-farms. Because member-farms are independent

entities, represent independent profit centers and act

independently, except that they jointly own the cooperative,

the cooperative association is neither a horizontal integration

of its member-farms nor a vertical integration between

member-farms and the cooperative. He asserted that “the

cooperative is a third mode of organizing coordination.”

References:

Emelianoff, Ivan V. Economic Theory of Cooperation:

Economic Structure of Cooperative Organizations, Washington,

D.C. 1942 (litho-printed by Edwards Brothers, Inc., Ann

Arbor, Michigan), 269 pages. (A reprint by the Center for

Cooperatives, University of California, 1995, may be accessed

at: http://cooperatives.ucdavis.edu/reports/index.htm.)

Shaffer, James D. “Thinking About Farmers’

Cooperatives, Contracts, and Economic Coordination,”

Cooperative Theory: New Approaches, ACS Service Report

Number 18, U.S. Department of Agriculture, Agricultural

Cooperative Service. July 1987, pp. 61-86.

American Heritage Dictionary of the English Language,

New College Edition, Houghton Mifflin Company, Boston,

1976. n

The Nature of the Cooperative 5
By K. Charles Ling, Ag Economist

Cooperative Programs

USDA Rural Development

charles.ling@wdc.usda.gov

Editor’s note: This article is a sequel to

“What Cooperatives Are (and Aren’t),”

Rural Cooperatives, Volume 76, Number

6, November/December 2009.

he year 2012 has been

declared by the United

Nations General

Assembly as the

International Year of

Cooperatives in order to highlight the

contribution of cooperatives to socioeconomic development worldwide.

That same year also will be the 90th

anniversary of the publication of

“Economic Philosophy of Cooperation,” the first academic paper on

the theory of cooperation, published in

the American Economic Review (Nourse,

1922; Hess). The piece was written by

Edwin G. Nourse, who later became

the first chairman of the Council of

Economic Advisers, Executive Office of

the President, 1946-49.

This may be an opportune time to

review Nourse’s ideas on cooperation

and see if they have relevance to the

reality of the market performance of

cooperatives today and, therefore, if

they deserve to be relearned.

Nourse’s primary focus, along with

the oft-quoted “brief remarks” he made

years later (Nourse, 1945), was on the

role agricultural cooperatives played in

the marketplace. This arose from his

observation that the attempt to apply

the cooperative form of organization to

economic needs and problems in

agriculture was critically important.

Purposes of cooperation

The following examples are taken

from Nourse’s paper to illustrate how

farmers organize cooperatives to

perform various market functions

jointly and efficiently in various market

situations — functions that cannot be

satisfactorily carried out alone by

individual farmers:

1) Cooperation for market access — An

example is a small fruit-producing area

far from any large market. The product

is perishable, hence both risk and

marketing expense are high. Volume is

not large enough to attract a private

distributor. Facing this situation,

producers have the option of organizing

a cooperative association to market

their products. These cooperatives have

frequently demonstrated the ability to

achieve successful results where private

outside entrepreneurship fails to

perform.

2) Local to regional coordination — A

local cooperative creamery may initially

be effective in meeting the competition

of other small, private creamery

operations. However, when competing

creameries have grown to be entities of

great size, the competition must be met

by a distributing organization of equal

scope. This will often be achieved

through federation of the cooperative

creameries across a region which may

embrace an entire state, several states or

parts of a state.

3) Region-wide associations — In many

instances, growers in horticultural

regions have organized and integrated

highly efficient businesses that serve

producers across an entire production

region by assembling, processing and

6 The Nature of the Cooperative
distributing their products. These

agencies have eliminated wasteful

competition both at the local shipping

point and at the central markets.

Further-more, they are the instruments

of the producer and owner of the

goods, and hence are likely to be more

aggressive in the effort to reduce

expense and wastage in the handling

process and to improve quality and

enlarge outlets.

(Author’s note: Cooperative

organizations covering entire

production regions have been most

prevalent in California because of the

characteristics of the state’s economic

geography. This type of cooperative

organization was called “the California

plan” and was promoted on a national

scale in the 1920s by Aaron Sapiro, with

varying degree of successes and failures

(Sapiro; Larsen, et al).)

Countervailing power

The above examples show how

cooperatives are organized and grow to

enable farmers to exercise “countervailing power” in the market-place,

although the term was not coined until

the 1950s when economist John

Kenneth Galbraith cited the type of

cooperatives made famous by Sapiro as

an example for his explanation.

Nourse certainly recognized the

importance of countervailing power if

cooperatives are to have a strong

market position. As he stated: “Possibly

the keynote of the philosophy lies in the

idea that a means must be found for

giving agriculture a type of organization

whose productive and bargaining units

respectively will expand in step with the

growing needs of the agricultural

techniques (and its accompanying

capital demands) and of the size

requisite to an effective bargaining

position in contact with the units of

commercial organization with which

they must deal.”

Pro-market

Nourse said that the theoretical

implication of agricultural cooperation

“is preeminently that of functional

reorganization rather than

comprehensive economic regeneration.”

In other words, the farmer takes the

essential facts of the market as given

and, working together with other

producers through the cooperative,

seeks to be in the most effective market

position to compete. Thus, the

distinctive economic philosophy of this

business form is viewed “as a means to

improve the lot of both farmer and

consumer by improving the efficiency

of the economic machine.”

Cooperatives enable farmers to

effectively compete in the marketplace

and garner market signals that put them

in a position of prompt and sensitive

response to the reaction of the

consuming public and guide their

farming business decisions. According

to Nourse, the cooperative objective is

twofold (Nourse, 1945):

1) “It is to make the most

economical and efficient market

channel by which whatever volume of

product farmers see fit to produce gains

access to the attention and the

purchasing power of all who might use

such a product. (For supply-buying coops, most economical access to the best

sources of the goods they need.) Thus,

a true supply-and-demand price is

allowed (and aided) to express itself for

the guidance of producers.”

2) “It aims to reflect these market

conditions back most promptly and

fully to producers in ways that will both

guide and, so far as possible, assist them

in changing their methods so as to

continue production and to prosper or

to shift to more suitable lines of

production.”

Competitive yardstick

In Nourse’s view, the cooperative is a

means for promoting and maintaining

competition in the marketplace. The

supply-demand-price dynamic

“provides a powerful stimulus to the

association to devise further economies

of method which will enable them to

maintain the level of net returns to the

grower. Such competition also spurs the

private agency to outdo the cooperative

in its efficiency in order to hold its

business.”

He used the term “yardstick” years

Marketaccess,countervailingpowerandyardstickrolesenhanceeconomicefficiency

The Nature of the Cooperative 7
later (Nourse, 1945), when he said the

place for the agricultural cooperative in

the nation’s business “is primarily that

of ‘pilot plant’ and ‘yardstick’ operation.

Its objective is not to supersede other

forms of business but to see that they

are kept truly competitive.”

The cooperative is to “occupy

certain strategic points, and there to set

a plane or pace of competition which

will assure for the farmer efficient

service at true long-run cost.” When

such services (manufacturing,

distributing, transporting, financing,

etc.) are furnished efficiently and

economically (which means in a truly

competitive manner), “there is no

occasion for the farmer to occupy the

field and divert some of his capital and

some of his managerial time and effort

to these tasks and away from his main

enterprise of farm production.”

Farmers should remain vigilant.

Nourse cautioned: “It is of the upmost

importance, however, that farmers shall

have both the legal institutions and the

organizational ‘know-how’ to step into

these fields when and to the extent that

service is inadequate or unduly high in

cost. It is important also that they

remain in each of these fields with an

organization sufficiently large to attain

high efficiency so that farmers shall be

protected against any subsequent lapse

in the quality of service or temptation

to profiteer in charges by the

noncooperative service agencies.

“But it is just as important that the

cooperatives recognize when they have

in fact attained their real objective by

demonstrating a superior method of

processing or distribution or by

breaking a monopolistic bottleneck, and

that they should then be content merely

to maintain ‘stand-by’ capacity or a

‘yardstick’ operational position rather

than try to occupy the whole field or a

dominating position within it. In some

cases, they may be well advised in

entirely terminating operations once

they have stimulated regular

commercial or manufacturing agencies

to competition amongst themselves.”

Nourse’s economic philosophy of

cooperation may be summed up in a

nutshell: Cooperatives make it feasible

for farmers to jointly market their

products. The cooperative may evolve

to a scale large enough to effectively

bargain with other market participants

and/or to avail itself of scale economies

in processing and marketing operations.

Subject to the same market disciplines

and supply-demand-price dynamics as

any business, the presence of the

cooperative challenges other market

participants to operate efficiently and

thus strengthens the competitive market

mechanism. When the market for

members’ products has become truly

competitive, the cooperative may want

to assume only a stand-by position but

maintain the legal institutions and

organizational capacity to reenter the

field, if necessary. Table 1 summarizes

all these points in the left column.

Examples in real life show that

Nourse’s ideas on cooperatives are still

very relevant today. Consider dairy

cooperatives, which as a group are the

most prominent U.S. agricultural

marketing cooperatives. A point-bypoint comparison of dairy cooperative

practices to Nourse’s theory is

summarized on the right column of

table 1. It shows that market

performance of dairy cooperatives

coincides with the basic principles

posited by Nourse’s economic

philosophy of cooperation.

With current renewed interest in the

cooperative form of doing business, it

may be worthwhile for the new

generation of cooperators to relearn

Nourse’s ideas and fully understand the

roles cooperatives play in the

marketplace.

Editors note: More details on cooperative

theory and practice using dairy cooperatives

as a case study will be available in a

forthcoming research report from the

Cooperative Programs office of USDA

Rural Development. n

“The cooperative is a means for promoting and

maintaining competition in the marketplace...Its

objective is not to supersede other forms of

business,but to see that they are kept truly

competitive.”

8 The Nature of the Cooperative
References

Galbraith, John K. “American Capitalism: The Concept of Countervailing

Power,” revised edition, Houghton Mifflin Company, Boston, 1956; esp.

Chapter XI, The Case of Agriculture, pp. 154-165.

Hess, Jerry N. Oral History Interview with Dr. Edwin G. Nourse,

Washington, D. C., March 7, 1972, Harry S. Truman Library,

Independence, Missouri.

http://www.trumanlibrary.org/oralhist/nourseeg.htm.

Larsen, Grace H. and Henry E. Erdman. “Aaron Sapiro: Genius of Farm

Co-operative Promotion,” The Mississippi Valley Historical Review, Vol.

49, No. 2, 1962, pp. 242-268.

Nourse, Edwin G. “The Economic Philosophy of Co-Operation,”

American Economic Review, Volume XII, No. 4, December 1922, pp. 577-

597.

Nourse, Edwin G. “The Place of the Cooperative in Our National

Economy,” American Cooperation 1942 to 1945, American Institute of

Cooperation, 1945, pp. 33-39.

Sapiro, Aaron. “True Farmer Cooperation,” Journal of Agricultural

Cooperation, Volume 8, 1993, pp. 81-93, reprinted from the World’s Work,

May 1923, pp. 84-96.

United Nations. “United Nations Declares 2012 International Year of

Cooperatives,” Press Release DEV/2784, December 21, 2009, New York.

Economic philosophy of cooperation

Cooperatives are organized for efficiently carrying

out specific business functions.

Cooperatives can be of any size (and can be local,

regional or national in scope) that allows them to

function efficiently in the marketplace.

Cooperatives afford farmers the organizational sizes

for exercising countervailing power.

Cooperatives are pro-market; they let the market

supply-and-demand price be the guidance for

producers.

Cooperatives are a means for farmers to promote

and maintain competition — as the competitive

yardstick.

In those fields where the market has become truly

competitive and farmers can be well served by

other firms, cooperatives may want to cede the field

and assume only a stand-by position (to preserve

members’ capital, time and efforts for use on the

farm), while maintaining the legal institutions and

organizational capacity to step in if there is a

relapse of market inadequacy.

Market performance of dairy cooperatives

49,675 dairy farmers in 155 cooperatives marketed

83 percent of U.S. milk in 2007.

The smallest local cooperative has a few members

marketing less than 1 million pounds of milk per

year; the largest one has more than 10,000

members in the 48 contiguous states and markets

tens of billions of pounds of milk.

Collective bargaining for better prices and terms of

trade is the exercise of countervailing power.

Dairy cooperatives and their member-farmers are

subject to the disciplines of the market in a free

economy.

To be competitive, processors must match the

effectiveness and efficiency of dairy cooperatives.

Dairy cooperatives have comparative advantages

in procuring milk and have major shares in making

hard products (71 percent of butter, 96 percent of

nonfat and skim milk powder, and 26 percent of

cheese — the latter decreased from 34 percent in

2002). Their shares are less significant in sectors

that are capital-, technology- and service-intensive

and that carry high product and market risks (7

percent of fluid milk, 4 percent of ice cream, 11

percent of yogurt, 14 percent of sour cream. Their

share of cheese has also declined in recent years).

However, dairy cooperatives have the wherewithal

to take up the slack if the market fails to perform

well.

Table 1 — Comparison of Nourse’s cooperative theory and dairy cooperative practice

Note: Data from “Marketing Operations of Dairy

Cooperatives, 2007,” USDA/RD Research Report

No. 218, 2009.

The Nature of the Cooperative 9
Whatthey are andwhatthey do
By K. Charles Ling, Ag Economist

Co-op Programs/ USDA Rural Development

e-mail: charles.ling@wdc.usda.gov

Editor’s note: Two previous articles in Rural Cooperatives —

“What Cooperatives Are (and Aren’t)” (Nov./Dec. 2009) and

“What Cooperatives Do,” (March/April 2010) — explain the

economic structure of cooperatives and their role in the

marketplace. Together, these two narratives examine the

economic theory of cooperation as advanced, respectively, by

Ivan V. Emelianoff and Edwin G. Nourse. These writings

constitute a comprehensive framework for understanding

cooperatives (summarized in tables 1 and 2, left column). This

third article examines dairy cooperative practices to illustrate

how well the theory fits the reality, and vice versa. It is

excerpted from the author’s research report: “Co-op Theory,

Practice and Financing,” available from USDA.

airy cooperatives, as a group, represent

the most prominent of all agricultural

marketing co-op sectors. Co-op milk and

dairy product sales represented 42

percent of total commodity marketing by

all U.S. agricultural cooperatives in 2007 (Deville, et al.).

Dairy cooperatives account for a majority of milk sold in

the United States, especially at the first-handler level and

in the manufacture of “hard” dairy products (butter,

cheese and milk powders).

In 2007, there were 155 dairy cooperatives in the

nation owned by 49,675 member-producers, or 84

percent of the nation’s licensed dairy farms. They

delivered 152.5 billion pounds of milk, or 83 percent of

all milk marketed (Ling).

Cooperatives marketed 71 percent of the nation’s

butter, 96 percent of nonfat and skim milk powders, 26

percent of natural cheese and 42 percent of dry whey

products. Their shares of “soft” and cultured products

were less significant: 4 percent of ice cream, 13 percent

of ice cream mix, 11 percent of yogurt and 14 percent of

sour cream. Co-ops processed 7 percent of the nation’s

packaged fluid milk products in 2007.

Mission and functions

There is no mystery as to why so many dairy farmers

organize in cooperatives: they seek to jointly and

efficiently market their milk far better than they could as

individuals. Milk is a “flow” product (cows are milked

twice or thrice daily) and is highly perishable; it must be

picked up from the farm and delivered to the market

(milk plants) soon after it is produced. By working

together through their cooperatives, farmers strive for

better control over the movement of the milk through

the marketing channel and to attain higher value for

their milk.

The functions and services the farmers demand of

their respective cooperatives vary, depending on the

specific market situation the members of a cooperative

face and their particular needs. Dairy cooperatives may

be charged by members with the responsibility of

performing one or more (or all) of the following

marketing functions:

• Provide an assured market; typically there is a written,

or tacit, agreement between a member and the

cooperative that the cooperative is the exclusive

marketing agent of the member’s milk.

• Negotiate milk pay price and terms of trade with milk

buyers (investors-owned processors).

• Collect and ensure payment from milk buyers.

• Check weights and tests; this helps to ensure that the

milk payment a member receives is accurate and

commensurate with the quantity and quality of the

milk delivered to milk buyers.

• Arrange for milk hauling; milk obviously must be

picked up from the farm in a timely fashion and

delivered to the plant of first-receipt. This can be

performed by the cooperative’s own haulers, by

contract haulers or by haulers retained by members.

The cooperative may also be responsible for setting or

negotiating hauling rates.

• Provide field services; cooperatives typically have field

service personnel to assist with on-farm production

problems and regulatory and inspection issues for the

farm to achieve quality-milk production.

• Disseminate market information about the situation

and outlook of the milk market; this is provided to

members for use in making dairy farming business

decisions.

• Other marketing-related services that help members

deal with all the minutiae related to producing and

marketing quality milk.

In addition, dairy farmers may ask their cooperative to

leverage its group strength to procure various other

services to help sustain their farming operations and farm

life. Some of the services may include providing:

• Insurance products, such as disaster insurance for the

D

These MMPA family farm members were featured in a “June Is Dairy Month” ad produced with Kroger grocery stores,

one of the co-op’s major customers. Kroger wanted to emphasize to shoppers that milk in the dairy case came from

home-state farms. Photo courtesy Kroger and MMPA

The Nature of the Cooperative 11
farm, health and/or life insurance (for farmers and their

families and farm employees) and farm workers’

compensation.

• Retirement programs.

• Risk management services to deal with market

uncertainties.

• Farm business consulting services, such as farm expansion

feasibility studies and business plans.

• Operating capital and facility capital financing.

• Financial planning services.

• Livestock marketing services (mainly for culled cows and

calves).

• Other services that may help members’ farming operations.

Organization

Dairy cooperatives can be of any size (and can be local,

regional or national in scope), depending on whatever scale

the membership considers to be the most appropriate for

marketing their milk.

A small local cooperative may have a few member-farms

and market less than 1 million pounds of milk a year. A

regional co-op may have hundreds or thousands of members

in more than one state and handle millions, or even billions,

of pounds of milk. The nation’s largest dairy cooperative has

about 10,000 member-farms in all of the 48 contiguous states

who deliver tens of billions of pounds of milk annually to

their co-op.

All dairy cooperatives are known to be centralized

organizations with direct membership. A limited number may

have other dairy cooperatives as association members, but the

practice is usually for accommodating the fact that the

cooperative is the marketing agent of all or part of the milk,

dairy products or services of these association members.

Dairy cooperatives operating in the same market may

form marketing agencies in-common to rationalize milk

hauling and shipment for reducing transportation costs, to

share market information, or to collectively bargain with

buyers for higher prices for milk or dairy products marketed.

Governance

Members of dairy cooperatives exercise ownership and

business controls through a board of directors that is elected

from among member-farmers. Candidates for the board are

typically nominated by a committee of elected members who

are not directors. Elections of the directors are usually done

at the annual membership meeting.

If a cooperative is large, in terms of membership or

geographical area, members may be grouped into districts (or

areas/regions/divisions/locals). Directors then may be

nominated from the district and elected at the cooperative’s

annual meeting. Districts are usually drawn such that

members in the same district are more or less homogeneous.

Voting at the district level is typically by one member/one

vote. The number of directors each district is entitled to may

be different due to proportionality considerations based on

milk volume. Some boards may have at-large members.

In a large cooperative, a delegate body elected by members

may be needed to channel information and make decisions on

behalf of the membership. The delegate body may be

empowered to represent the membership in all decisions,

except for matters that specifically require votes by the entire

membership.

A limited number of dairy cooperatives have non-member

directors, typically in the states where they are required by

law. Non-member directors usually play an advisory, nonvoting role on the board.

An executive committee of elected officers and selected

board members may be constituted to facilitate decisionmaking when the board is not in session. The board may also

appoint several committees to carry out specific board

functions, such as audit, finance, membership and marketing

committees.

The board controls the cooperative’s business on behalf of

members and makes major decisions; it also sets the policy

and determines the overall direction of the cooperative.

Management carries out the co-op’s day-to-day operations.

Another very important function of cooperative board

members is serving as a conduit of communication between

the management and the rank-and-file members.

Operations

Dairy cooperatives perform various marketing functions to

carry out the most important task of providing an assured

market for members’ milk. They may engage in one or more

of these activities:

• Bargaining — Find a market for members’ milk and

bargain/negotiate with milk buyers for milk prices and

terms of trade.

• Fluid processing — Own or retain plant capacity to

process some or all member milk into fluid products. Fluid

plants may also process soft and cultured products.

• Niche marketing — Own or retain plant capacity to

process some or all member milk into specialty (niche)

products.

• Making hard products — Own or retain plant capacity to

manufacture hard dairy products (such as cheese).

Manufacturing plants also provide a home for milk when it

is in excess of market demand and transform the milk into

storable products for further processing or later

distribution.

Of the 155 U.S. dairy cooperatives, 108 may be classified

as bargaining cooperatives because bargaining is their only, or

main, marketing activity. Four co-ops are fluid processing

operations that do business primarily in processing and

distributing fluid products. Another 19 of these businesses are

niche marketing cooperatives. The remaining 24 may be

called diversified cooperatives, having bargaining and one or

more processing/manufacturing functions as their main

operations.

Besides assuring a market for members’ milk, dairy

12 The Nature of the Cooperative
cooperatives may also perform some or all of the other milk

marketing functions listed in the mission and functions

section above. In addition, they may procure farm supplies or

provide other services for members.

Dairy cooperatives also provide services to milk buyers in

accordance with the terms of trade negotiated, such as

delivering milk on schedule, maintaining quality control and

related laboratory services, preconditioning or standardizing

milk and/or fulfilling full-supply contracts.

Market performance

A cooperative affords dairy farmers the organizational size

that is necessary for exercising countervailing power to

effectively bargain and deal with milk buyers and other

market participants.

The dairy industry has evolved in a way that dairy

cooperatives and processors have developed a high degree of

bilateral dependency

Because dairy cooperatives are organizations of farmers,

they have the comparative advantages of working closely with

members for assembling milk, providing field services and

performing farm-related functions. It is these advantages that

accord them the predominant market share at the firsthandler level.

In additon to this dominance in milk procurement, co-ops

have the responsibility of balancing milk supply. Many dairy

cooperatives maintain plant capacity to manufacture reserve

and surplus milk into storable products such as butter, milk

powders and cheese. Consequently, they have major market

shares of these hard products. Like a reservoir, these

cooperative plants absorb milk in excess of demand and

provide supplemental milk to the market when it is needed.

Many processors rely on dairy cooperatives for milk

supplies that are tailored to their requirements for volume,

quality, composition and delivery schedule, so they can focus

their attention on the sectors where they are dominant:

making fluid, cultured and soft products (and lately cheese)

and further processing and packaging dairy products for the

consumer market. These sectors tend to be capital-,

technology- and service-intensive and are exposed to high

product and market risks.

Farmers, who are generally risk-averse and have many

Table 1 — Comparison of Theory and Dairy Cooperative Practice: What Cooperatives Are

Theory: Economic Structure of Cooperatives

Cooperative organizations represent the aggregates of economic

units.

A cooperative is an agency owned and controlled by members

through which they conduct their business.

Each member-farm fully retains its economic individuality and

independence.

The board of directors is elected from among member-farmers.

Proportionality and service at-cost are two basic principles.

Members provide advances (i.e., equity capital) for financing the

cooperative.

Patronage refunds are returned to members who have been

underpaid or overcharged.

Dividend on capital, if any, is interest payment for using members’

capital.

Being an aggregate of member-farms, the cooperative is neither a

horizontal integration of its members nor a vertical integration

between the cooperative and its members. It is a third mode of

organizing coordination.

Economic Structure of Dairy Cooperatives

A dairy cooperative is the aggregate of dairy member-farms.

A dairy cooperative is owned, controlled and used by members as

the milk marketing arm of their dairy farming business.

Member dairy farms are independent economic units, each making

its own business decisions.

Directors are members; they may have non-member directors who

usually are non-voting advisors and may be mandated by state laws.

These principles are applied in every facet of operations that relate

to member business.

Almost all equities are member capital; ownership of a fraction (a

portion of preferred stock) is not discernable from the financial

statements.

Patronage refunds are net savings returned to members.

Dividends, if paid, are usually on preferred stock, and typically at less

than 8 percent.

There may be some degree of coordination among members as they

voluntarily and collectively adapt to market situations. However, this

is not the same as vertical or horizontal integration.

The Nature of the Cooperative 13
demands on their financial resources on the farm, probably

prefer to stay out of these sectors rather than compete headon with processors (their milk customers), as long as the

market performs well and their farming business can be

sustained.

Still, there are a substantial number of dairy cooperatives

operating in these sectors, although as a whole their market

share is not high. The upshot is that though dairy

cooperatives are generally less active in these sectors, they

have the size, organization and wherewithal to enter the

market if the situation calls for it.

Financing

Based on the complete financial data of 94 dairy

cooperatives for the fiscal year ending in 2007, total assets of

these cooperatives were $12 billion (or $8.41 per

hundredweight/cwt of milk). Current assets accounted for

60.4 percent ($7.3 billion or $5.08/cwt) and fixed and other

assets accounted for the other 39.6 percent ($4.8 billion or

$3.34/cwt). These 94 businesses represented 61 percent of all

dairy cooperatives and marketed 142.9 billion pounds of

milk, or 94 percent of cooperative milk volume (Ling, table

12).

Total liabilities of these co-ops were $8.7 billion. Of this

amount, 72.3 percent were current liabilities ($6.3 billion or

$4.40/cwt) while 27.7 percent ($2.4 billion or $1.69/cwt)

were long-term debts. Equities, the balance of assets and

liabilities, were $3.3 billion ($2.32/cwt).

Dairy cooperatives typically pay members for their milk

twice a month. A large proportion of the current assets and

the current liabilities are for such pending periodic cash

payments to members.

This is a unique characteristic of the balance sheet of dairy

cooperatives. Therefore, it is important to focus on the ratio

of long-term debts to equity in evaluating financial strength,

which was 72.6 percent for the 94 cooperatives.

Equities can be grouped into four categories: common

stock, preferred stock, retained earnings and allocated

equities.

Common stock — In 2007, common stock only

accounted for 0.1 percent of total equities. This is because

common stock of cooperatives is usually issued for witnessing

membership and carries minimal nominal value.

Preferred stock — Preferred stock, as reported, was 7

percent of total equities. A substantial portion of the

preferred stock was issued by some cooperatives to members

for witnessing retained patronage refunds or for witnessing

members’ additional investment in the cooperative and may

be considered as allocated equities. It is not clear who holds

the remaining preferred stock (probably representing less

than 5 percent of total equities); the holders could be nonmembers as well as members.

Retained earnings — Retained earnings could be

earnings derived from non-member businesses, but may also

include allocated equities that some cooperatives choose not

to separately specify in the financial reports, retained net

savings that are going to be allocated later, or earnings that

are difficult to attribute to specific member transactions.

Therefore, retained earnings that are not likely to be

subject to allocations (or considered by some to be

“permanent” equity) should be less than the reported 10.8

percent of total equities. In any case, retained earnings

belong to the cooperative and therefore are owned by

members.

In most cases, non-member businesses of dairy cooperatives are incidental to the dairy operation. These may include:

• Processing into storable products other firms’ surplus

(distressed) milk that needs to find a home.

• Sales of goods sourced from other firms in dairy stores or

other sales outlets.

• Sales of dairy or farm supplies that may include customers

who are non-members.

In a limited number of cases, retained earnings are profits

from investment activities that may or may not be related to

the core business of serving members’ marketing and farming

needs.

Allocated equities — The 94 cooperatives reported that

82.1 percent of their equities ($1.91/cwt) were allocated to

members. Allocated equities are members’ capital from one

or more of these sources:

Retained patronage refunds — Retained patronage refunds

are net savings that are allocated to members based on

patronage but are retained to finance the cooperative’s

operations after a cash portion has been paid to members.

Members must treat the entire patronage refund (retained as

well as cash payment) as income for tax purposes.

Cooperatives usually revolve retained patronage back to

members after a certain period of time.

Capital retains — Some cooperatives use capital retains to

finance the operations or, more often, for special projects

such as building new plants. Money is withheld from milk

payment at a certain rate per hundredweight of milk.

Members must treat capital retains as income for tax

purposes. Capital retains are also revolved back to members

after a certain period of time.

Base capital plan — Some larger diversified dairy

cooperatives have adopted base capital plans to establish a

more stable equity pool. Under such a plan, a target base

capital level is established at a rate per hundredweight of milk

marketed during a representative period. The base capital

may be funded by retained patronage and/or capital retains,

or by other means of member contribution. Once a member

attains the prescribed base capital level, future patronage

earnings allocated to the member are paid in cash.

Members provide almost all equity capital. Counting

common stock, preferred stock (that are issued to members),

retained earnings and allocated equities, almost all equities

(probably more than 95 percent) of dairy cooperatives are

supplied and owned by members.

14 The Nature of the Cooperative
Table 2 — Comparison of Theory and Dairy Cooperative Practice: What Cooperatives Do

Market Performance of Dairy Cooperatives

49,675 dairy farmers in 155 cooperatives marketed 83 percent of U.S.

milk in 2007.

The smallest local cooperative has a few members marketing less

than 1 million pounds of milk per year; the largest one has about

10,000 members in the 48 contiguous states and markets tens of

billions of pounds of milk.

Dairy cooperatives may grow, or have grown, to the size necessary

for effectively bargaining with milk buyers for better prices and terms

of trade.

Dairy cooperatives and their member-farmers are subject to the

disciplines of the market in a free economy.

To be competitive, processors must match the effectiveness and

efficiency of dairy cooperatives.

Dairy cooperatives have comparative advantages in procuring milk

and have major shares in making hard products (71 percent of butter,

96 percent of nonfat and skim milk powder, and 26 percent of cheese,

although the latter decreased from 34 percent in 2002). Their shares

are less significant in sectors that are capital-, technology- and

service-intensive and that carry high product and market risks (7

percent of fluid milk, 4 percent of ice cream, 11 percent of yogurt, 14

percent of sour cream. Their share of cheese has also declined in

recent years). However, dairy cooperatives have the wherewithal to

take up the slack if the market fails to perform well.

Theory: Market Performance of Cooperatives

Cooperatives are organized for efficiently carrying out specific

business functions.

Cooperatives can be of any size (and can be local, regional or

national in scope) that allows them to function efficiently in the

marketplace.

Cooperatives afford farmers the organizational size for exercising

countervailing power.

Cooperatives are pro-market; they let the market supply-and-demand

price be the guidance for producers.

Cooperatives are a means for farmers to promote and maintain

competition; they serve as a “competitive yardstick.”

In those fields where the market has become truly competitive and

farmers can be well served by other firms, cooperatives may want to

cede the field and assume only a stand-by position (to preserve

members’ capital, time and efforts for use on the farm), while

maintaining the legal institutions and organizational capacity to step

in if there is a relapse of market inadequacy.

Theory and reality fit

Considering all of the above, it is clear that the economic

structure and market performance of dairy cooperatives are

in full accord with the economic theory of cooperation as

expounded by Emelianoff and Nourse. Dairy cooperatives’

mission, functions, organization, governance, operations,

market performance, financing, etc., all conform to the

theoretical prescriptions, as tables 1 and 2 show. Cooperation

as practiced by dairy farmers in marketing milk is an

enduring business model that is in full agreement with the

economic theory of what cooperatives are and what

cooperatives do.

The dairy market has seen some extreme highs and lows in

the past few years. While co-ops tend to be a stabilizing

influence on ag markets, they cannot prevent such market

shifts. Still, the cooperative form of a business remains the

overwhelming choice of dairy farmers for marketing,

processing and many related services. n

References

• DeVille, Katherine C., Jacqueline E. Penn, and E. Eldon

Eversull. Cooperative Statistics, 2008, U.S. Department of

Agriculture, Rural Development, Service Report 69,

November 2009.

• Emelianoff, Ivan V. Economic Theory of Cooperation: Economic

Structure of Cooperative Organizations, Washington, D.C.

1942 (litho-printed by Edwards Brothers., Inc., Ann Arbor,

Michigan), 269 pages. (A reprint by the Center for

Cooperatives, University of California, 1995, may be

accessed at: http://cooperatives.ucdavis.edu/reports/

index.htm.)

• Ling, K. Charles. Marketing Operations of Dairy Cooperatives,

2007, USDA Rural Development, Research Report 218,

July 2009.

• Nourse, Edwin G. “The Economic Philosophy of CoOperation,” American Economic Review, Volume XII, No. 4,

December 1922, pp. 577-597.

• Nourse, Edwin G. “The Place of the Cooperative in Our

National Economy,” American Cooperation 1942 to 1945,

American Institute of Cooperation, 1945, pp. 33-39.

• Rural Cooperatives, USDA Rural Development, Volume 76,

Number 6, November/December 2009 and Volume 77,

Number 2, March/April 2010.

The Nature of the Cooperative 15
By K. Charles Ling, Ag Economist

USDA Co-op Program

Note: This article is a sequel to “What

Cooperatives Are (and Aren’t),” “What

Cooperatives Do,” and “Dairy Co-ops:

What They Are and What They Do,”

Rural Cooperatives, Volume 76, Number 6,

November/December 2009; Volume 77,

Number 2, March/April 2010; and

Volume 78, Number 2, March/April 2011,

respectively. Past issues are posted on the

USDA Rural Development website:

www.rurdev.usda.gov.

n our free-market

economy, the

cooperative is a unique

business model in that

it is an aggregate of

individual economic units. In the

agricultural sector, a cooperative is an

aggregate of member-farms.

Using the dairy sector as an example

for this article, the cooperative takes

whatever milk volume is produced by

members and then acts as their

exclusive marketing agent. Members’

farming operations are not under the

cooperative’s administrative control, and

the cooperative cannot dictate how

members operate their dairy farms.

This operating mode entails its own

unique economics that comprises the

following elements:

• When milk price goes up or down,

the milk volume a farm may produce

depends on the financial objective of

the farm: whether it wants to attain

maximum total profit (minimum loss

in a loss situation), maximum total

revenue (up to the break-even point),

or minimum average cost.

I

How co-ops do it

Dairy co-ops are a prime example of

the economics of co-op marketing

Photos courtesy Darigold

16 The Nature of the Cooperative
• Production input cost changes do not

change a farm’s rated capacity, but

instead shift the farm’s cost curves

straight up or down. The milk volume

that the farm produces, again,

depends on the financial objective of

the farm. (Cost curves refer to a

typical, simple diagram showing how

milk production costs vary in relation

to production volume. See figure 1.)

• Depending on how farmers respond

to milk price and input cost changes,

the milk volume the cooperative has

to handle may continually fluctuate.

• Likewise, milk production is a

biological process and is subject to

daily and seasonal fluctuations.

• The seasonality of milk production

generally does not match the

seasonality of fluid milk demand. This

mismatch requires cooperatives that

supply milk to the fluid market to

balance seasonal supply with seasonal

demand and handle the inevitable

seasonal surplus milk volume at a

substantial supply-balancing cost.

A fuller explanation of the unique

economics of dairy cooperative

operation is facilitated by the focusing

on a model dairy farm.

Model dairy farm

A farm is constructed with its

dairying infrastructure to accommodate

a dairy herd of a certain size. It has a

rated capacity of producing a certain

number of pounds of milk per day.

When the farm produces milk at the

capacity volume, the average cost of

milk production per hundredweight

(cwt) should be at a minimum. If milk

price for the month is the same as the

minimum average cost, then the farm’s

milk production for the month is at

capacity and the farm is said to be in

“equilibrium.”

Milk price variation

If milk price is lower than the

minimum average cost, the farm will

incur a loss for every cwt of milk it

produces. According to textbook

optimization theory, the farm would

minimize its total losses by producing

milk at a volume where milk price

(marginal revenue) equals marginal

cost.

However, although marginal cost is a

useful concept, its “real-life calculation”

has many complications and, therefore,

it is not readily available for practical

day-to-day operational decision-making

(This also applies to other concepts

related to marginal productivity). For

such decisions, the time-honored

business practice is to use average cost

in the profit-and-loss estimation.

In the present case, it is very likely

that the dairy farm will still strive to

attain the lowest average cost by

producing milk up to its rated capacity,

even though doing so would incur a

higher loss. So, depending on which

cost concept a farmer uses, milk volume

produced by the dairy farm may be

somewhere between the two amounts

just mentioned.

When milk price is higher than the

minimum average cost, the farm will

enjoy a profit. The farmer may decide

to attain the lowest average cost by

producing at its rated capacity. Or, the

farmer may want to achieve maximum

total profit by producing a milk volume

where milk price (marginal revenue)

equals marginal cost, if the latter is

actually known.

Alternatively, the farmer may strive

for maximum total revenue and increase

its production up to the volume where

the farm will break even. Thus, when

milk price is higher than the minimum

average cost, the amount of milk

produced by the dairy farm may be

somewhere in the range framed by the

three possible milk volumes just given.

Replicating the model dairy farm

ten, a hundred or even a thousand

times, depending on the size of a

cooperative, the aggregate milk volume

produced by its members is certain to

fluctuate. The cooperative may know

with certainty the aggregate volume of

members’ rated capacity, which would

logically be the basis for planning its

milk handling capacity.

However, the uncertain volume of

actual delivery means on some days the

cooperative will have slack capacity,

while on other days it may have to

scramble to make sure every drop of

milk has a home. Also in response to

the fluctuating volume, milk hauling

may have to be rerouted for most

economical coordination.

It should be noted that because a

cooperative is formed to market

whatever the aggregate volume of milk

produced by its members, it does not

have its own milk production functions,

milk production cost curves or milk

supply curves.

Milk production

input cost variation

Suppose milk price remains the same

as the minimum average cost given at

the rated capacity volume, but the cost

of production input, such as feed or

fuel, has increased. Because the

infrastructure and the size of the dairy

herd do not change, the rated capacity

of the farm will stay the same.

However, the average cost curve and

its associated marginal cost curve will

shift upward. The farm will suffer a

loss, and it may want to minimize its

total losses by producing milk at a

volume where milk price (marginal

V

P

Pounds/day

$/cwt

MC AC

Figure 1: Average cost (AC) and marginal cost

(MC) vs. milk production volume

The Nature of the Cooperative 17
18 The Nature of the Cooperative

revenue) equals marginal cost.

Short of knowing the marginal cost,

it is very likely that the dairy farm will

work to attain the lowest average cost

by still producing milk at its rated

capacity. When production input cost

increases, milk volume produced by the

dairy farm may be somewhere between

the two milk volumes just referred to.

On the other hand, if production

input cost decreases, the average cost

curve and the associated marginal cost

curve will shift downward and the farm

will reap a profit. The farm may still

decide to produce milk at its rated

capacity. Or it may increase its

production up to the break-even point

that will return the highest total

revenue.

Alternatively, the farm may want to

achieve maximum total profit by

producing at the milk volume where

milk price (marginal revenue) meets

marginal cost. When production input

cost decreases, milk volume produced

by the dairy farm may be somewhere in

the range framed by the three volumes

just articulated.

Again, the aggregate volume of

member milk faced by the cooperative

is rather uncertain, depending on how

members make their day-to-day

production decisions in reaction to

production input cost changes.

The discussion thus far shows the

challenges a dairy cooperative faces in

handling fluctuating milk volume when

either milk price or production input

cost changes. When both price and cost

changes are considered at the same

time, the picture is even more

complicated.

Still, this is a highly simplified

scenario. In real life, not every farm is

like the model dairy farm; in fact, no

two farms are alike. They are not likely

to be of the same size and make the

same production decision. That means

the volume variation may be even more

uncertain than what has been described.

In addition, the seasonality of milk

production further aggravates milk

volume uncertainties.

Seasonal production variation

Milk production is affected by a

cow’s physiological condition, which is

subject to seasonal changes. The

seasonal nature of milk production is

best portrayed by the index of

seasonality, such as shown in table 1,

which is based on milk deliveries to the

Northeast regional market and

documented in an earlier USDA

research report. The table shows that

the first six months of the year is a

period of higher-than-average milk

deliveries, with May being the peak.

The index of 106 indicates that May

is 6 percent higher than annual average

daily deliveries. Milk deliveries decline

sharply from June to July and stay

relatively low throughout summer and

fall. Deliveries are usually lowest in

November.

With an index of 95, November is 5

percent below annual average daily

deliveries. Deliveries recover in

December and increase steadily through

winter and spring. The drop from May

to November is 11 percentage points.

Seasonality of milk production, in

essence, shifts a farm’s cost curves

downward to the right during a

seasonally high production month or

upward to the left during a seasonally

low production month. During a

seasonally high production month

(seasonality index is more than 100),

since the same infrastructure and the

same herd size will produce more milk,

the farm’s capacity should be higher

than originally rated.

Also because the same fixed cost is

spread over a higher milk volume, the

average cost of producing milk should

be lower. The combined effect would

shift the cost curves rightward and

downward.

On the other hand, during a

seasonally low production month

(seasonality index is less than 100), since

---------------Percent---------------

January 100.1 101.9

February 101.8 100.6

March 103.7 100.9

April 105.4 98.2

May 106.0 98.1

June 103.4 94.0

July 97.8 94.2

August 97.0 98.1

September 96.3 105.2

October 95.4 104.6

November 95.0 102.8

December 98.1 101.4

Annual average 100.0 100.0

Source: Ling, K. Charles. Cost of Balancing Milk Supplies:

Northeast Regional Market, U.S. Department of Agriculture,

RBS Research Report No. 188, October 2001.

Note: Different regions of the country may experience

different seasonality, and seasonality may change over time.

Producer milk

Month deliveries

Fluid

demand

Table 1―Indices of seasonality of producer milk

deliveries and fluid demand
the same infrastructure and herd size

will produce less milk, the farm’s

capacity should be less than originally

rated. And because the same fixed cost

is spread over a smaller milk volume,

the average cost of producing milk

should be higher. The combined effect

would shift the cost curves leftward and

upward.

The net effect of shifting seasonal

capacity and cost curves means that the

members’ milk volume the cooperative

has to handle will fluctuate seasonally

throughout the year. This further

compounds the challenges of marketing

members’ milk.

Seasonal demand variation

On the milk demand side, seasonal

variation is mainly caused by fluid

(beverage) uses. This is because the

milk volume required by fluid

processing plants is directly and

instantaneously derived from

consumers’ demand of fluid products,

which is highly seasonal. Manufacturing

plants that make storable products such

as cheese are different. They tend to

maintain a throughput volume at or

near plant capacity in order to achieve

least-cost operations.

The example in table 1 shows that

fluid demand is highest in September

and maintains a higher-than-average,

though declining, level through fall and

winter until March; fluid demand is

lower-than-average from April through

August. The peak in September

(seasonality index = 105) is 5 percent

above annual average daily

consumption.

The lowest fluid consumption month

is June, with an index of 94, or 6

percent below the annual daily average.

The June low is a drop of 11 percentage

points compared with the September

peak.

Thus, seasonality of fluid demand

usually runs counter to the seasonality

of milk production. Fluid demand tends

to be high during those months when

milk production is low, and tends to be

low when milk production is high. The

mismatch of supply and demand is a

major challenge the cooperative has to

handle, as shown in the following

example.

Suppose that on an annual daily

average basis, the cooperative’s

members deliver 10 million pounds of

milk a day, and the cooperative markets

4 million pounds to fluid milk

processors and a constant 2.5 million

pounds to dairy product manufacturing

processors.

Suppose further that milk production

and fluid demand follow the seasonal

patterns given in table 1. In May, the

cooperative’s members will produce

10.6 million pounds of milk a day, while

fluid plants will use 3.9 million pounds

and the manufacturing processors will

---------------Million pounds/day---------------

January 10.0 4.1 2.5 3.4

February 10.2 4.0 2.5 3.7

March 10.4 4.0 2.5 3.8

April 10.5 3.9 2.5 4.1

May 10.6 3.9 2.5 4.2

June 10.3 3.8 2.5 4.1

July 9.8 3.8 2.5 3.5

August 9.7 3.9 2.5 3.3

September 9.6 4.2 2.5 2.9

October 9.5 4.2 2.5 2.9

November 9.5 4.1 2.5 2.9

December 9.8 4.1 2.5 3.3

Annual average 10.0 4.0 2.5 3.5

1

Items may not add to totals due to rounding.

Member

milk

Month deliveries

To fluid

milk

processors

Table 2―An example of a cooperative's milk in excess of demand by fluid

milk and manufacturing processors1

To

manufacturing

processors

Co-op milk in

excess of

sales

The Nature of the Cooperative 19
use 2.5 million pounds. The cooperative will have 4.2 million

pounds of milk a day in excess of demand by fluid plants and

manufacturing processors (table 2).

On the other extreme, the same calculation will show that

the daily excess volume will be 2.9 million pounds in the fall

months (September through November); a reduction of 1.3

million pounds a day from May.

If the cooperative has its own manufacturing plants to use

a constant volume of 2.9 million pounds of milk a day, then

the cooperative still needs to have facilities to handle a

seasonal surplus of 1.3 million pounds of milk a day in May.

During other months, the seasonal surplus balancing facilities

will be under-utilized and will run dry in the fall months,

resulting in costly plant operations.

If a cooperative does not have enough surplus balancing

capacity (or in the case of bargaining cooperatives that do not

have any plant capacity), there are two ways for them to

dispose of surplus milk. They can sell the surplus milk in the

spot market, usually at a price discount, or they can pay a

“tolling fee” to have the milk manufactured into storable

dairy products at plants owned by others.

The price discount and the tolling fee are charges for

defraying the costs of owning and operating surplus handling

plant facilities.

Other marketing cooperatives

The unique economics of cooperative marketing operation

is applicable in the situation where the cooperative is the

exclusive marketing agent of the milk produced by members.

Other agricultural commodities (such as fruits, vegetables,

nuts, poultry, sugar, etc.) that exclusively rely on the

cooperative to market members’ products would have unique

economics of cooperative operation similar to that of dairy

cooperatives.

However, they differ from milk in some important aspects.

The main difference is that milk is a “flow” product — day in

and day out — while other farm commodities are harvested

in lumps toward the end of the growing season of several

weeks or months.

In the analysis of the economics of cooperative marketing

of milk, the unit of time used is on a per day basis. The same

analysis of other commodities has to use a unit of time that is

appropriate for a particular commodity.

Some producers of commodities that are storable and have

a long marketing season (such as grains and oilseeds) may

view the cooperative as but one of multiple outlets and

market through it only if the cooperative offers the best

terms and services among all alternatives. In such a case, the

cooperative may still maintain its uniqueness in its cooperative structure, organization, governance and equity financing.

Its marketing operation, however, is not different from other

marketing firms (firms other than cooperatives). n
his series of articles has attempted to clarify the nature of the

cooperative business model in our free-market economy by explaining

the cooperative’s unique economic structure as an aggregate of

independent economic units (member-farms). Co-ops are organized

to achieve a common goal(s) using organization, governance, equity

financing, operations and economics that are unique to cooperatives. Cooperatives

have been shown to be pro-market, helping farmers gain market access and exercise

countervailing market power, and serving as a competitive yardstick for their industry.

This final article attempts to show how cooperatives relate to other market

participants through their roles in transaction governance, or “in aligning incentives

and crafting governance structures that are better attuned to their exchange needs”

(Williamson, 2002, p. 172).

As it has been in some of the previous articles, the dairy industry will again be used

as an example to demonstrate the role of the co-op. In marketing milk and milk

products, farmers and their cooperatives may engage in the following transaction

scenarios.

T

The Nature

of Cooperatives

By K. Charles Ling, Ag Economist

USDA Rural Development

Cooperative Programs

Editor’s note: This completes a

series of five articles that examine

the characteristics that make

agricultural cooperative businesses

unique and valuable in our economy.

The previous articles in the series

were: “What Cooperatives Are (and

Aren’t)” (November/December

2009 issue); “What Cooperatives

Do” (March/April 2010); “Dairy

Co-ops: What They Are and What

They Do” (March/April 2011); and

“How Co-ops Do It: Dairy Co-ops

Are a Prime Example of the

Economics of Co-op Marketing,”

(November/December 2011). Past

issues of Rural Cooperatives are

posted on the USDA Rural

Development website:

www.rurdev.usda.gov. Hard copies

can be obtained by e-mailing

requests to: coopinfo@wdc.usda.gov,

or by calling (202) 720-8381.

Roles in economizing transaction cost is a new

dimension for understanding value of co-ops

A worker prepares to pull milk samples

from co-op tankers. The samples are

checked before a tanker is cleared for

unloading. USDA photo by Lance Cheung

The Nature of the Cooperative 21
Scenario I. — In a subsistence agricultural economy, farm

production in excess of family consumption may be sold off

farm. For example, a farm family may have one or two cows

for producing milk to satisfy the family’s food needs. If there

is surplus milk, it may be sold to neighbors (food safety

regulations permitting). The transactions are incidental to

subsistence farming, do not require specific assets, and are

primarily operations of a bygone era in the United States.

Scenario II. — Commercial milk production requires

substantial capital investment in specialized assets: milk cows;

barns, milking parlors and other buildings; machinery and

equipment; skilled labor and management, etc. Most of these

assets are specifically for producing milk and cannot be easily

employed for alternative uses. Furthermore, milk is a “flow”

product and is highly perishable. Its market is inherently

volatile due to daily, as well as seasonal, variations of milk

production and fluid milk demand. Supply and demand

variations are not coordinated.

Asset specificity, high product perishability and market

volatility make dairy farmers vulnerable when dealing with

milk buyers (usually dairy food processors). There are many

dairy farmers, but a small number of milk processors.

Processors also must deal with “asset specificity” — they own

dairy plants that are capital- and technology-intensive and

require large size to take advantage of the economies of scale.

But they are in a dominant bargaining position vis-a-vis

individual dairy farmers.

Farmers organize cooperatives to gain bargaining and

countervailing power. However, asset specificity still causes

uncertainty and poses hazards to the investment of the dairy

farmers and the processors if there is no credible contractual

safeguard. Contracts that spell out the terms of trade as legal

rules may be formulated in an effort to relieve the hazard.

But it is impossible to foresee and encompass all

contingencies in a contract, due to human limitations.

Relying on courts for relief is time-consuming and costly.

This is a scenario of transaction without credible contracting,

and the transaction does not have safeguards to relieve the

investment hazard and protect the investment.

Scenario III. — For a highly perishable commodity such

as milk, it is vitally important for both producers and

processors to work together to make sure milk flow is smooth

and without interruption. Producers need to have an assured

outlet for the milk once it is produced, while processors

require a steady supply of fresh milk to manufacture highquality dairy products and efficiently utilize plant capacity.

The dairy industry has evolved in such a way that many

dairy cooperatives and processors have developed a high

degree of bilateral dependency. Because dairy cooperatives

are organizations of farmers, they have the comparative

advantages of working closely with members for assembling

milk, providing field services and performing farm-related

functions (84 percent of U.S. dairy farmers marketed milk

through cooperatives in 2007, the year of USDA’s latest dairy

cooperatives survey).

Many processors rely on dairy cooperatives for milk

supplies that are tailored to their requirements for volume,

quality, composition and/or delivery schedule, so they can

focus their attention on processing and packaging dairy

products. Under such an arrangement, the transactions

between cooperatives and processors are assisted with what is

called credible contracting and supported by inter-firm

contractual safeguards. Instead of a set of legal rules with

court enforcement, the contract here is a framework or a set

of guidelines for interactions between the firms.

Discrepancies in performance are resolved through

amicable consultation or negotiations or by arbitration. The

court is only used as a last resort remedy.

Scenario IV. — Besides selling members’ milk to buyers

(processors), it may be necessary for a dairy cooperative to

forward-integrate into processing some or all of its members’

milk into various dairy products. Being marketers of

members’ milk, many cooperatives have to maintain plant

capacity to balance milk supply and manufacture reserve and

surplus milk into storable products. Otherwise, the surplus

milk will be at the mercy of the market and lead to depressed

milk prices. In order to generate higher margins from the

market for members’ milk, some cooperatives also may

choose to integrate into processing fluid products or specialty

dairy products, or further processing hard products. These

processing enterprises are under the cooperative’s hierarchical

administrative control.

Transaction governance structures

The roles of a cooperative in the above scenarios fit with

the analysis of the roles of a firm in transaction governance

that constitute the core of transaction-cost economics

(Williamson, 2010, 2007, 2005, and 2002).

In Scenario I, transactions between numerous suppliers

and buyers are for an undifferentiated product. The product

is made with a general purpose technology and does not

require assets that are specific for its production (asset

specificity is zero). Transaction governance is accomplished

through market competition. The transaction governance

mode is unassisted market.

When the product uses special purpose technology that

requires specific assets for its production, as described in

Scenario II, asset specificity is greater than zero. Asset

specificity causes uncertainty and poses hazards to the

investments of the suppliers and the buyers. Contracts that

are formulated as legal rules may provide no safeguards to

protect against investment hazards. Here, transaction

governance is still the market, and the transaction governance

mode is unrelieved contractual hazard.

In Scenario III, firms seek out reputable, trustworthy

counterparts to reduce investment hazards. Such transactions

give rise to bilateral dependencies, and the parties have

22 The Nature of the Cooperative
incentives to promote a continuous, long-term relationship,

thus safeguarding specific investments. Transactions are

supported by inter-firm contractual safeguards; the contract

here is a set of guidelines for mutual adaptations. The

transaction governance mode is credible contracting, a hybrid

mode between (unrelieved hazard) market and full

integration.

Successive, technologically separable stages are brought

under unified ownership and vertically integrated and

controlled in Scenario IV. In this scenario, the transaction

governance mode is hierarchical administrative control. This

mode occurs when a higher degree of asset specificity and

added uncertainty pose greater needs for cooperation in

mutual adaptations between successive stages.

The transaction governance modes are summarized in

table 1. Each mode in the table represents a generic mode of

governance, and each generic mode of governance embodies

its own internally consistent attributes of incentive intensity

(reward for effort), administrative control, and contract law

regime – and, therefore, has its own strengths and

weaknesses.

The governance structure Mode A is the unassisted

market. The governance structure Mode B is the market

where asset specificity exposes transacting parties to

uncertainties and, without safeguards, to unrelieved

contractual hazards to their investments. Mode C is where

the market is assisted with credible contracting. All successive

production stages are integrated under hierarchical control in

transaction governance Mode D.

The attributes of a market mode are high incentive

intensity, little administrative control, and a legal rules

contract regime. On the other hand, attributes of hierarchy

are low incentive intensity (where pricing for the successive

stages is cost-plus), considerable administrative control (by

fiat), and forbearance is the implicit contract law of internal

organization (the parties must resolve their differences

internally).

Transaction governance in practice

Dairy cooperatives may be classified into one of four

categories, based on the main marketing function(s) they

perform (table 2). Their transaction governance roles

depend on their lines of business.

All four categories of dairy cooperatives may have joint

ventures with other cooperatives or firms to process and

market certain dairy products. The cooperative supplies dairy

inputs and the partner(s) provide technical or marketing

know-how to the joint venture.

This is one way of bringing product processing under the

cooperative’s partial control. In this case, transaction

governance mode may be viewed to fall somewhere between

Mode C and Mode D.

Conclusions

Cooperatives are transaction governance structures, as are

non-cooperative firms. Depending on the lines of business of

a cooperative or other type of a firm, transactions can occur

under all possible governance modes. Cooperatives adapt to

various governance modes for economizing on the

transaction cost, just as other firms do.

For entering into credible contractual relationships with

buyers (processors), the cooperative’s functions of providing

market access and exercising countervailing power put its

members, collectively through the cooperative, on a relatively

more equal footing with buyers. This should make credible

contractual relationships between sellers and buyers more

attainable and stable.

Furthermore, as its members’ collective marketing agency,

A: Unassisted market 0 0 High Little Competitive norm

B: Unrelieved hazard >0 < > Legal rules contract regime

C: Hybrid (Credible contracting) >> < > Credible contracting

D: Hierarchy (Administrative) > > Low (Pricing Considerable Internal implicit contract law

for successive (by fiat) (Forbearance)

stages is

cost-plus)

Source: Adopted from Williamson, 2005, Figure 1: Simple Contractual Schema.

Note: ">" indicates a mode having a higher intensity of the particular attribute than the mode above it.

"<" indicates a mode having a lower intensity of the particular attribute than the mode above it.

Asset

specificity

Transaction

governance mode

Investment

hazard

safeguard

Table 1―Transaction governance modes and attributes

Incentive

intensity

Admin.

control

Contract

law regime

The Nature of the Cooperative 23
the cooperative serves as a single transaction entity for

credible contracting with buyers. It also introduces order and

eliminates conflicts among members who would otherwise be

competing individually for customers. As a result, transaction

costs should be reduced.

A cooperative does not own the assets for producing the

milk (for example) that the cooperative markets for its

members; the assets and the investment hazard associated

with asset specificity belong to member-farms. By pooling

members’ milk in its marketing efforts, the cooperative, in

essence, also pools the investment hazard. As a result, each

member’s share of the hazard conceivably is less than if they

individually market their products. The fact that asset

specificity and the associated investment hazard belong to

individual members reaffirms the cooperative’s unique

economic structure of being an aggregate of its memberfarms.

These analyses show how cooperatives relate to other

market participants through their roles in transaction

governance and will hopefully broaden understanding of the

cooperative’s place in the market economy. Together with the

earlier work on cooperative basics, they should clarify the

nature of the cooperative.

References

• Ling, K. Charles. The Nature of the Cooperative: A Dairy Cooperative Case

Study, USDA Rural Development, Research Report 224. (Forthcoming)

• Williamson, Oliver E. “The Theory of the Firm as Governance Structure:

From Choice to Contract,” Journal of Economic Perspectives, Volume 16,

number 3, summer 2002, pp. 171-195.

• Williamson, Oliver E. “The Economics of Governance,” American

Economic Review, 95 (May 2005), 1-18.

• Williamson, Oliver E. “Transaction Cost Economics: An Introduction,”

Economic Discussion Papers, Discussion Paper No. 2007-3, March 1, 2007.

http://www.economics-ejournal.org/economics/discussionpapers/2007-3.

• Williamson, Oliver E. “Transaction Cost Economics: The Natural

Progression,” American Economic Review, 100 (June 2010): 673-690. (Prize

Lecture, the Sveriges Riksbank Prize in Economic Sciences in Memory of

Alfred Nobel 2009, Stockholm University, Sweden, December 8, 2009). n

Table 2―Category of dairy cooperatives by marketing function(s) and their transaction governance roles

Category of cooperatives

Bargaining

Niche marketing

Fluid processing

Diversified

Main function

Negotiate with milk buyers for

milk prices and terms of trade; a

few may operate milk handling

facilities but not milk plants.

Own or retain plant capacity to

process members’ milk into

specialty/niche products.

Own or retain plant capacity to

process members’ milk into fluid

products. May also process soft

and cultured products.

Perform bargaining and all or

most other marketing functions.

As a group, sold 53 percent of

milk to other handlers

(bargaining), while

manufactured the remaining 47

percent into various products.

Dimension

108 cooperatives (out of 155

U.S. total, or 70 percent).

Together handled 23 percent of

the 155.8 billion pounds U.S.

cooperative milk volume, but

few handled more than 1 billion

pounds of milk each.

19 cooperatives. Most handled

less than 50 million pounds of

milk each. Together handled

less than 1 percent of U.S.

cooperative milk volume.

Four cooperatives. Milk volume

processed was moderate.

Together handled less than 1

percent of U.S. cooperative milk

volume.

24 cooperatives. Three out of

four cooperatives in this group

handled 1 billion or more

pounds of milk and none

handled less than 50 million

pounds. Together handled 75

percent of the U.S. cooperative

milk volume.

Transaction governance mode

Regular milk sale is usually

Mode C (hybrid); may be Mode B

(unrelieved hazard) for spot milk

sales.

Product processing stages are

Mode D (hierarchy); wholesale

distribution of products is

usually Mode C and may be

Mode B; and retail sales are

usually Mode B.

Product processing stages are

Mode D; wholesale distribution

of products is usually Mode C.

Bargaining function is usually

Mode C; product manufacturing

and further processing stages

are Mode D; wholesale

distribution of products is

usually Mode C and may be

Mode B; and spot milk sales may

be Mode B.

Table source: All dairy cooperative statistics cited are 2007 data, the year of USDA Cooperative Programs’ most recent dairy survey.

24 The Nature of the Cooperative