by JM Staatz · 1989 · Cited by 208 — that existing theories of farmer cooperation had failed to address adequately Beginning in 1980, the Agricultural Cooperative Service (ACS) in the.
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A 109.10 84 Farmer Cooperative Theory: Recent Developments United States Department of Agriculture Agricultural Cooperative Services ACS Research Report Number 84 WAITE MEMORIAL BOOK COLLECTION DEPT. OF AG. AND APPLIED ECONOMICS 1994 BUFORD AVE. -232 COB UNIVERSITY OF MINNESOTA ST. PAUL, MN 55108 U.SA.

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preface By the late 1970’s, it had become clear to the cooperative community that existing theories of farmer cooperation had failed to address adequately many of the critical issues facing farmer cooperatives. The environment in which these organizations and their patron-members operated had grown much more complex than in the 1950’s and 1960’s, when most of the previous theories about the behavior of farmer cooperaUves were developed. Hence, there was a need for new theoretical work to guide empirical, problem-oriented research aimed at finding ways to improve performance of individual cooperatives, and the cooperative system as a whole. Beginning in 1980, the Agricultural Cooperative Service (ACS) in the U.S. Department of Agriculture played a critical role in fostering a new round of work on cooperative theory by funding research at several land-grant universities. Some results of that research have already appeared in the report, Cooperative Theory: New Approaches, edited by Jeffrey S. Royer (ACS Service Report No. 18). This report is companion to the earlier publication, and attempts to synthesize the results of the ACS-sponsored “Cooperative Theory Project” as well as other recent developments in the theory of farmer cooperation.1 Many people provided helpful reviews of this report, including James Shaffer, Larry Hamm, V. James Rhodes, Ronald Cotterill, Jeffrey Royer, Michael Turner, Hugh Moore, Kenneth Duft, David Cobia, and David Holder. Any remaining errors of fact or interpretation are solely those of the author. Ii’

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contents HIGHLIGHTS iv WHY STUDY COOPERATIVE THEORY? .. 1 Organization of the Report . : . 1 Role of Theories and Economic Models 1 DEVELOPMENTS IN COOPERATIVE THEORY THROUGH 1980 .. 2 The Cooperative as a Form of Vertical Integration .. 2 The Cooperative as a Firm .. 3 The Cooperative as a Coalition .. 8 RECENT DEVELOPMENTS IN COOPERATIVE THEORY .. 8 Reasons for the Resurgence .. 8 Approaches Used . 9 Extensions of the “Cooperative as a Firm” Approach .. 9 Analyses of Cooperatives in the Planning Sector 12 The Cooperative as a Nexus of Contracts .. 14 The Cooperative as a Coalition . 19 SUMMARY, CONCLUSIONS, AND IMPLICATIONS .. 22 Implications of Recent Theoretical Research .. 22 Cooperative Goals and Governance .. 22 Cooperative Finance .. 22 Improving System Coordination 23 Public Policy Toward Cooperatives . 23 Implications for Future Research 24 NOTES .. 25 REFERENCES .. 28 iii

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iv The 1980’s witnessed a resurgence of research by agricultural economists on the theory of agricultural cooperation. The renewed interest cooperative theory resulted from the recognition that existing theories failed . address many of the challenges facing agricultural cooperatives today. The challenges include the need for cooperatives to compete with very large, oft conglomerate, investor-owned firms (IOF’s); the necessity of raising large amounts of equity capital to capture economies of size; the dilemmas in serving a highly heterogeneous group of members, whose interests sometimes conflict; and the difficulties of dealing in increasingly risky markets:, In addition, the growth and consolidation of cooperatives raised many ;1 questions for public policy, such as whether large cooperatives posed antitru ; problems; whether cooperatives could improve market coordination, thereby substituting for Federal income-and price-support programs; and whether large, multi-division cooperatives really behaved any differently from IOF’s. In attempting to address these issues, economists have extended previous models that viewed the cooperative as a firm; developed new approaches that model the behavior of cooperatives in highly concentrated industries (lithe planning sector”); analyzed the cooperative as a coalition of various participants, such as farmers, managers, board members, and input suppliers; and modeled the cooperative as a set of explicit and implicit contracts among these partiCipants. In carrying out these analyses, theorists have adapted many approaches originally developed for the analysis of investor-owned firms, such as applications of game theory, agency theory, behavioral theories of the firm, and the theory of contestable markets. The recent work has shown that the structure of cooperatives offers them opportunities and creates challenges for them different from those present in IOF’s. Consequently, cooperatives may perform differently than IOF’s, both as individual economic entities and in their effect on the wider economy. Whether an individual cooperative realizes its potential for improving economic performance and farmer welfare, however, depends critically on the co-op’s structure and practices. The theoretical work has also demonstrated that setting operational goals for a cooperative involves striking delicate balances. For example, a co-op needs to balance the goal of increasing its net margin with the goal of offering members attractive prices. Attempting simply to maximize the cooperative’s net margin does not maximize members’ welfare, nor does focusing solely on providing members with favorable prices. Similarly, when the cooperative has a heterogeneous membership, the co-op needs to balance benefits among various members to preserve the membership base. In some instances, differential pricing of goods and services to members is necessary to prevent those with better market opportunities from abandoning the cooperative, which could leave the remaining members worse off. Striking such delicate balances is one of the key responsibilities of the board of directors. Another area of theoretical work has been the implications of the owner relationship for cooperative finance. The lack of ability to “float stock” constrains the equity base of cooperatives and prevents the emergence of a secondary market for cooperative equity certificates. The absence of such a

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brz market has a number of implications for cooperative investments and governance, including the reluctance of cooperatives to undertake projects with long gestation periods and the need for cooperatives’ boards of directors to playa much more active role -in the governance of their organizations than do IOF boards of directors. Theory also suggests that potential exists for improving the performance of the entire cooperative system, not just individual cooperatives. For example, in some cases there is theoretical justification for more collaboration and less competition among cooperatives. Such collaboration could reduce total system costs and improve returns to farmers. But both theoretical work and common observation highlight several factors that can block such collaboration, such as the vested interests of current managers, owners, and board members, and the belief by some members that competition is the only way of ensuring control over management. Hence, any move to increase collaboration among cooperatives will have to address these issues. The theoretical work also shows that in some circumstances cooperative members would be better off taking collective action via the cooperative, but that incentives exist for them to behave independently, acting as free riders. An example is the lack of patron commitment to a cooperative that is acting as a competitive yardstick. To capture the potential for improved coordination, cooperatives need to develop mechanisms to increase member commitment, such as contracts with members that have significant penalties for nonperformance. The development of such mechanisms needs to be coupled with actions aimed at strengthening member control, however; otherwise, such actions might simply remove membership pressure on the management and the board to perform their duties effectively. The recent theoretical research also reaffirms that there are often valid justifications for public policies to support cooperatives, particularly because of their effects on competition in highly concentrated markets and their potential to improve market coordination. The recent work cautions, however, that the public should not grant carte blanche to cooperatives, as certain types of cooperative structures may behave similarly to an IOF conglomerate. In particular, theory suggests that cooperatives that follow a closed membership policy and make heavy use of unallocated retained earnings are more likely to pose antitrust problems. Areas warranting additional theoretical research include further analyses of cooperative-IOF joint ventures and analyses of how cooperatives can effectively collaborate to counterbalance increasing IOF concentration in certain segments of the agricultural economy. In addition, the theoretical work outlined in this report generates many new hypotheses that deserve empirical investigation. Testing these hypotheses may be one of the most fruitful areas for further cooperative research. v

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r Farmer Cooperative Theory: Recent Developments John M. Staatz, Associate Professor Department of Agricultural Economics Michigan State University WHY STUDY COOPERATIVE THEORY? Recently the CEO of a major California cooperative spoke on “Agricultural Cooperatives: Are They Still Relevant?” (Allewelt). The question is heretical to many in the cooperative community, yet it is one that is increasingly heard. The answer ultimately depends on what, if anything, is unique about farmer cooperatives, and what advantages they offer patrons in dealing with today’s complex and rapidly changing business environment. Cooperative advocates have discussed their unique features ever since the days of the Rochdale pioneers. In the 1920’s, two schools of thought developed in the United States regarding the justification for, and function of, farmer cooPeratives. One school, identified with Aaron Sapiro, argued that the major function of farmer cooperatives was to unify farmers on a commoditywide basis so that they could exert market power and raise total returns to agriculture. By contrast, followers of Edwin Nourse contended that cooperatives should function as “competitive yardsticks.” They should not try to monopolize commodity markets but simply add enough competition to the system to give farmers a basis on which to judge the performance of investor-owned agribusinesses. Since the 1940’s, academicians, particularly economists, have drawn on Sapiro’s and Nourse’s ideas as well as general economic theory to develop formal models of cooperatives’ behavior. These models highlight how the unique features of farmer cooperatives affect their business practices and examine the implications of those practices for patron-members and society at large. Between the mid-1940’s and the mid-1960’s, cooperative theorists focused particularly on the nature of the relationship between the cooperative and its member-patrons and the implications of that relationship for how the cooperative priced its goods and services, for how those pricing and output decisions affected market competition, and for the appropriate rules for governing the cooperative. After the mid-1960’s, research on cooperative theory fell off Notes and references carried at end of text. dramatically. The environment in which cooperatives and their members operated, however, continued to evolve rapidly, posing new problems and opportunities for cooperatives, many of which were not addressed by existing theories of farmer cooperation. In response to these new challenges, there has been a resurgence during the 1980’s of theoretical work on farmer cooperatives. A key element in this resurgence has been financial and intellectual support offered by the Agricultural Cooperative Service (ACS). Since 1980, researchers have explored the basic nature of farmer cooperation, the theoretical benefits and limits to cooperative enterprise, and the implications of these for cooperative members, managers, and public policy. This report describes and evaluates the recent theoretical developments; examines some of their implications for cooperative decisionmaking, management practices, and public policy; outlines remaining areas of conflict and gaps in the theory of agricultural cooperation; and discusses topics for future research. Organization of the Report Although this report briefly mentions some recent work by European theorists, it focuses primarily on the North American agricultural economics literature since 1980.2 It also concentrates almost exclusively on the literature concerning agricultural marketing and supply cooperatives. It does not review the voluminous, and in many ways parallel, literature on the theory of the labor-managed firm (including the agricultural production cooperative) or on the theory of agricultural bargaining cooperatives (which is similar to the theory of labor unions) and mentions only briefly work on the theory of consumer cooperatives.] Role of Theories and Economic Models Before proceeding, it is useful to say a few words about the nature and purpose of economic theories and models. All models and theories of behavior are by definition abstractions and simplifications of reality. The purpose of a theory is to simplify the complexity of

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independent member firms. Throughout his analysis, Phillips assumed that member firms dealt exclusively with the cooperative. Therefore, he did not address the broader question of how a firm determines its degree of participation in the cooperative: “When a group of individual firms form a cooperative association, they agree mutually to set up a plant and operate it jointly as an integral part of each of their individual firms (or households in the case of a consumer cooperative). The cooperative has no more economic life or purpose apart from that of the participating economic units than one of the individual plants of a large multi-plant firm” (Phillips, pp. 74-75). Two separate issues need to be distinguished: Whom was the cooperative set up to serve and how does it make its output and pricing decisions? Phillips did not distinguish these issues as separate, concluding that since the cooperative was set up solely to serve its members, its decisions could be modeled as if the cooperative were one plant of a multiplant firm. Many years earlier economists had developed rules for how an IOF operating several different plants should set output levels in each plant to maximize profits, and Phillips argued that the optimal output and pricing rules for the members of a cooperative could be determined by simply extending this basic theory. Phillips’ proposed pricing and output rule involved all the member firms producing at a point where their marginal costs of production were equal to the marginal revenue the cooperative received from an additional unit of output. Among the problems with this proposed solution is that members would not have an incentive to produce at that level if the cooperative plant faced either increasing or decreasing marginal costs. In those cases, the marginal cost faced by the member would diverge from that faced by the cooperative as a whole. For example, if a processing cooperative faced increasing marginal costs, the per-unit margin would fall for each additional unit of raw product the cooperative processed. The individual member would only take into account how this decrease in per-unit margins affected his or her profits, not those of the other members of the cooperative and hence would have an incentive to expand production beyond the optimum level for the cooperative as a whole. The member would therefore not bear the full marginal cost of his or her actions on the cooperative. (For details, see Sexton, 1984b, pp. 64-69.) Furthermore, following the Phillips rule requires that each member know the equilibrium outputs of all other members to determine how much to produce. Phillips argued that to achieve an optimum level of production, each member must share the benefits and costs of the joint plant in direct proportion to the member’s share of the total business conducted through the cooperative. Similarly, the benefits and costs of individual departments should be allocated among the members in direct proportion to .1heir use of those departments (pp. 76-78). Such a view seems consistent with the cooperative principle of service at cost. It assumes, however, that: 1. All costs of cooperative activity should be borne by members because they accrue all the benefits of that activity, 2. All the benefits from one department of a cooperative accrue solely to the direct users of that department, 3. All activities of the cooperative in one time period generate benefits only in that time period, and 4. Overhead costs can be allocated among departments in a nonarbitrary manner. In raising the issue of sharing costs and benefits of the cooperative in proportion to use, Phillips helped spark the debate over “equal versus equitable treatment” of members of a cooperative. The issue has become more pointed in recent years with the growing diversity of cooperative members. Phillips clearly came down on the side of those who advocated differential treatment of members based on their degree of patronage. In keeping with his “theory of proportions,” Phillips also advocated that voting in cooperatives be proportional to patronage. He argued that since costs and benefits in cooperatives should ideally be distributed proportionately, the rule of one-person, vote in cooperatives “had no scientific basis” (pp. 86-87). The argument over proportional voting continues today, with some contending that it is necessary to put control of the cooperative in the hands of those who , really use it. Others, however, see proportional voting as threatening the basic tenet of democratic control. The Cooperative as a Firm Stephen Enke, writing about consumer cooperatives in 1945, was the first to analyze the cooperative formally as a separate type of business firm. He pointed out that on a day-to-day basis the cooperative manager had to choose what to maximize (total sales, level of the patronage refund, profits, etc.). 3 II I I 1’1′ II! , ,

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Enke traced the consequences for the cooperative and for society as a whole of choosing alternative goals. Enke’s work represented the beginning of a long and often muddled debate about what cooperatives should or did seek to maximize.4 Often this debate confused what was desirable with what was feasible and did not distinguish shortrun outcomes from longrun outcomes. Enke analyzed the situation of a cooperative that was operating either as a monopolist or in monopolistic competition (fig. I). In other words, the cooperative had some influence over the price it could charge for its goods and services. (The cooperative’s ability to vary its prices without losing all of its patrons is indicated by the downward-sloping demand curve in figure 1.) The cooperative also had some fixed investments, such as a store of a given size.’ Enke concluded that in situation the welfare of both the cooperative mem and society as a whole was maximized if the cooperative manager sought to maximize the sum of cooperative’s “profits” (producer surplus) and the members’ benefits from lower prices (consumer surplus).6 This was achieved at the point where the cooperative’s marginal cost curve intersected its ; demand curve (point B). At that point, the decrease i”*J member-patron benefits that would result from the in the cooperative’s “profits” from a unit increase in ,1:; would be just offset by the increase in benefits (as measured by consumer surplus) that would;i result from the lower prices that accompanied expandcMI output (Cotterill, pp. Figure 1 – Alternative Shortrun Goals for a Supply or Consumer Cooperative Operating In Monopolistic Competition Price f>1 – -_._-Ł..ŁŁŁ.Ł.Ł. · lMARGINAL REVENUE · · Point A – Maximization of cooperative’S profit (analogous to IOF’s goal of profit maximization) Point B -Maximization of sum of consumer and producer surpluses (Enke’s solution) Quantity Point C – Minimization of member price consistent with covering costs (“zero surplusn solution -e.g., Helmberger-Hoos) Source: Enke, p. 149. Similar figures are also pr:esented in Kaarlehto (1956), p. 283; LeVay, p.12; and Cotterill, p. 189. 4

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I r Enke’s model emphasized that to maximize member benefits, the cooperative manager had to balance the benefits members received as owners of a profitable enterprise with the benefits they received as patrons of an establishment that offered favorable prices. Going too far in one direction or the other, that is, running the cooperative in a manner that simply maximized profits as a separate entity or running it in a way that simply minimized prices to members, would reduce total member benefits. Enke’s work thus emphasized an important implication of the unique owner-patron relationship in cooperatives-the need to balance benefits derived as stockholders with those derived as patrons. There is a problem, however, with the managerial goal that Enke proposed: Under most circumstances members would not want to patronize the cooperative at the level that would maximize total member benefits. At point B in figure 1, the cooperative would generate a per-unit net margin equal to BO. If this were rebated to members in proportion to their patronage, they would likely interpret the refund as a reduction in the price, which would give them an incentive to expand their patronage beyond the welfare-maximizing point B. If the cooperative does not impose some limit on patronage, the only stable patronage point (equilibrium) is point C, at which point the cooperative earns no net margin. Point C, however, is not the maximizing point. Point B would be a stable equilibrium only if the members regarded the patronage refund as a windfall gain or if the cooperative faced constant marginal costs of production. In the latter case, the marginal cost and average cost curves would coincide, as would points B and C.’ Enke’s work initially was ignored by theorists working in the area of agricultural cooperatives. Most of the early work on the agricultural cooperative as a firm emerged in reaction to the writings of Emelianoff, Robotka, and Phillips, which generated much critical discussion in professional journals. Critics of the “cooperatives as vertical integration” approach attacked the narrow definition of the firm used by Emelianoff, Robotka, and Phillips, and hence the implied locus of decisionmaking within the cooperative, and the existence and stability of the cooperative equilibrium posited by Phillips. Emelianoff and his followers had argued that because cooperatives do not accumulate capital and seek profit for their own account, they did not meet the classical definition of a firm. The critics countered by describing the cooperative as a “going concern,” an entity to which participants delegate entrepreneurial functions to gain the advantages of joint action. These authors argued that such revocable delegation of authority resulted in hired managers making most of the cooperative’s day-to-day decisions. Managers pursued certain objectives (for example, maximizing the cooperative’s net margins or sales), and the pricing and output decisions of the cooperative resulted from the pursuit of those objectives. HeImberger and Hoos, whose work became the standard model in cooperative theory for nearly 20 years, argued that the agricultural cooperative could be modeled as a separate firm, using tools from the standard neoclassical theory of the investor-owned firm. HeImberger and Hoos explained that the theory of the profit-maximizing firm needed to be modified before it was applied to cooperatives because, the authors argued, cooperatives did not try to maximize their own profits but rather those of their members. Cooperatives did this by operating on a profit basis and returning all their “surplus” (net margins) to the members. HeImberger and Hoos assumed that in an agricultural processing cooperative, the manager would try to maximize member benefits by maximizing the average per-unit cooperative surplus (or “pay price”) to the farmer. For a supply cooperative, the analogous goal would be to minimize the price of the good or service sold by the cooperative, subject to meeting per-unit costs of production. This would be achieved by operating at point C in figure 1. HeImberger and Hoos developed models of both shortrun and longrun behavior by an agricultural processing cooperative. In the shortrun model, the cooperative took the amount of output supplied by the members as given. In the longrun model, output could be varied depending on whether the cooperative adopted an open-or closed-membership policy. Hence, unlike Phillips, HeImberger and Hoos addressed the question of when it would be in the interest of current members to limit further membership in the cooperative. The general conclusion was that it would be in the interest of existing members to expand membership whenever expansion would allow the cooperative to capture economies of size, thereby reducing per-unit processing costs’ On the other hand, if the cooperative were facing increasing marginal costs, expanding the volume moving through the plant would increase per-unit costs, and it would be in the interest of existing members to restrict membership to prevent this from happening’ Even if it were in the interest of existing members to limit membership, others might want to join the 5

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cooperative if it offered better prices than alternative market outlets. Hence, there can exist a potential conflict of interest between existing members and potential members of the cooperative. Heimberger and Hoos claimed that how this conflict was resolved depended on who controlled the cooperative. A cooperative dominated by a manager intent on expanding the volume of business might opt for expanding membership, while an organization firmly in the hands of farmer members might restrict it. Although HeImberger and Hoos discussed this polen conflict, they did not attempt to model the bargainin ” process among members, the board, and management; settle the matter. : Heimberger and Hoos assumed that members acted as price takers, that is, an individual member could not influence the price the cooperative’ offered. Consequently, each farm-firm had a defined supply curve, which showed the amount of ra product the firm would be willing to sell to the ‘ Figure 2 – Heimberger and Hoos Model of Cooperative Price and Output Determination In the Long Run-Open and Closed Membership Raw product price, Pm Source: HeImberger and Hoos (1962), p. 289. Notes: Sc = Aggregate supply curve for closed-membership cooperative So = Aggregate supply curve for open-membership cooperative LRNR = Longrun net returns function Volume of raw product handled, M The net revenue function, as defined by HeImberger and Hoos, shows for each level of output of the cooperative the maximum per-unit amount (or ‘Pay price”) the cooperative can offer for the raw product and still cover all processing costs. The net revenue function is thus analogous to the cooperative’s demand function for the raw product, based on the assumption that the cooperative strives to just break even. 6

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