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Essential economic roles of farmer co-ops.

Economic structure of cooperatives--what are co-ops?

In his 1942 book, Economic Theory of Cooperation: Economic Structure of Cooperative Organizations, Ivan V. Emelianoff said that for economic analysis of cooperatives, the economic structure of cooperative organizations should be clearly defined, and the definition should be free from the encumbrance of sociological, legal, technical, social-philosophical and ethical considerations.

His definition: "Cooperative organizations represent the aggregates of economic units."

"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."

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."

This economic definition of cooperatives seems to be simple, yet it is very robust. What naturally flows from this definition are what people often call "cooperative principles," such as: members own, members control, members use, and members benefit from the cooperative.

Following Emelianoff's definition, these are the characteristics of cooperatives:

* A cooperative is an agency owned and controlled by members and 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 working 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.

* 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." (Shaffer)

Market performance of cooperatives--what do cooperatives do?

The first academic paper on the theory of cooperation, "Economic Philosophy of Co-operation," by Edwin G. Nourse, was published in 1922 in the American Economic Review. His ideas still have relevance to the reality of market performance of cooperatives today.

Several examples from the paper illustrate how farmers organized in agricultural cooperatives can jointly perform certain market functions efficiently--functions which usually cannot be satisfactorily carried out alone by individual farmers. These include:

* Cooperation to gain market access for producers who otherwise do not have a market outlet.

* Local and regional coordination of cooperatives to compete with private competitors that have grown to great sizes.

* Formation of region-wide associations of growers, often in horticultural regions, to assemble, process and distribute their products.

These examples show how cooperatives are organized and grow to enable farmers to exercise countervailing power and compete. Although Nourse did not directly use the term "countervailing power" (the term was coined later, by Galbraith in 1956), he did state that the keynote of the philosophy of cooperation was for agriculture to have a type of organization of the size that has an effective bargaining position in dealing with commercial organizations.

Another term in the cooperative lexicon that is attributable to Nourse is "competitive yardstick," following his "brief remark" in 1945, in which 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."

This is the summary of Nourse's ideas regarding the roles cooperatives play in the marketplace:

* Cooperatives are organized for efficiently carrying out specific business functions.

* Cooperatives can be of any size and geographical 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 of efficient operations.

* 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.

[Author's note: Whether the market could ever be truly competitive is debatable.]

Transaction governance roles of cooperatives--how do cooperatives interact with other market participants?

Cooperatives interact with 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).

In marketing milk and milk products (for example), farmers and their cooperatives may engage in the following transaction scenarios.

Scenario I. In a subsistence agricultural economy, farm production in excess of family consumption may be sold off farm. There could be many sellers and buyers. The transactions are incidental to subsistence farming, do not require specific assets, and primarily belong to a bygone era.

Scenario II. Commercial milk production requires capital investment in specialized assets that cannot be easily employed for alternative uses. Asset specificity, product perishability and market volatility cause uncertainty and pose hazards to the investment of dairy farmers. They are vulnerable when dealing with a small number of milk buyers (processors). They may organize cooperatives to gain countervailing power. However, contracts that spell out the terms of trade as legal rules may not relieve the hazard. 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.

Scenario III. Cooperatives are organizations of farmers and have comparative advantages of working closely with members for assembling milk, providing field services and performing farm-related functions. Many processors have chosen to rely on cooperatives for milk supplies that are tailored to their requirements for volume, quality, composition and/or delivery schedule. Under such an arrangement, the transactions 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 negotiation or by arbitration.

Scenario IV. In addition to selling members' milk, it may be necessary for a dairy cooperative to forward-integrate into processing dairy products to balance milk supply or to generate higher margins from the market for members' milk. These processing enterprises are under the cooperative's hierarchical administrative control .

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). The four scenarios correspond to the four transaction modes in table 1 that is adapted from Williamson's Simple Contractual Schema (figure 1).

The transaction 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 at cost-plus), considerable administrative control (by fiat) and forbearance is the implicit contract law of internal organization (the parties must resolve their differences internally).

Cooperatives are transaction governance structures, as are non-cooperative firms. Depending on the lines of business, transactions can occur under all possible governance modes. Cooperatives adapt to various governance modes for economizing on the transaction cost.

For entering into credible contractual relationships with buyers, 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, the cooperative serves as a single transaction entity for credible contracting with buyers. Therefore, it introduces order and eliminates conflicts among members who would otherwise be competing individually for customers. All these should contribute to lower the transaction cost.

A cooperative does not own the assets for producing the milk 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 members' 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 member-farms.

Variations on the cooperative business model

Cooperative organizations represent the aggregates of economic units. The intrinsic cooperative structure entails the uniqueness of the cooperative's organization, governance, equity financing and operation. Different commodities have their own characteristics and different types of cooperatives have their own special attributes.

Laying out each type of cooperative (or each cooperative) in the format of table 2 (page 23) provides a comprehensive view of their similarities and differences. Most variations occur in the area of operation, where the cooperative's commodities, lines of business and transaction governance modes determine how it operates.

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.

* 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.

* 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.

* 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.

* 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).

* American Heritage Dictionary of the English Language, New College Edition, Houghton Mifflin Company, Boston, 1976.

Editor's note: This article focuses on the core points of the author's presentation, "Farmer Cooperatives and Value Creation: the Example of Dairy Farmers in the United States," delivered at the 5th meeting of the Organization for Economic Cooperation and Development (OECD) Food Chain Analysis Network, Oct. 30-31 in Paris. It is also a concise summary of a recently completed study into the nature of the cooperative, as reported in two recent research reports available from USDA Rural Development (RR 221 and 224) and a series of nine articles that have appeared in Rural Cooperatives magazine.

This summary addresses four salient points:

1. Economic structure of cooperatives--what are cooperatives?

2. Market performance of cooperatives--what do cooperatives do?

3. Transaction governance roles of cooperatives--how do cooperatives interact with other market participants?

4. Variations on the cooperative business model.

By K. Charles Ling, Ag Economist

USDA Rural Development

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

Table 1--Transaction governance modes and attributes

Transaction              Asset         Investment hazard
governance mode          specificity   safeguard
                         (k)           (s)

A: Unassisted market     0             0

B: Unrelieved hazard     >             0

C: Hybrid                >             >
(Credible contracting)

D: Hierarchy             >             >
(Administrative)

Transaction              Incentive              Administrative
governance mode          intensity              control

A: Unassisted market     High                   Little

B: Unrelieved hazard     <                      >

C: Hybrid                <                      >
(Credible contracting)

D: Hierarchy             Low                    Considerable
(Administrative)         (pricing for           (by fiat)
                         successive stages is
                         cost plus)

Transaction              Contract
governance mode          law regime

A: Unassisted market     Competitive norm

B: Unrelieved hazard     Legal rules contract
                         regime

C: Hybrid                Credible contracting
(Credible contracting)

D: Hierarchy             Internal implicit
(Administrative)         contract law
                         (Forbearance)

Source: Adapted 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.

Table 2--Variations on the cooperative business model

Types of             Structure                 Organization
cooperatives

Dairy cooperatives   Aggregates of economic    Centralized member
(1)                  units                     organizations

Agricultural         Aggregates of economic    Mostly centralized
marketing            units                     member organizations;
cooperatives                                   some are federated

New-generation       Aggregates of economic    Centralized member
cooperatives         units                     organizations

Purchasing           Aggregates of economic    Local (retail)
cooperatives         units                     cooperatives are
(2)                                            centralized; many
                                               federated with other
                                               locals; federated
                                               cooperatives may have
                                               direct members

Affordable Care      Aggregates of economic    Organized by sponsors;
Act CO-OPs (3)       units (health insurance   then become local (in-
                     subscribers)              State) centralized
                                               member organizations

Multi-stakeholder    Aggregates of economic    Centralized member
cooperatives (4)     units                     organization

Farm production      Aggregates of economic    Centralized member
cooperatives         units that are not        organization
                     independent in
                     production operation

Cooperatives with    Mixture of patron and     Defined by state laws
non-patronage        non-patron members
members

Types of             Governance                Source of equity
cooperatives

Dairy cooperatives   Member-governed           Members
(1)

Agricultural         Member-governed           Members
marketing
cooperatives

New-generation       Member-governed           Members; tied to
cooperatives                                   delivery rights

Purchasing           Member-governed           Members
cooperatives
(2)

Affordable Care      Initially formation       Sponsors and
Act CO-OPs (3)       board; then member-       supporters; accumulated
                     governed                  surpluses

Multi-stakeholder    Member-governed           Members
cooperatives (4)

Farm production      Member-governed           Members
cooperatives

Cooperatives with    Defined by state laws     Defined by state law
non-patronage
members

Types of             Operation
cooperatives

Dairy cooperatives   Members' exclusive
(1)                  marketing agent--
                     unique economics

Agricultural         Unique economics if
marketing            exclusive marketing
cooperatives         agent; otherwise, like
                     other firms

New-generation       Business volume defined
cooperatives         by delivery rights

Purchasing           Sourcing supplies or
cooperatives         services for sale to
(2)                  members and patrons

Affordable Care      Operations are the same
Act CO-OPs (3)       as other insurance
                     issuers in the relevant
                     markets; must meet COOP
                     Program standards and
                     requirements

Multi-stakeholder    A framework for
cooperatives (4)     multiparty, multi-
                     stage credible
                     contracting among
                     members

Farm production      A vertical integration
cooperatives         between members and the
                     cooperative in
                     production

Cooperatives with    Defined by state laws;
non-patronage        most likely member-
members              patrons' business

(1) Separately listed and used as the standard bearers of
traditional cooperative business model.

(2) Include farm supply cooperatives, utility cooperatives, service
cooperatives, consumer cooperatives, credit unions, etc.

(3) Qualified Nonprofit Health Insurance Issuers under the Consumer
Operated and Oriented Plan (CO-OP) Program.

(4) Defined as cooperatives having, for example, farmers, final
customers and intermediaries in the supply chain as members.
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Author:Ling, K. Charles
Publication:Rural Cooperatives
Date:Nov 1, 2013
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