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BARRIERS AND OPPORTUNITIES FACING COOPERATIVES
IN IMPROVING THE ECONOMIC COORDINATION
OF THE FARM SUPPLY INDUSTRY

BY
John Joseph Haydn

A DISSERTATION

Submitted to
Michigan State University
in partial fulfillment of the requirements
for the degree of

DOCTOR OF PHILOSOPHY
Department of Agricultural Economics

1988

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ABSTRACT

BARRIERS AND OPPORTUNITIES FACING COOPERATIVES
IN IMPROVING THE ECONOMIC COORDINATION
OF THE FARM SUPPLY INDUSTRY

BY
John Joseph Haydn

Farm supply cooperatives are major actors in the
agricultual input industry, providing a wide range of
products and services for their farmer members. But there
is a growing concern that farmer cooperatives are no longer
living up to their potential. Problems within the
federated cooperative system surface at two levels. In a
vertical sense, there has been an erosion of patron-owner
commitment to their cooperatives. Manifestations of this
problem are evident in patronage and capitalization issues.
A second problem involves the coordinating relationships
among cooperative firms. Poor horizontal coordination is
demonstrated by the often aggressive and detrimental
competitive behavior among local and regional cooperatives.

This research examines the barriers and opportunities
to improved micro and macro coordination of federated
supply cooperatives by utilizing a systems approach. The
systems analysis is supplemented with game theory and

transaction cost economics. Transaction costs

demonstrates the effect asset-specificity has on the
coordination and performance of the input system and the
response of farmer-members to these class of inputs. Game
theory emphasizes the structure of incentives to explain
the behavior of various players in the input system.
Finally, a case-study of farmers, local and regional
nidwest supply cooperatives is the primary research method
used to illustrate these conceptual tools.

An important finding of the study is that vertical
coordination in the federated system is hindered by the
structure of incentives facing participants and the
specialzed nature of many inputs used by farmers. A mean-
variance model of farmer decision making showed that a
producer's major incentive to forward contract is the
discount premium attached to the purchase, not a desire to
minimize risk. Finally, the confluence of a competitive
ideology, economic necessity and the vested interests of
perSons in positions of power, are the major reasons why

competition among cooperatives persists.

Copyright by
John Joseph Haydn
1988

ii

ACKNOWLEDGEMENTS

The achievement of a personal goal is never solely
attributable to that individual. Such has been the case
for this research.

John Staatz, my program and dissertation advisor,
provided invaluable guidance at all stages of the research.
His meticulous methods and generosity of time greatly
facilitated and enhanced the final product. I sincerely
thank him. Jim Shaffer was uncommonly persistent in
challenging my thoughts and ideas, especially at the early
stages of the research. His contributions are appreciated.
The dissertation also benefited from the remaining members
of my committee, Al Schmid and Jack Mchwen. Finally, I
would like to thank Stan Thompson and Bob Myers for their
valuable assistance with chapter six.

This research was funded under a cooperative agreement
between Michigan State University and Agricultural
Cooperative Service (AC8) of USDA. I express my gratitude
to the ACS for their financial support and their assistance
in various aspects of the research. In particular I would
like to thank Jim Haskell, John Dunn and Randall Torgeson.

Perhaps the most crucial contributors were the many

cooperative members, managers and board members who

iii

graciously granted me interviews and shared with me their
views and experience of farm supply cooperatives. I am
very grateful to them.

Even though my parents, Eugene and Mary, were not
physically present throughout my program, they supported my
efforts wholeheartedly and instilled within me that special
desire to "keep trying." They know my love for them.

Of course my greatest debt and appreciation are to my
wife, Lnanne, who stood by and supported me throughout the
entire graduate progam. Without her love, effort and
understanding, the goal would never have reached fruition.

I deeply thank her.

iv

TABLE OF CONTENTS

CHAPTER 1 - INTRODUCTION . . . . . . . . . . . .

The Problem. . . . . . . . . . . .
Research Objectives and Hypotheses . .
Cooperative Entry into the Farm Supply
Industry . . . . . . . . . . . . . .
Farm Supply Problems: Current Problems
1. 41 Problems of a Vertical Nature .
1.42 Problems of a Horizontal Nature.

UMP

1
1
1
1.

h
o o o o
o o a 0

CHAPTER 2 - A FRAMEWORK FOR THE ANALYSIS OF FARM
SUPPLY COOPERATIVES. . . . . . . . .

2.1 Principle Components of the Framework. .
2.11 A Systems Approach . . . . . .
A. The Cooperative Vertical System
B. A Horizontal Perspective. . . .
2.2 Additional Concepts for Analyzing
Cooperative Coordination . . . . . .
2.21 Game Theory. . . . . . . . . .
A. The Cooperative Game. . . .
B. The Noncooperative Game . .
2.22 The Transaction Cost Approach.
2.23 The Transactions Approach to
Cooperative Organization . . . . . .
A. Cooperative versus Investor-Owned
Firms . . . .
B. Asset Fixity, Uncertainty and
External Effects. . . . . . . . .
2.3 Concluding Remarks . . . . . . . . . . . .

CHAPTER 3 - RESEARCH METHODS . . . . . . . . . .

3.1 General Approach . . . . . .
3. 2 Literature Search and Pilot Interviews
3. 3 Case Studies . . . . . . . . . .
3.31 Rationale. . . . . . . . .

3.32 Interview Design . . . .
3.33 Cooperative Firm Selection
A. Regional Selection. . .
B. Local Selection . . .
C. Farmer Selection. . .
3.34 The Interview Process. .

21

21
21
22
29

33
34
35
39
43

45

45

47
58

6O

60
60
61
61
62
64
64
64
65
66

CHAPTER 4 - PATRON-OWNER COMMITMENT AND VERTICAL

COORDINATION . . . . . . . . . . . . . 69
4.1 The Commitment Dilemma . . . . . . . . . . . 69
4.11 Patronage and Commitment . . . . 69
A. Farmers' Patronizing their Local
Cooperative . . . . . . 69
B. Local Cooperatives Patronizing
their Regional. . . . . . . . . . . 71
4.12 Capitalization and Commitment. . . . . 72
A. Farmer Investment in Local Co-ops:
A Local Perspective . . . . . . . 72
B. Local Investment in the Regional
Firm: A Regional Perspective. . . . 74
C. Equity Redemption Programs. . . . . 76
D. Misdirected Investment Policies . . 81
4.2 Member Commitment and Economic Coordination. 82
4.21 Commitment through Patronage . . . . . 82
A. A Regional Perspective. . . . . . . 82
B. A Local Perspective . . . . . . . 86
4. 22 Equity Capital and Coordination. . . . 90
A. Regional Effects. . . . . . . . . . 90
B. Local Effects . . . . . . . . . . . 92
C. Total System Effects. . . . . . . . 95
4.3 Chapter Summary. . . . . . . . . . . . . . . 97

CHAPTER 5 - PROBABLE CAUSES OF PARTICIPANT BEHAVIOR 100

5.1 The Structure of Incentives. . . . . . . . . 100
5.11 Commitment through Patronage . . . . . 105
A. Farmer Commitment: A Farmer-Local

Perspective . . . . . . 105

B. Local Commitment: A Local-Regional
Perspective . . . . . . . 118

5.12 Commitment through Equity Investment:
A Synthesis. . . . . . . . . . . 121

5.13 Commitment: A Cooperative Game Analysis 125
5.2 Asset Pixity and Uncertainty. . . . . . . . 130
5.21 Input Fungability and Management

Practices. . . . . . . . . . . . . 131
A. A Classification of Inputs. . . . . 131
B. Management Effects. . . . . . . . . 134
5.22 Asset Specificity and Risk . . . . . . 139
A. Farmer Risk . . . . . . . . . . . . 139
B. Local Risk. . . . . . . . . . . . . 140
C. Regional Risk . . . . . . . . . . . 142
5.23 Input Fungability and Economic
Coordination . . . . . . . . . . . . . 143
5.3 Chapter Summary . . . . . . . . . . . . . . 148

vi

CHAPTER 6 - FORWARD CONTRACTING AS AN EXCHANGE

6.1

6.4

MECHANISM . . . . . . . . . . . .

Forward Contracting and the Cooperative
System. . . . . . . .
6.11 Benefits to Firms and the System .
6.12 Obstacles to Forward Contracting .
Forward Contracting in Factor Markets .
6.21 Exchange in Forward Contracting
for Inputs . . . . . . . . . . . . .
6. 22 The Model. . . . . . . . . . . . .
6. 23 Empirical Results. . . . . . . .
Forward Contracting: Incentive Structure
and the Distribution of Benefits. . . .
6.31 A Farmer View. . .
6.32 A Local View . .
6.33 A Regional View.
Chapter Summary . . .

CHAPTER 7 - THE COOPERATIVE SYSTEM AND

7.1

7.3

CHAPTER 8 - THE COOPERATIVE SYSTEM AND

8.1
8.2

HORIZONTAL COORDINATION. . . . . . . . .

Introduction. . . . . . . . .
7.11 Rationale for Behavior . . .

A. A Local View . . . . .

B. A Regional View . . . . .
7.12 A Nonc00perative Game Analysis
Horizontal Coordinating Mechanisms:
Destabilizing Forces. . . . . . . . . . .
7. 21 Introduction . . . . . . .
7. 22 Incentives and Participant Behavior.
Chapter Summary . . . . . . . . . . . . .

COORDINATION . . . . . . . . . . . .

Purpose of Study and Approach
Vertical Coordination Issues.
8.21 Commitment . . . . . . .
A. Major Findings. . . . . .
B. Conclusions and Recommendations
8.22 The Forward Contract Mechanism . .
A. Major Findings. . . . . . . . .
B. Conclusions and Recommendations
8.23 Farm Inputs and Asset-Specificity.
A. Major Findings. . . . . . . . .
B. Conclusions and Recommendations
Horizontal Coordination Issues. . . . .
8.31 Pre-reorganization Impediments .
8.32 Post-reorganization Impediments.
Future Research . . . . . . . . . . .

vii

HORIZONTAL

O O O O O O O O O O O O O O O

151

153
153
158
160

162
165
169

175
175
179
181
183

186

186
189
189
193
197

205
205
207
212

216

216
217
217
217
220
224
224
226
229
229
230
233
233
235
237

APPENDIX - COOPERATIVE QUESTIONNAIRE . . . . . . . 241

BIBLIOGRAPHY O O O O O O O O O O O O O O O O O O O 2 4 6

viii

LIST OF TABLES

Trend in Cooperative Market Share of
Farm Supplies Purchased by Farmers,
1951-1985 0 O O O O O O O O O O O O O O O 0

Interview Breakdown for Case Studies. . . .

Regional and Local Cooperative Managers'
Perceptions of Farmers' Alternative

Sources of Input Supplies . . . . . . . . .

Regional and Local Cooperative Managers'
Perceptions of Locals' Alternative
Sources of Input Supplies . . . . . . . . .

Regional and Local Cooperative Managers'
Views on Equity Investment and Redemption
Practices . . . . . . . . . . . . . . . . .

Factors that Influence Commitment as
Reflected by Age of Patron. . . . . . . . .

Major Farm Inputs of Farm Supply
Cooperatives and their Degree of
Fungibil ity O O O O O O O O O O O O O O O 0

Ordinary Least Squares (OLS) Estimates
of Fertilizer and Corn Price Expectations
M0d818 O O O O O O O I O O O O O O O O I O 0

Optimal Fertilizer Forward Contract Ratios
Under Alternative Degrees of Risk Aversion
and Discounts . . . . . . . . . . . . . . .

11

67

70

70

73

106

132

172

172

LIST OF FIGURES

A Simplified Illustration of the Federated

Cooperative System.

Conceptualization of Farmer Purchasing
Practices for Inputs.

The Three-Tiered Structure of the Federated
Cooperative System.

Illustration of Rules for Differentiating

Cooperative and Noncooperative Games.

Cost of Exchange for Famr Inputs as their
Specificity Increases, Using spot market (em)

or contract (c)

24

25

31

35

50

CHAPTER 1

INTRODUCTION

1.1 The Problem

This research focuses on farm supply cooperatives and
their role within the input sector of agriculture. It
recognizes cooperatives as a unique form of business
organization with potential to improve the coordination and
performance of the farm supply industry. Like their
proprietary counterparts, cooperatives have recently been
subject to powerful evolutionary forces that are
transforming the nature of the farm supply business.
Markets are becoming increasingly global: competitors
larger and more aggressive. Agriculture is struggling out
of a down-turn characterized by farmer and agribusiness
bankruptcies, loss of major export markets, chaos in farm
credit, and greater levels of volatility and uncertainty
than ever before (U.S. Department of Agriculture, October
1, 1987). In response, massive restructuring has occurred
at all levels of the food system. Merger, acquisition,
consolidation and integration by input manufacturers and
distributors have resulted in more crucial challenges to
input cooperatives (U.S. Industrial Outlook, 1987). A

further complicating factor is the relentless move towards

2
higher levels of agricultural specialization. Its primary
‘manifestations are a growing aiapaaiay between large and
small farms and increasing apaaiaiizatign of inputs,
capital equipment, and production methods. These forces
are placing new pressures on cooperatives to meet the needs
of an increasingly diverse membership.

And yet cooperatives should be well-suited to dealing
with these problems. Since cooperatives are owned and
controlled by patron-members, benefits that accrue to the
organization should be returned to them, flat to "outside"
investors. Also, because patrons have invested in their
cooperative, they are more likely to communicate their
needs and desires through their Board of Directors.1 To
the extent that management and customer have capitalized on
this relationship through effective communication, errors
in forecasting product demand should be minimized. This
has particular relevance to highly specialized and risky
inputs.

At another level, one-might anticipate that since the
fundamental purpose of cooperatives is to improve the
economic position of farmers, and because farmers are both
paazana and gynars, cooperative firms would be more

inclined to coordinate activities where economic

 

1These two characteristics, ownership and control,
suggest that patron loyalty may be greater for a
cooperative than for a proprietary firm. For a more in-
depth discussion of this topic, see Staatz, 1987a.

3
opportunities presented themselves. In other words,
because of the ownership element that links the cooperative
vertical system, traditional barriers that prevent improved
inter-stage coordination should be less obstructive than
for investor-owned firms (IOFs). Under this assumption one
‘would not expect excessive capital under-utilization or
poor inter-stage coordination within the cooperative
system. Hence, the analog to investor-owned firm
efficiency through competition could be characterized as
cooperative efficiency through cooperation.

In reality, however, it is clear that cooperatives are
not living up to their potential. The cooperative system
is in apparent disarray as evidenced by the emergence of
two practices carried out by many cooperative participants:
(1) in a vertical sense, a growing iagk_gf_ggmmitnant on
the part of patron-owners, and (2) in a horizontal sense,
more intensive gampaaitign among cooperatives--at both the
local and regional levels. The potential impact of this
behavior on the coordination and performance of
cooperatives is profound when one considers its root
causes. Altering this behavior is essential for the long-
term survival of the cooperative way of doing business, but
the antidote for some firms may be a bitter pill to
swallow.

These issues will be dealt with in more detail shortly.

First, however, the objectives and hypotheses of the

4
research are presented. These are followed by a discussion
of past farmer difficulties that precipitated the formation

of input supply cooperatives.

1.2 Research Objectives and HYpotheses

The primary purpose of this research is to examine the
opportunities and barriers to using cooperatives for
improving micro and macro coordination of farm supplies.
Micro coordination refers to the coordination of functions
and activities between firms. Coordinating total supply
with total demand for a product or an industry at each step
in the production-distribution process constitutes macro
coordination (Shaffer, 1987). Hence, the research involves
examining cooperative performance in both vertical and
horizontal dimensions. The following objectives and

hypotheses form the central structure of this research:

1.21. Micro Coordination Objectives
* Identify major vertical coordination problems within

and between the economic stages of the cooperative

system.

* Discuss barriers that hinder cooperative vertical
coordination.

* Recommend opportunities for improving system

performance and demonstrate potential effects from

their use.

1.22.

1.23.

5
Micro Coordination Hypotheses
The adoption of explicit purchasing agreements
between members and their cooperative could improve
vertical system coordination and reduce risks and
costs to participants on both sides of the market.
Current use of purchasing agreements is impaired
because of the unwillingness of certain participants
to share the risks of commitment.
As inputs become more specialized, the cost and
risks of handling them becomes greater. Inputs with
more asset-specific characteristics are handled

differently than are more fungible inputs.

Macro Coordination Objectives

Identify critical horizontal coordination problems
within the cooperative system, at both the local and
regional levels.

Discuss existing coordinating mechanisms used by
cooperatives and identify barriers that are
preventing a wider and more effective application of
these mechanisms.

Recommend changes in the structure of incentives
that would make individual member behavior more
consistent with the goals and objectives of the

group.

6
1.24. Macro Coordination Hypotheses

* The process of macro coordination by cooperatives is
impaired by competition and vested interests among
patron-owners, board members and management.

* Once a new level of macro coordination occurs (e.g.,
joint ventures or mergers), performance may be
reduced because: a) firms participating in the joint
activity are economically incompatible: b) the
incentive structure is incapable of maintaining a
stable environment for participants, or: c) vested
interests prevent the implementation of sound

economic decisions.

1.3 Cooperative Entry into the Farm Supply Industry

Farmer cooperatives represent the coalescing of
agricultural producers for purposes of achieving benefits
unattainable through individual action. Cooperatives
evolved for two seemingly different reasons, supply
management (the Sapiro approach) and a "competitive
yardstick” approach (advocated by Nourse), by which system
production and performance might be evaluated (Shaffer,
1987). The first reason directs benefits to producers by
matching supply with demand in a way that achieves prices
at or above costs of production. The competitive yardstick
concept was developed with the aim of keeping firms serving

farmers honest by providing a mechanism (via the

7
cooperative) for comparing input prices or the costs of
providing processing and marketing services. This latter
argument helps explain the evolutionary growth of farm
supply cooperatives.

Historically, there was concern by U.S. farmers about
the prices charged and the uncertain quality of some key
farm supplies. Two inputs, feed and fertilizer, were
prominent in this respect. During the 1920's and 1930's
unsatisfactory performance of feed manufacturers and
distributors created interest in purchases through
cooperatives (Heflebower). Apparently, farmers were
convinced that the margins of some investor-owned retailers
were above necessary costs (Harper: Wysor, p.14). A more
effective stimulus was the usual low quality formula feeds,
whose ingredients were largely unknown. Ricky and
Abrahamsen claim the industry during this period was
essentially in a "patent medicine" stage.

Heflebower documents how this dissatisfaction led to
the "open-formula" movement, where each bag of feed had its
ingredients clearly labeled (p.79). In Indiana,
Cooperative Extension workers published research findings
of significant productivity gains from livestock raised on
these labeled products (Hull). This served further to
encourage the practice of open formula labelling.

Similar experiences were documented for fertilizer

products during the same period. Again, suspect prices and

dubious quality stimulated cooperative activity by farmers.

Early in this century fertilizer was identified

only by brands: what it contained was a

mystery. Yet different crops and different

soil conditions require different combinations

of active ingredients. Without knowledge of

the contents, farmers could not relate a

fertilizer to their experience or to the

recommendations of the Agricultural Extension

Service (Heflebower, p.81).
Open-formula packaging, pioneered by cooperatives, soon
dominated as a marketing practice, yet this did not solve
the farmers' problem of fertilizer prices. Cooperative
entry into the fertilizer business began at the retail
level and, once established, integrated further into mixing
and blending, where investment barriers were not too high.
However, a period followed where additional advances were
negligible, and for good reasons. First and foremost was
the prohibitive cost associated with the very specialized
plant and equipment used in fertilizer manufacturing. A
second problem involved establishing supply sources for
phosphate and potassium fertilizers. This could be
achieved through either direct ownership or indirectly by
contract arrangements with mine owners. Eventually, the
financial obstacles were overcome and cooperatives eased
into the manufacturing process (Vogelsang).

Rising costs of transportation also stimulated farmer

interest in supply cooperatives. For a number of reasons,

including population concentrations caused by

9
industrialization and agricultural specialization, farmers
found themselves Operating further and further from
industrial centers. Although many investor-owned firms
(IOFs) operated in these areas, farmers often discovered
that, because of their location, costs were either high or
services unobtainable. To ameliorate this situation,
farmers organized cooperatives to purchase their inputs.
In addition to securing a steady source of farm supplies,
cooperatives were able to reduce costs by placing large
orders near points of production. Even today, when
transportation is no longer a serious constraint,
cooperatives have managed to assist patron members when

IOFs vacated less profitable regions.

1.4 Farm Supply Cooperatives: Current Problems

The current decade has been difficult for the U.S.
agricultural sector. Expanding domestic production in the
mid-to-late 1970s led to a situation where the supply of
farm products outstripped effective demand. Excess
production, weak export demand and depressed grain prices
became manifestations of this over-supply that caused
substantial restructuring within industries producing farm
inputs.

Both marketing and farm supply cooperatives are
similarly affected. Cooperatives continued to adjust and

reposition operations in 1985 in response to a depressed

10
agricultural economy. These adjustments were reflected in
declining revenues (farm supply down 25 percent from 1984),
net margins (down 45 percent), total assets (down 8
percent), and other financial conditions (USDA, Vol.53,
1986).

Either in spite of or because of industry difficulties,
farm supply cooperatives have continued to increase their
total market share of most inputs (Table 1.1). Most of
this growth has occurred in three areas, fertilizer,
petroleum and agricultural chemicals.2 With the exception
of chemicals, cooperatives are active in all the major
economic stages (i.e., manufacturing, wholesaling and
retailing). Feed and seed have shown no real gains over
time, largely because of the highly competitive nature of
the industry or due to the intervention of government in
certain activities. This overall growth in market share
conceals some of the important problems afflicting the
cooperative form of organization. These problems are deep-
rooted, multi-dimensional, and fall under two broad
classifications---vertical and horizontal coordination.
The primary focus of this research is on critical aspects
of vertical coordination as they affect cooperative

performance in a federated system. However, it is nearly

 

2This growth should not be construed as a consequence
of increased patronage by members. Regional respondents
asserted that manufacturing cooperatives rely heavily on
non-member business like IOF wholesalers/retailers and
international markets to maintain demand.

11

Table 1.1. Trend in Cooperative Market Share of Farm
Supplies Purchased by Farmers, 1951-1985.

 

Supply Year and Percent Share of Total Market

Item 1951 1961 1971 1981 1985
Feed 17.8 18.2 16.9 18.1 16.0
Fertilizer 15.7 25.8 30.1 36.1 44.0
Petroleum 18.8 24.9 35.1 35.2 44.0
Chemicals 11.6 15.5 19.8 33.9 29.0
Seed 16.7 15.7 15.3 14.5 15.0
Machinery 4.2 4.6 5.8 5.4 2.1
Average 14.1 17.4 20.6 23.8 25.0

 

Source: 1) USDA, ACS Research Report No. 37, 1984.
2) . Service Report No. 17, 1986.

axiomatic that there is a close relationship between
vertical and horizontal coordination. Consequently, issues
of a horizontal nature are also dealt with in this

research.

1.41. Prdblems of a vertical Mature

As just mentioned, farm supply cooperatives have
established themselves at the three major stages of the
input system. Regional and local cooperatives currently
perform these functions and their purpose is intendedly
singular-~to improve the economic position of their farmer
members. Indeed, during the growth period of the mid-to-
late 1970's, it was through the impetus of patron—owners

(who were concerned about securing a source of supplies)

12

that cooperatives vertically integrated upstream for their
major input needs. Many farmers, their local cooperatives
and the highly integrated regionals fared well during this
period. However, with the subsequent downsizing of U.S.
agriculture and the growing threat of domestic and foreign
competition (in conjunction with increasing agricultural
specialization), new problems surfaced for the cooperative
way of doing business.

The first problem concerns an erosion of patron-owners'
commitment to their cooperatives. It is evidenced in two
fundamental ways: (1) the praaaiaa_af_airaamyanaian at both
the farmer and local levels, and (2) inadequate levels of
291W.

Traditionally, farmer members have purchased supplies
from their local affiliate, which in turn obtained its
needs from the regional cooperative. Historically this
practice made good economic sense given the scale economies
at each stage of the vertical system. Recently, however,
and perhaps in part due to more efficient and less
expensive transportation systems, some large local
cooperatives (which have become known as super-locals or
mini-regionals) have begun bypassing their regionals and
purchasing directly from manufacturers or even competing
regionals. Similarly, at a lower level, some large farmers
circumvent their local cooperative and acquire supplies

from a manufacturer, a regional, or a competing investor-

13
owned firm (IOF). In both cases, the impetus for this
practice lies in either the volume discounts and, in some
instances, special services passed on to these large
buyers, or the fact that their needs are simply too great
for the cooperative supplier to handle adequately. In sum,
the current problem is one of the cooperative system
needing to evolve and what this evolution entails in terms
of adjustment costs and the distribution of these costs
among system participants.

An insufficient level of equity capital is a second
indicator of cooperative difficulty at the local and
regional levels. To illustrate, in 1962, equity capital
represented 52.4 percent of total capital assets of the 100
largest cooperatives. By 1970 this fell to 39.1 percent
and by 1980 equity capital had fallen to 28.6 percent
(Davidson, 1985). Since then, cooperatives have sought to
strengthen their equity balance by divesting assets and
substantially reducing or terminating patronage refunds.3
As a consequence, by 1985, equity to asset ratios had
increased to 34 percent for the 100 largest cooperative
firms (Davidson and Royer, 1987). Equity capital is
typically generated in three ways: (1) direct investments
in cooperative shares, (2) per-unit capital retains on

purchases or sales, and (3) retained patronage refunds from

 

3In 1985, total patronage refunds (cash and retained
allocations) dropped 20.2 percent to their lowest level in
five years (Davidson and Royer, 1987).

14
net savings. The latter two practices have been used to
augment insufficient capital from direct member
investments. However, with declining volume for many
cooperatives (due to member purchases from competing
cooperatives or IOFs), these sources have been similarly
reduced.

Patron-owners' incentives to circumvent their
cooperative could stem from better input prices from
competitors or just overall poor performance by the
cooperative for an extended period of time. In either
case, because of the unique ownership characteristics of
farmer cooperatives, there are tradeoffs involved from this
behavior that are not present with an IOF/customer
relation.4 In the short run, the effects of circumvention
may be a cost savings to those patrons who practice it.
But the longer-run outcome to both patron and firm is
doubtful due to the consequences of ”system leakage."
Farmers are undermining their locals and locals are
undermining their regionals. In effect, the demand curve
facing individual cooperatives shifts to the left, thereby

reducing the volume of sales. Lower volume implies higher

 

4There are two elements to this argument. First,
because IOF patrons are not owners of the firm, performance
of the firm affects them only through price. If the price
is unacceptable, the patron simply goes elsewhere. Second,
this ”ownership linkage” is not present with IOFs in the
input industry. Each economic stage is independent of the
other and, as a consequence, the system leakage problem
does not exist.

15
per-unit costs, and eventually, higher factor prices. This
makes the circumventors' cooperative less competitive,
providing additional incentive for other members to adopt
this behavior. Further, since most equity capital is
generated through retained earnings from net savings, the
firm's financial position deteriorates as does its capacity
to revolve member investments. In turn, uncertainty with
regard to equity redemption programs discourages financial
support from remaining owners.

In different terms, lack of commitment affects the
overall coordination of the cooperative system in two
fundamental ways. First, it complicates the
synchronization of the various economic stages within the
input system. A "stage” in production is defined as "any
operating process capable of producing a saleable product
or service under appropriate circumstances" (Mighell and
Jones, p.7). Coordination is jeopardized when firms'
planning capabilities are mitigated by the practice of
circumvention. Regional manufacturers experience less
reliable product demand estimates, which makes production
decisions riskier (through the increased likelihood of
under- or over-production). similarly, wholesalers and
retailers are less confident of their purchasing decisions
and unfavorable inventory levels are more likely to occur.
Finally, the agricultural producer may be faced with an

inadequate supply of inputs if upstream players

16
significantly misjudge demand. At the very least, farmers
face higher prices as manufacturers and distributors
compensate themselves for greater levels of risk.

A second manner in which cooperative coordination is
affected is by a firm's inability to respond to economic
opportunities because of its poor financial position.
Marion (1976) identifies this as ”adaptive coordination,"
since it may involve changing the system to improve its
longer run performance. A high debt-to-asset ratio is
indicative of this problem among some cooperatives. By
raising the firm's cost of money, the supply cooperative
has little choice but to recover this cost through higher
input prices. Higher prices make the firm less
competitive, reduce its income through lower sales volume
and diminish its ability to retain earnings for equity.
Absent sufficient levels of this low-cost money, firms will
be unable to invest in or upgrade their fixed assets.
Scarce resources will be directed at more urgent priorities

like servicing debt and paying employee salaries.

1.42. Prdblems of A Horizontal Nature

The total number of marketing and farm supply
cooperatives declined from 7,535 in 1976 to 5,625 in 1985
(Farmer Cooperative Statistics, 1985). Measured by annual
average gross business volume, farmer cooperatives

increased in size, due in part to mergers and

17
consolidations. Despite this growth, the majority of
cooperatives are small (90 percent have business volumes of
less than $15 million) and serve local areas. Many are
faced with deteriorating balance sheets or, in extreme
cases, bankruptcy. Local cooperatives are confronted with
numerous problems, including under-utilization of capital
that may be a result of unsound investment policies. These
difficulties appear to surface at two levels. At one
level, there are barriers that hinder or prevent
cooperatives from taking advantage of certain economic
opportunities. For instance, consider a situation where
two local c00peratives ingiyigaaiiy possess insufficient
membership to achieve fertilizer plant size economies. In
other words, the fixed costs of the plant would be less
prohibitive if volume were increased. This in turn would
lower the per-unit cost of producing fertilizer. Clearly
it is in their mutual interest to combine membership.
Certain forces, however, prevent the reorganization from
taking place. This coordination problem is referred to as
3 W12:-

A second level addresses coordination problems that
transpire afta: a partnership arrangement has already been
established. In the above example, assuming the ex ante
barriers were overcome and a merger occurred, consider the
effect on operating efficiencies if, because of resistance

from certain member groups, disposal of redundant assets is

18
not forthcoming. This behavior would act as a financial
drain to the new firm and result in a poorer earnings
statement. Absent efficacious behavior on the part of
membership, adoption of coordinating mechanisms to improve
performance is a potentially fruitless undertaking. Hence,

this coordination problem is referred to as an gags;
WW

Explication. Pre-restructuring barriers fall under three
categories: (a) competition among firms, (b) patron-owner
heterogeneity, and (c) vested interests.

Cooperative competition stems from multiple sources.
One is an underlying philosophy of many members that
competition is inherently good: it is a disciplinary
mechanism that keeps IOFs and cooperatives honest and
performing well. Unfortunately, this view fails to account
for the fundamental difference between the two forms of
organization-- a cooperative member is both gnatgma: and
gunar. Thus in a cooperative, the same farmers may own
each of the competing firms and hence are competing with
themselves. The second aspect concerns internal and
external pressures that may encourage competition.
Internal pressures develop because individual incentives
push managers, board members and patron-owners to encourage
it. An internal pressure could be a cooperative policy of

keeping costs down by increasing volume through such

19
practices as brand labelling and aggressive advertising. A
depressed agricultural economy is an example of an external
pressure. It effectively reduces the size of the pie
available to competing firms.

Cooperative heterogeneity is a second problem which has
implications for vested interests of certain groups.
Consider, for example, large and small farmers who are
members of the same local cooperative. Although these
farmers may each produce similar crops and use similar
inputs, because of their size differentials, their needs
are substantially different. Large farmers may benefit
appreciably from a consolidation if sufficient size
economies could be captured. Small farmers may resist the
restructuring if they believe it could weaken their long-
standing position. In this case, their own vested
interests may take precedence over the welfare of the
larger cooperative. For instance, since any reorganization
must be approved by the cooperative Board and, depending on
the association's by-laws, often by at least two-thirds of
its members, inter-group bargaining could arise between
competing interests. A potential danger is that during the
negotiating process the plan's integrity and worth to the
cooperative is jeopardized.

Post-reorganization problems affect the long-term
viability of collective action. For instance, cooperatives

that form joint ventures have been known to compete

20
actively against each other for the same business (Turner).
In situations where members are not on equal footing, the
gains of one can be at the expense of the partner. Impetus
for this behavior is that participants face individual
incentives to act independently, even though they could
gain more through collective action (Staatz, 1987b).

Vested interests may slow or stop the necessary

disposal of redundant assets. Adopting a coordinating
mechanism does not ensure better performance.
Consolidation as a response to excess capacity is of value
only if the asset base is reduced to an efficient size. In
these circumstances, cooperatives might be more susceptible
to pressures of vested interests than would their IOF

counterparts.5

 

5The major concern of IOF's owners is the end-of-year
profit statement and the subsequent appreciation of their
stock. Assets are of value only to the extent they
contribute to these objectives. Owners of a cooperative, on
the other hand, may have ulterior motives to sustain
redundant assets. For instance, consider a farmer living
near a town where "redundant" co-op facilities are to be
closed because there is sufficient co-op capacity in a town
25 miles away. Here, the farmer's cost (in terms of time
and transportation) of using the co-op is raised if the
”redundant" facilities close.

CHAPTER 2

.A FRAMEWORK FOR THE ANALYSIS
FARM SUPPLYOEOOPERATIVES
2.1 Principle Components of the Framework

This section introduces a systems approach for
analyzing problems and opportunities facing farm supply
cooperatives. In the first part, the approach is applied
to the vertical dimension of a federated cooperative
system. The second part uses the approach to evaluate
coordination issues from a horizontal perspective. In both
instances, the emphasis is on how individual firm (micro)
behavior ultimately affects system-wide (macro)
performance.

Game theory and transaction cost economics are then
applied to cooperative coordination issues. Their purpose
is to support the systems approach by explaining why a
particular behavioral trait might have developed. Once the
cause for the behavior is identified, specific actions can
be recommended to improve cooperative firm and system

performance.

2.11 A Systems Approach
Even though the systems approach was initially designed
to improve the performance of the food marketing system,

21

22
its application is well suited for other industrial sectors
(Bouma: Hammonds). In simple terms, the concept views
activities in the context of the larger system in which
they exist, not in isolation. Abdalla suggests that the
approach is useful for two main reasons. First, it
emphasizes that activities are interconnected. Individual
decisions produce external effects that may lead to a sub-
optimal macro results. Second, from an organizational
standpoint, it permits the identification of opportunities
for changing individual behavior in a manner that leads to
improved system-wide performance. Application of the
systems approach is useful in both the vertical and

horizontal dimensions.

A.WW

The broader vertical systems orientation stresses the
performance of the total sequence of activities carried out
in the production and marketing of a commodity. The
concept implies that system performance depends not only on
the performance of the individual stage, but also on the
coordination of the many vertically aligned stages
(Abdalla, p.14). Further, as the system becomes
increasingly specialized and complex through the
industrialization process, synchronization of these
economic stages becomes more difficult.

In a federated cooperative system there are three tiers

23

that constitute the marketing channel for input supplies--
the regional cooperative, the local cooperative, and the
farmer or patron-owner. A simplified model of these
participants and their economic functions is shown in
Figure 2.1. Given the unique owner relationship between
farmers and their cooperative, the consequences of
individual actions on the larger system are more direct
than for IOFs. For example, some farmers, instead of
purchasing fertilizer from their local cooperative, may
choose to buy from competing IOFs because of lower prices
(Figure 2.2, path 1). Even though the farmer realized an
immediate cost savings, this behavior has detrimental
effects on both individual cooperatives and eventually the
farmers themselves. By purchasing outside the system,
farmers impose costs on their local cooperatives through a
reduction in volume sales and unplanned inventories. Lower
product volume translates into lower retained earnings,
which diminishes the cooperative's operating capital and
its ability to revolve equity accounts. Furthermore,
unintended inventories result in higher storage costs that
places additional pressure on an already shrunken pool of
operating capital. Since per-unit costs have risen, the
local cooperative has little choice but to raise input
prices.

This problem arises because co-op members do not pay

the full cost of their actions. They can, in the short run

24

 

 

 

 

 

 

 

 

 

EQQNQHIQ_§IA§E§

REGIONAL * Manufacturing

I

u * Distribution

I

i * Wholesaling
LOCAL * Retail

I

I

I

I

v
FARMER * Consumer

 

 

 

Figure 2.1 A Simplified Illustration of the Federated
Cooperative Vertical System.

 

(Ownership) (Service)

25

 

 

 

Regional <- -----

1N

 

 

 

 

 

 

 

 

 

 

 

 

I
I
I
l
I
I
I
I
IOF Local |
I
I
I
I
I
I
I
I

’I‘ I~
I

z (3)

I

I

' _._ _ __(}I_ _ __ ___fl __ Farmer _- (2)

 

 

Figure 2.2 Conceptualization of Farmer Purchasing
Practices for Inputs. Path 1 represents the case of
system leakage, path 2 depicts circumvention, and path 3
represents the traditional purchasing method.

free-ride on the cooperative, buying only the lowest-
priced services and obtaining other goods and services
elsewhere. Although this behavior is economically rational
in the short-run, longer-term consequences have detrimental
implications.

In summary, patron-owner behavior of buying outside

the cooperative system results in greater costs to the
cooperative, greater costs to ail members through lower

equity redemption, and higher prices for those owners that

26
remain loyal to their association. Finally, to the extent
higher prices erode the firm's competitive position in the
marketplace, both loyal and disloyal owners bear the
financial consequences of uncommitted membership.

Another effect of uncommitted behavior is that local
managers who experience surplus inventories will have an
incentive to reduce upcoming purchases from their regional.
If this practice is sufficiently widespread among local
firms (prompted by farmers buying outside the cooperative
system), regionals may be faced with an unwanted
inventories. The regional must then either lower prices to
move the product or accept the consequences of excess
inventories--either way, margins are reduced. Lower
earnings by the regional imply lower patronage rebates to
member-locals and a constrained capacity to retire equity
accounts. These actions erode the regional's competitive
position and provide additional incentive for locals to
purchase outside the system. Furthermore, to the extent
that patronage payments and equity retirements have been
reduced, locals will be unable to pass these benefits on to
their patron-owners. The net effect of "system leakage" is
that not only is cooperative performance compromised, but
confidence in the cooperative way of doing business is
undermined as benefits derived from patronge slowly
disappear.

On the other hand, there are potential changes that

27
might involve higher costs at one stage, but create savings
for another stage which exceed these costs. For instance,
a continuing trend in agriculture is a growing divergence
between large and small farms. Some of the largest
Operations are of a size and scale that may preclude
effective servicing by the local cooperative.1 In other
words, the large farmer's incentive for doing business with
the local is mitigated in the absence of differential
pricing: or the large farmer's volume may simply be too
large for the local to accommodate adequately. If the
large farmer by-passes the local and purchases directly
from the regional he avoids one value-added stage in the
marketing sequence (Figure 2.2, path 2) and realizes a cost
savings.2 In this situation, the local firm suffers from a
significant loss in sales volume. As a consequence,
retained earnings, operating capital and storage costs are
all adversely affected. But now, since the agricultural
producer remains within the cooperative system, total
system effects are less severe than in the earlier case
(where members purchased outside the system), since demand
facing the regional firm is unchanged. Only the local

cooperative is worse off (with the farmer being better off)

 

1The "80/20" rule holds here, i.e., 20 percent of the
members account for 80 percent of the business. A local co-
op that loses this class of patrons faces a very uncertain
future.

2This assumes that the regional can in fact provide
these marketing services cheaper than the local.

28
and this may be partially offset by the regional through
patronage refunds and dividend payments. Still, Ianaining
members of the local may be hurt by circumvention, as the
local's unit cost of serving them may increase with the
loss of the large patron's volume.

There is an additional dimension to this
"circumvention" practice as well. The raison d'etre of the
local and regional cooperative is to improve the financial
position of its members. Inability to meet the needs of a
particular class of patrons undermines cooperatives'
economic and philosophic justification to participate in
the market. To the extent this is true, local cooperatives
must reassess their own role and capacity within the input
sector of agriculture and determine a course of action that
will satisfy their primary mission.

In summary, application of the systems approach to
improving performance of farm supply cooperatives requires
an alignment of goals and objectives from members of the
three-tiered federated system. This implies altering the
structure of incentives so that the goals of the larger
system and those of cooperative members are in harmony. In
situations where membership is highly heterogeneous and
interests diverse, the process of achieving true

cooperation becomes increasingly complex.

29

film

A systems approach is also useful for evaluating
performance at the macro or industry level. It is
particularly germane to problems of cooperation. This
perspective stresses that individual firm (micro-level)
decisions have ”spill-over" effects to adjacent firms and
to the performance of the industry as a whole. Indeed, it
was recognition of the cumulative effect of individual
decisions on industry performance that first led to the
formation of large-scale commodity cooperatives. At the
time, farmers were making rational decisions for their
individual firms but lacked a mechanism that created
individual incentives for farmers to take those effects
into account. As price takers they had no individual
incentive to limit production even though they may have
known that if everyone behaved in this manner, producers as
a whole would be worse off. Implementation of supply
control by these commodity cooperatives had some success in
bringing prices more in line with costs of production
(Knapp) -

The first chapter mentioned that farmers created supply
cooperatives to obtain “fair" prices and acceptable quality
in their inputs. These cooperatives were usually formed to
carry out a specific business function like bulk fuel
delivery or fertilizer retailing. Since the local firm had

a limited market and limited capital resources, local

3O
associations pooled their needs for larger volume by
forming a regional cooperative. This horizontal and
vertical process resulted in the three-tiered structure
shown in Figure 2.3. In time, both locals and their
regional added business activities, with members' needs
serving as the linkage (Hull). However new technology (and
other factors) placed pressure on cooperatives to expand
their customer base in order to achieve improved cost
efficiencies. As trade territories continued to grow, many
cooperatives found themselves competing against one
another, even when they were owned by the same farmers
(Ratchford).

The major way local cooperatives compete is through
price, although this competition is manifested in three
different ways: (1) through competitive pricing, (2) by
carrying a full line of products, and (3) by carrying a
full line of services. The concern of this research is the
impact this behavior has on cooperative performance. The
source of the problem is that individual firms do not have
the incentive to take into account the larger system
effects of their actions. The impetus behind this behavior
appears to stem from the gaaiai_yaiaa communities place on
their cooperative as well as the deep-felt belief that
cooperative competition is inhalangiy_gaaa.

Consider the following scenario. Over an extended

period, two adjacent cooperatives independently build a

31

 

 

REGIONAL

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

FARMER 3

 

 

 

 

 

 

\ AI
IFARMER 4

 

 

Figure 2.3 The Three-tiered Structure of a Federated

Cooperative System.

 

(Ownership)

(Service)

32
fertilizer mixing plant and purchase fertilizer delivery
vehicles. Both cooperatives financed their investments
with a loan from a lending institution. In addition to
monthly interest payments, these cooperatives have
operating expenses that include salaries, equipment, and
maintenance. A complicating factor is that sales for each
firm have fallen in recent years due to a combination of
less committed membership and government set-aside
programs. As a consequence, these firms are experiencing
substantial under-utilization of plant and equipment, with
attendant higher unit operating expenses. Adding pressure
to this high cost structure is managers' incentive to keep
prices low as farmers (being members of both cooperatives)
play the firms against one another to capture the lowest
possible price.

In summary, each firm faces the following costs: (1)
fixed costs--(a) the cost of money (interest on debt): (b)
maintenance costs on plant and equipment: and (c) costs
associated with duplicate administrative functions and
personnel salaries: (2) variable costs--those that are due
to inefficient production and marketing methods.
Ironically, in their desire to maintain their own identity
and competitive ideology, these cooperatives may
unintendedly raise both cost categories. In adopting this
behavior these firms must (eventually) raise input prices

to defray higher costs (making them lags competitive) and

33
‘will face a greater likelihood of financial demise if a
feasible restructuring plan is not initiated. Lastly, each
cooperative failed in its primary mission---to improve the
financial well-being of its member-owners because its
behavior has led to higher input prices, a larger debt load
and a reduced ability to revolve equity accounts.

In this situation, performance was diminished at both
the firm (micro) and system (macro) levels through
competitive behavior. By taking collective action,
coordination and performance at both the firm and system

levels would be enhanced.

2.2 Additional Concepts for Analyzing
Cooperative Coordination

This section introduces some additional concepts that
complement the vertical systems approach to farm supply
cooperatives. They are useful in that they help identify
and explain technological, organizational and behavioral
factors that complicate the coordination process. Any
efforts to improve cooperative firm and system performance
are contingent upon correct evaluation of problem sources.
The following constructs are used with this in mind. Prior
to this, a few supplemental assumptions about environmental
conditions and human behavior are presented.

First, participants are assumed to operate within an

uncertain environment. Second, information to reduce this

34
uncertainty is costly and difficult to obtain. This
difficulty is due in part to the limited cognitive
abilities of participating agents. Thus decision makers
exhibit bounded rationality and must contend with impacted
information. Finally, external effects from individual
actions are pervasive and problems of a "public good"

nature (non-excludability) are common.

2.21 Game Theory

At its most fundamental level, game theory is a
mathematical analysis of principles of decision making in
situations involving two or more players with conflicting
interests and mutual interdependence. A game of strategy
consists of a series of events, each of which may have a
finite number of distinct results. The results of some
events are determined by chance, and the results of others
by the free decision of players. Because it emphasizes
decision making under conditions of mutual interdependence
and takes into account the allocations of benefits and
costs from collective action, game theory is particularly
useful in evaluating farmer cooperatives. The following
sections briefly discuss two types of behavior analyzable
using the theory of games as presented by Staatz (1987b).
These behavioral types are classified as aaapazatiyg and
nanaggpagaaiya games and are differentiated by rules of

communication and commitment (Figure 2.1). Unfortunately,

35

 

 

 

 

Cooperative Noncooperative
_Eul.s.s Game Game
Communication yes no
Binding
Commitment yes no

 

Figure 2.4 Illustration of Rules for Differentiating
Cooperative and Noncooperative Games.

real world problems do not always allow neat and tidy
classifications as illustrated in the figure below. This
is particulary true for some of the vertical

and horizontal issues that surface in farm supply
cooperatives. The following discussion is undertaken with

these limitations in mind.

A. The Cooperative Game

In a cooperative game, participants are allowed to
communicate in order to develop joint strategies and
binding commitments. A presumption is that preferences
among players are non-homogeneous. The game further
assumes there are potential net benefits through joint
action, but that participants must decide on how these
benefits can be allocated in a manner satisfactory to all.
If agents fail to agree on this allocation, the coalition

will not materialize. Staatz maintains that when a

36
cooperative game is applied to farmer cooperatives, two
interrelated questions are of concern: (1) how do existing
policies affect the payoffs to various coalitions within
the cooperative, and (2) are these payoffs adequate to
prevent defection by any of these coalitions (Staatz,
1987b)?

In applying the theory of cooperative games to inter—
firm issues of a federated system, farmer-members, their
local cooperative, and the regional firm are the crucial
players in the game. Within an intra-firm context,
managers and members of the board are also important
players. Hence, potential bargaining positions include
issues relevant to this vertical set of participants.
Examples of baggaining_pa§i;ign§ within this framework
could include: (a) governance relationships between the
regional firm and member locals, such as their degree of
autonomy and their representation on the board of
directors: (b) investment issues, such as criteria for
selecting business ventures (e.g., profitability, risk
management, or market dominance): and (c) capitalization
issues that include the desire to make financial
commitments based on a longer-run view of system needs.

To illustrate, current governance disagreements between
locals and their regional can be viewed in game theoretic
terms. Local cooperatives argue for policies directed at

satisfying their own members' interests. On the other

37

hand, a regional firm must take into account the interests
of the larger cooperative system it is serving. Bargaining
positions could split between those locals that are mag;
dependent on the regional versus those that are iaaa;
dependent. Conceivably, those locals least dependent on
the regional are also the regional's largest sources of
volume and, thus, potentially more capable of influencing
the final outcome.3 However, if the large members are
unable to influence this outcome in their favor and if they
perceive higher payoffs outside the cooperative, they may
choose to defect, in which case the coalition breaks down.

The underlying assumption of the cooperative game is
that there are certain efficiencies to be gained by joint
activity when compared to the payoff from independent
action. These gains are represented by a fiaparagaiaiya

Winn}.

A characteristic function shows the minimum
level of payoffs that any potential coalition
of players can guarantee itself.
Superadditivity of the characteristic
function means that a single coalition of all
players (the grand coalition) can always
guarantee itself a higher level of payoff
than can two or more disjoint subcoalitions
that in total involve all the players
(Staatz, 1987b, p.120).

 

3The cooperative practice of one-member, one-vote
could mitigate this influence. However, if voting rules are
not changed to increase the political power of the larger
patrons, they may opt to exit the cooperative (see Staatz,
1987b, p. 126).

van
is I
toqe
fir
the

acti

38
Two conditions related to a superadditive characteristic
function are noteworthy. First, two subcoalitions
(individuals or groups) can always gain at least as much by
working together as they can from working separately. This
is not sufficient, however, to ensure that they xiii work
together. If joint action is to occur, not only must this
first condition hold, but each group's individual share of
the joint "pie" must exceed the payoffs it could obtain by
acting independently (Staatz, 1987b).

In their application to farmer cooperatives, these
conditions imply that when allocating costs and benefits to
patron-owners, management must take into account the effect
this allocation may have on members' willingness to remain
in the organization. To the extent members have non-
homogeneous preferences and operate farms with varying
degrees of size and efficiency, achieving some allocation
that satisfies all parties simultaneously may be extremely
difficult.4 In the interim, the many subcoalitions will be
maneuvering their positions in a manner conducive to
obtaining the best possible outcome for themselves.

To illustrate, in order to remain competitive, managers

of farm supply cooperatives are frequently pressured into

 

4How difficult it is depends on how strongly
superadditive the characteristic function is. If it is yazy
superadditive, the parties will be much better off
(in total) working together. In this case it may be easier
"slice up the pie" in a manner that makes everyone happy
than if there are only small gains to cooperation.

39
buying new and (or) highly specialized inputs. Typically,
however, only a portion of the farmers may want or require
the product and yet, depending on the pooling practices of
the cooperative, the investment risk may be borne equally
by all members. More generally, as the practice of supply
cooperatives handling diverse products increases, the
potential for conflict of interests among members, hence
governance problems, is compounded. Hansmann has noted
that some cooperatives (e.g., Land O' Lakes) have attempted
to ameliorate this situation by computing patronage refunds
separately, often at considerable accounting expense.
Apparently, the benefits derived from this exercise
(minimizing patron-owner defection) justify the financial
investment in discriminatory bookkeeping.

Staatz asserts there are two factors that determine the
ability of players to extract concessions from their
cooperative: the cost the member could impose on other
members of the cooperative by leaving and the other
players' perceptions of the cost he would impose on himself
if he were to exit (p.122). These have important
implications for the bargaining positions of large farmers
and super—locals in their efforts to achieve concessions or

preferred treatment within their organization.

B. The Noncooperative Game

Two characteristics of the noncooperative game are that

P133

Desi

“in.
”Item

40
players are unable to communicate with one another and to
make binding agreements. It is this first feature that
qualifies a prisoner's dilemma as one special case of a
noncooperative game. In situations where a noncooperative
game is a prisoner's dilemma, an inferior outcome to the
players result. Further, because they cannot make binding
commitments or credible promises, noncooperative games are
typified by a complete lack of trust among the players
(Schotter and Schwodiauer, p.480).

A salient feature of a non-constant sum game or so
called Prisoner's Dilemma, attributable to A.W. Tucker
(see Luce and Raiffa [1957 p.941), is that even though the
choice of a joint strategy could improve each player's
position, the incentives facing them encourage individual
defection and ensure an inferior outcome. More generally,
the game illustrates the situation where cooperation could
improve the welfare of those who participate. If the
players could find a way to agree on a joint strategy and,
just as important, a way to enforce the agreement, both
would be better off than if they acted independently.5
This last aspect of any joint strategy, enforcement, is
important because, it is still in the interests of both to
secretly break the agreement.

An alternative to the static prisoner's dilemma is a

 

5Key to a prisoner's dilemma is that no mechanism
exists to enforce such cooperation: hence a Pareto-worse
outcome results.

de
Si

0!

811
de:

in;

41
finpargana in which a single-period game (constituent game)
is infinitely iterated and "the payoffs are the net present
values of the stream of payoffs from the constituent games"
(Staatz, 1987b, p.130). There are numerous circumstances
under which even a supergame made up of infinitely iterated
prisoner's dilemmas will itself be a prisoner's dilemma
although it need not be (for details under each scenario,
see Staatz, 1987b).

Perhaps one of the best examples of a prisoner's
dilemma supergame has to do with system leakage problems of
vertical coordination. Consider the two subcoalitions,
large versus small farmers. If both groups would remain
perfectly loyal by purchasing all input supplies from their
cooperative, both would be better off. The cooperative
would gain from size efficiencies and all the benefits
associated with planning that influence the marketing
process. Hence, although the payoffs to each player are
higher if they both cooperate, the incentives facing the
players are such that each has an individual incentive to
defect, although they know the other player is acting
similarly. In contrast to IOFs that specialize along one
or two product lines, farm supply cooperatives typically
carry a full line of products and services. There are
situations where this can provide incentive for members to
defect. For instance, by carrying a complete set of

inPuts, it may be impossible to maintain the lowest prices

42

across all commodities at all times. However, a full
complement of inputs may allow the co-op to keep the
ayaxaga price of the inputs competitive even though
individual prices may at times be noncompetitive. Lower
prices on inputs from competitors constitute incentive to
defect. In fact large farmers may have a stronger
incentive to defect than small farmers. However, even
though each player may gain iniaiaiiy from their "tit for
tat” strategy,6 because these players are both owners of
the cooperative, repeated defections will ultimately
undermine the co-op and, hence, their own position as well.

A second example in which behavior of cooperatives
resembles a prisoner's dilemma regards competition among
locals. There are many instances when joint action by two
or more farm supply cooperatives could increase their net
earnings. Examples of under-utilized storage and
transportation equipment are indicative of the problem.
Through cooperation they could combine facilities and
equipment and, with a larger total membership, reduce per
unit costs of providing products and services. In spite of
potential longer-term gains from collective action, it
often fails to materialize. This uncooperative behavior
might be the result of poor communication lines due to a

lack of mutual trust, high information costs, or vested

 

6A tit for tat strategy is simple: A players first
move is to cooperate, then s/he does whatever the partner
did on the previous move.

43
interests of certain decision-makers who are protecting
their ggn self-interest. Whatever the cause, potential
members of a profitable coalition eschew collective action

and act independently.

2.32 The Transaction Cost Approach

The transactions cost approach, as presented by Coase
and later expanded by Williamson, explores microeconomic
issues of market and firm hierarchies by examining their
functions, behavior, and organizational structures. The
approach focuses on how characteristics of a transaction
affect the cost of handling it through various forms of
organization. A transaction occurs whenever "a good or
service is transferred across a technically separable
interface" (Williamson (1985) p.1). Transaction costs
include the costs of gathering and processing relevant
information: reaching a consensus among firm decision-
makers: and drafting, monitoring and enforcing contracts
among other participants. These costs are the direct
consequence of environmental uncertainty, bounded
rationality and opportunism (taking advantage of another's
weaker position). To avoid being taken advantage of, each
side may desire an extensive contract that describes
exactly what is to be bought or sold and how the
contracting parties will deal with various contingencies.

However, because of uncertainty and the limitations of

44
human intellect (bounded rationality), it is impossible to
design a contract that specifies all possible future
contingencies. Given these constraints, complete
contingent claims contracting must ultimately fail.

An alternative to striving for an all-encompassing
contractual arrangement is to employ a series of short-
term, sequential contracts. The problem with "sequential
spot contracting" is that the good or service under
consideration may possess unique features requiring
specific information regarding how best to establish the
exchange arrangement with the customer. This is acquired
over time, and the supplier who achieves this first and
best benefits from a "first mover advantage" (Ouchi,
p.133). Essentially this eliminates threatening
competitors and the exchange reduces to a small numbers
situation or a bilateral monopoly. Under this condition,
each party may act opportunistically by claiming greater
production costs in order to justify higher prices. A
possible solution is for the trading partners to monitor
the actions and performance of the other. If the
associated costs are prohibitive, the exchange will
eventually fail "due to the confluence of opportunism with
small numbers bargaining, even though the limitations of
uncertainty with bounded rationality have been overcome"
(Ouchi, p.133).

The above scenario captures the essence of Williamson's

45
"Organizational Failures Framework” (1975). It stresses
that markets will fail when the costs of completing the
transaction across a market become greater than those of
handling the transaction via vertical integration. At that
point, internal organization will be superior to market
organization. Integration internalizes system problems and
allows solution through the firm's organizational and
administrative processes. The organizational form that
will succeed best in handling the transaction will be the
one that minimizes the sum of both transaction and

production costs for the activity.

2.23 The Transactions Approach to Cooperative Organization
WWW

Shaffer (1987) and Staatz (1987c) have outlined some
convincing reasons why the cooperative form of organization
should be distinguished from other organizational forms.
Shaffer asserts that within a free-market economy, a
cooperative represents a third mode of economic
coordination (where markets and integration represent the
first two modes). An important feature of a cooperative
association is that although patron-members collectively
own the firm, their individual farm units remain
operationally independent. Staatz (1987a) likens the
relationship between a cooperative and its members to a

contingency contract where the final product price is

46
ultimately contingent upon firm performance. He argues
that cooperatives may have an advantage over IOFs because
farmers may believe their firm will not use this practice
dishonestly. This trust or "loyalty factor" may in part be
explained by the longstanding agreements which typify the
cooperative-patron relationship. Williamson refers to this
as a ”relational contract", where the desire to continue
this relationship facilitates settlement of unspecified
contingencies'7 Actually, there are many instances where
informal implicit contracts (verbal agreements) supercede
the more costly formal arrangements. Indeed, it is this
incentive to preserve long-term relationships that supports
the assertion that transaction costs involving contracts
may be lower for a cooperative than for an IOF.

Another important element regarding the trust between

 

7Williamson actually discusses three classes of
contracts: classical, neoclassical and relational (1985,
pp. 69-72). Classical contracting assumes a high degree of
knowledge by the contracting parties, since all the
relevant future contingencies are accounted for in the
contract. As such, it is characteristically rigid and
relatively easy to enforce.

Neoclassical contracting is more pragmatic in that it
allows for flexibility in the agreement to handle possible
future disputes between trading partners. This form of
contract acknowledges people's limitations within a complex
and uncertain world and so recognizes the economic
necessity of utilizing arbitration or, in the event it
fails, litigation.

Whereas the reference point for neoclassical
contracting remains the original agreement, relational
contracting focuses on the long-term relationship as it has
developed through time. In other words, continuing the
ongoing relation takes precedence over obstacles that may
have developed because of some unforeseen event.

47
contracting parties is its mitigating influence on risky
investments, particularly those of a highly specific nature
(Staatz, 1984, pp.164-170). Asset-specific investments,
once made, are characterized by a salvage value
considerably below their acquisition price. There are
clear short-run incentives for a trading partner to act
opportunistically under these circumstances. The level of

trust often found within a cooperative association has

potential to ameliorate this condition.

 

Williamson (1985) asserts that within a given market
environment, the organizational structure that minimizes
the sum of production and transaction costs will tend to
dominate. He states further, however, that four principles
for efficient organizational design ultimately determine
the typa of organizational structure that evolves: the
asset fixity principle, the uncertainty principle, the
externality principle, and the hierarchial decomposition
principle. This section examines the first three
principles as they influence the organization and

performance of farm supply cooperatives.

1. Asset Fixity and uncertainty Principles. The asset
fixity principle states that as assets become increasingly
specialized or unique, the desirability of the spot market

48
as a mechanism for exchange diminishes (Williamson, 1981,
p.1548). Assets exhibiting this "specificity”
characteristic have fewer alternative uses than do more
general purpose assets and, as a consequence, the cost of
transferring them to these alternative uses is greater. As
this specificity increases, so too does the divergence
between the asset's acquisition price and salvage value.
Furthermore, as long as the value of the asset lies within
these upper and lower bounds, the asset remains fixed in
its current use (Johnson and Quance). It is this
divergence between an asset's purchase and resale values
that gives rise to rents that are potentially appropriable
through market transactions if one of the exchange agents
decides to act opportunistically (Klein, Crawford and
Alchian).

The uncertainty principle states that autonomous market
contracting becomes a less preferred exchange mechanism as
‘the uncertainty surrounding the transaction increases
(Williamson, 1979b). This is because uncertainty creates
incentives for some individuals to act opportunistically
against those in a more vulnerable position (e.g., through
the occurrence of some unforeseen event). In the case of
farm inputs, increasing specialization implies a
corresponding increase in uncertainty. For instance, it is
unlikely that farmers would regard the risks associated

With the purchase of diesel fuel in the same category as a

costly I
precisi
like In

lind HI

sakers
contra
contra
this I
- tenI
exchaI
trans:
of as:
Prefer
1, con
indiff
BaI
cOntest

49

costly host-specific insecticide that demands application
precision. Clearly the impact of an "unforeseen event",
like unfavorable weather, weighs heavily on a farmer's
mind when considering the purchase of this specialized
input. It is this characteristic that provides decision-
makers with an incentive to move from autonomous market
contracts to their less risky counterparts, like contingent
contracts and vertical integration (Staatz, 1987b). Within
this environment, a decision-maker must ascertain the
potential tradeoffs between these alternative modes of
exchange. This relationship is conceptualized within a
transaction cost framework in Figure 2.5. For lower levels
of asset specificity (k), the spot market (sm) is the
preferred medium of exchange: for higher levels of
k, contracting (c). At k, the decision-maker is
indifferent to either mechanism.8

Baumol, Panzar, and Willig, in their theory of
contestable markets, view this problem somewhat
differently. They argue that the exercise of market power
is most likely to occur in situations where assets are
immobile (fixed) on both sides of the market. Even though
the immobility of assets in farming creates incentives for

the farmer's trading partner to extract appropriable rents,

 

8This figure is an amended version of Williamson's
application of transaction cost economic to financing
investments. The idea was borrowed from him after attending
his seminar in May, 1988, at Michigan State University.

50

Cost of sm (k)
Transaction

c (k)

 

 

WI

Degree of Asset
Specificity (k)

Figure 2.5. Cost of exchange (assuming uncertainty and
opportunism) for farm inputs as their specificity
increases, using spot market (sm) or contract (c).

51
the ability to do so is contingent upon the assets of the
trading partner being immobile as well (Staatz (1987b)
p.90). Absent these barriers, there are incentives for
other firms to enter the market as long as the extractable
rents are positive.

Staatz (1987b, pp.90-91) further argues that, within
the context of the asset fixity principle, two of the most
common rationales for the creation of farmer cooperatives
are the need to build countervailing power and the need to
preserve market access. In discussing countervailing
power, he states that when farmers form cooperative supply
firms to compete directly with IOFs, this behavior improves
economic efficiency by compelling the IOFs to expand output
and increase their x-efficiency (Leibenstein). This is the
competitive yardstick rationale for forming cooperatives
discussed earlier. A second way farmer cooperatives can
increase economic efficiency is by mitigating the threat of
opportunism in the face of fixed assets. This action
encourages investment in specialized capital which is
subsequently employed to expand farm productivity.

Shaffer (1987) points out, however, that upstream
acquisition of specialized manufacturing facilities by
cooperatives often increases (rather than diminishes) the
uncertainty they face. Indeed, asset fixity and the
presence of opportunism has affected patron-owners and

their supply cooperatives in two important ways: through

52
higher levels of risk and more complex problems in
coordination.

Growing agricultural specialization is forcing farmers
to purchase (rather than produce on the farm) a greater
proportion of their total input needs. Individual farmers
are faced with larger and more risky investments as these
inputs become more asset-specific. Farms in general are
being pushed to greater levels of efficiency and, as a
result, the spread between the high-cost and low-cost
producer is narrowing (Goldberg: Hopkin and Associates).
This means that the efficient farmer, with his large
investment but small cost advantage, is more vulnerable to
outside conditions. He can no longer afford simply to ride
out the downside of a price-cycle while the inefficient (or
highly leveraged) producers are eliminated.

Regional manufacturers are similarly confronted with
growing levels of risk. Many of the manufacturing plants
built in the 1970s are under-utilized due to excess
capacity in various industries (e.g., fertilizer and
agricultural chemicals). Most of these investments are
highly asset-specific. In a depressed and more competitive
agricultural economy, cooperatives (and firms in general)
require more management flexibility, not less.

In response, some large cooperative manufacturers (e.g.,

Farmland and C.F. Industries) have closed under-utilized

53
plants and now operate with a 'make-versus-buy' strategy.9
Increasing specialization, affecting both the inputs and
the capital used to produce them, has made the market
environment less predictable. Returning to Figure 2-5,
this implies that more inputs are now located to the right
of k. Those firms that rely on autonomous market
contracting for transactions involving asset-specific
inputs or investments expose themselves to greater risks
and costs.

The second manner in which inputs are affected by asset
specificity is in the coordination process. With
agricultural specialization, not only are inputs themselves
becoming more specialized, but the number of inputs used
for the maintenance of a particular crop have grown
considerably. ”Broad spectrum” inputs (e.g., agricultural
chemicals) have been replaced by "target-specific" inputs
using refined application techniques. Knowing when, where
and how to apply these inputs is requiring higher levels of
precision, more sophisticated and costly equipment, and
increasingly specialized knowledge (Stebbins). In other
words, the risks to both buyers and sellers are greater

since both the "use" (application) period for the farmer

 

9A "make-versus-buy" strategy allows the firm to
reduce risk by supplying products under the two alternative
methods--manufacturing and/or purchase, depending on the
supply and demand conditions of the market. Manufacturing
provides a core supply with plant size adjusted for
efficient production. Additional needs can be met through
purchasing agreements with other manufacturers.

54
and the distribution period for the seller are appreciably
reduced. With specialized inputs, higher levels of
precision are necessary both to sell and use the products.
Clearly, even small errors in judgement can have important

adverse effects to either party.

2. The Externality Principle. Williamson (1981) applies
this principle to demonstrate the effect externalities have
on a firm's tendency to vertically integrate. More
precisely, he states that a firm will have incentive to
vertically integrate when participants in adjacent stages
impose externalities on the firm or when the firm imposes
positive externalities on adjacent firms (pp. 1549-50). In
the following discussion, the externality principle is
extended to account for both vertical and horizontal issues

affecting farm supply cooperatives.

yazaiaai_i§ana§--lack of patron-owner commitment. An
important externality arises when patron-owners (farmers or
local cooperatives) fail to commit themselves to their
cooperative. There are two dimensions to this problem.

The first is the practice of circumvention by large farmers
or super-locals (those firms with the strongest economic
incentive to behave in this manner). For example, a local
cooperative may choose to bypass the regional and purchase

supplies directly from another manufacturer (i.e., an IOF).

55
If the local is sufficiently large, it could reap net
benefits from possible volume discounts offered by the
manufacturer and from the omission of one or more yaiaa
afidad_atagaa in the distribution process. However, since
this is practiced by the larger patron-owners, the regional
cooperative could experience substantial declines in its
sales volume. Over time, this loss in volume could
effectively increase the average operating cost of the
regional and, as a consequence, the prices it must charge
the ranaining patrons. In the longer run, this practice
will serve to weaken the regional's competitive position
within the industry.

The cooperative principle of one-member, one-vote
currently allows many small patrons to over-rule the
demands of the large patrons. This "equal” treatment,
prevents large loyal patrons from obtaining certain
benefits that are associated with their size (e.g., volume
discounts). In effect, because of the intransigence of the
"majority," the 99:92 is imposing negative externalities on
large producers. The externality principle suggests that
failure of the cooperative to resolve this discrepancy
could result in these members integrating (probably

contractually) with alternative distributors.

Ho:iagn§ai_i§§aa§--pre and post reorganization barriers. A

pre-reorganization barrier is one that prevents a

56

cooperative from seizing an economic opportunity (e.g.,
acquisition or consolidation). A major barrier hindering
horizontal coordination is competition among cooperatives.
Competition has a pejorative connotation when it results in
needless duplication of capital equipment, labor
activities, and management functions. Those members who
ardently support and encourage this practice frequently
impose negative externalities on the cooperative and
members who depend most on the firm, i.e., those with fewer
alternatives. A second pre-reorganization barrier involves
vested interests in cooperatives with diverse membership.
For example, consider the prospect for a cooperative
acquisition. Continual bargaining among various groups
within the organization can erode the integrity of the
original plan or, in the event the groups fail to reach a
consensus, the acquisition may never materialize. Members
na§_inyaiyaa in the dispute would have also absorbed these
negative externalities.

Post-reorganization barriers hinder the performance of
a coordinating mechanism once it is adopted. Many
cooperatives form joint ventures for purposes of achieving
benefits unavailable through independent action. However,
some of these cooperatives actively compete against their
partners. For instance, cooperatives may have substantial
differences in the types of service equipment available to

them--trucks versus ownership or access to railcars. In

57

such a partnership, competitive behavior by the lower-cost
rail shipper could weaken the partner's financial position.

A second post-reorganization barrier is the
intervention by certain vested interests to slow or stop
the disposal of redundant assets. There are numerous
examples of cooperatives that consolidated in response to
problems of excess capacity, and yet, ex post facto, failed
to eliminate the redundant assets (Smith, Turner). Hence,
even though the coordinating mechanism may have been
appropriate, horizontal coordination did not improve
because of the detrimental behavior of individual groups
within the newly formed organization. Put differently,
opportunistic behavior by these groups lowered the welfare
of remaining members. It is then arguable that
cooperatives may be more susceptible to pressures of vested
interests than are their IOF counterparts. This is because
cooperative owners (as well as the local community) have
more at stake in their firm than do stockholders of an IOF.
Stockholders of an IOF base their decisions solely on the
performance of the firm as reflected in the end-of-year
profit statement and changes in stock value. Repeated poor
performance in an IOF would likely mean the termination of

management.10 As a consequence, vested interests--as they

 

10This statement is not meant to infer that contol
mechanisms of IOFs always guarantee acceptable performance:
many times they do not. This may be especially true in
situations where management has instituted takeover defenses.

 

58
affect profits-~are apt to be dealt with in a more
efficacious manner. On the other hand, vested interests
play a more significant role in cooperative organization.
For instance, the local cooperative is often the town's
single largest employer. Patron-owners may have family
members or relatives employed by the firm and, as such,
will have more incentive to participate in crucial
decisions affecting them.

The externality principle would predict that, if these
cooperatives do not evolve into larger and more efficient
organizations (because of the intransigence of certain
members), they will eventually be absorbed (integrated) by
stronger, better performing firms. A second possibility is
that members will leave (integrate with others) and the
cooperative will fail. This is the ultimate tradeoff that

confronts many poor performing cooperatives.

2.3 Concluding Remarks
This chapter introduces a systems approach for
analyzing problems and opportunities facing farm supply
cooperatives. The emphasis of the approach is on how
individual firm (micro) behavior ultimately affects system-
wide (macro) performance. But there are certain
coordination problems that are unique to farm supply

cooperatives and, as such, require special treatment. Game

theory and transaction cost economics are two theoretical

 

59
constructs that are particularly well suited to some of
these coordination problems. The major purpose of this
research is not merely to identify system problems but to
ascertain their underlying causes. As we shall see in
subsequent chapters, the source of many cooperative
problems lies in the structure of incentives facing
participants and the nature of the inputs that are utilized
by farmers. Game theory and transaction cost economics are
used to illuminate the idiosyncracies that affect the
coordination and performance of the cooperative system.
Prior to their application, research methods are presented

in chapter 3 followed by an explication of the scope and

depth of coordination problems in chapter 4.

 

CHAPTER 3

RESEARCH METHODS
3.1 General Approach

The information used to accomplish the objectives
presented in the first chapter came from three major
sources. Secondary data were obtained by conducting a
comprehensive literature search. An initial set of primary
data came from pilot interviews with general managers of
local cooperatives in Michigan. Finally, case study
interviews provided the largest single source of
information used in the research. The latter involved
personal interviews with senior executives of regional
cooperatives, general managers of local cooperatives and

patron-owners of these firms.

3.2 Literature Search and Pilot Interviews

The primary purpose of the literature search was to
identify key problems facing the agricultural input
industry in general and farm supply cooperatives in
particular. Since the focus of the research was on the
current and potential role of cooperatives within this
industry, information was desired in the following areas:
(1) current probiamg affecting farm supply cooperatives,
(2) affagta of these problems on cooperatives and their

60

61
members, (3) probable gaaaaa of these problems and, (4)
geographic location--yna;a were these problems most
pronounced and, if possible, involving what firms?

After a significant portion of the literature review
was completed pilot interviews within Michigan were
initiated with four general managers of local cooperatives.
These served to verify findings from the literature search
and were crucial because of the time lapse between dated
publications and current problems. These pilot interviews
were also supplemented by phone interviews with cooperative

experts from government and academia.

3.3 Case Studies

3.31 Rationale

There were a number of reasons why the case study
approach was employed in this research. A fundamental
reason was the nature of the study--it involved problem
solving within a complex intra and inter-firm environment.
Personal interviews were necessary to obtain a detailed
understanding of the dimensions of the problem as well as
the causes and effects of certain participant behavior, and
to explore the feasibility of possible solutions.

Second, there was a need to verify the working
hypotheses of the research, principally that some current
cooperative institutional arrangements were not conducive

to effective coordination of the cooperative gygaam, in

 

 

Q /—_E

62
both vertical and horizontal dimensions. Regarding
vertical coordination, a working hypothesis was that
cooperative firm and system performance was compromised by
a general lack of commitment between farmers and their
local cooperative and between local firms and their
regional cooperative. From a horizontal perspective, the
hypothesis was that ubiquitous competition at both the
local and regional levels had effectually made cooperatives
iaag competitive suppliers of farm inputs by raising
individual firm costs and attenuating system coordination
and performance. Personal interviews were deemed highly
suitable for flushing out causes for this apparent
detrimental behavior within and among cooperative firms.
Personal interviews permit the researcher to obtain
detailed information on specific issues and explore
unexpected avenues that surface throughout the interview
process. These opportunities would be unavailable using

alternative means like mail surveys.

3.32 Interview Design

Since the research explores vertical and horizontal
relationships within the cooperative system, the design has
two levels of focus. The first major focus (delving into
micro issues) concentrates on three parties: regional
cooperatives, local cooperatives and farmers. The second

level of focus (dealing with macro issues) involves

63
regional and local cooperatives only. In analyzing the
micro issues, since the three parties each represent
alternative sides of a transaction, a "mirror image”
approach was adopted (Purcell). The technique involves
asking decisionmakers who are located at opposite ends of
an exchange (for example, buyers versus sellers) their
perceptions of a particular problem. Since each party's
understanding of the problem will be based on its own
experience of the transaction, the interpretations should
differ. Uncovering participant perceptions (and potential
misconceptions, as Hamm notes) is vital to the problem
solving emphasis of the study.

The interviews were carried out with people who were
thought to be most knowledgeable about the above-mentioned
issues. Typical respondents for the regionals were either
the vice-president for economic planning or the vice-
president for farm supplies. At the local cooperative
level, general managers were interviewed. The sample of
farmers interviewed consisted of both board members
(roughly one-third) and non-board members. It was felt
that board members might have different views than non-
board members. Another aspect of the interview process
regards confidentiality. Even though the information
sought was largely nonsensitive to those interviewed,
respondents were promised that names of individuals or

firms would not be used. One reason for this procedure is

64
that, given the nature of the research, little would be
gained by attributing names to statements. Secondly, it
was felt that respondents might be more open if they knew
their views and opinions would be held in confidence.
Since the research method is a case-study, detailed
information was desired.

The second major focus of the research dealt with
coordination issues at the regional and local levels (i.e.,
regional-to-regional and local-to-local). In a sense, the
mirror image approach is applicable here as well, even
though these firms are not, in strictly defined terms, on
opposite ends of a transaction. However, given that they
are each competing for the same members' business (whether
farmers or locals), they are in a sense at opposite ends of
the same problem. Regional and local firms were

interviewed with this in mind.

3.33 Cooperative Firm Selection

A1__82919n§l_§2122§1981 These firms were selected on a
purposive basis. They had to meet the criteria set forth
in the first chapter--namely be strongly affected by
problems of member commitment and inter-firm competition.
Selection was accomplished by obtaining a consensus from
experts in government and academia. These cooperatives

also had to be major suppliers of farm inputs.

§a__Lgaai_§aiaaaigna These firms were also selected on a

65
purposive basis, but conditional on satisfying some
logistical constraints. All locals had to meet the same
micro and macro criteria as the regionals. The problem was
that in order to cover the vertical issues effectively, the
locals would have to be members of the pre-selected
regionals. In addition, since the sample was small and
organizational relationships between the regionals and
locals could be expected to differ, it was necessary to
ensure that the ratio of regional to locals was roughly the
same for each federation. Since several thousand locals
were members of these firms and their affiliations unknown,
a random selection method was not considered feasible. The
most obvious method was to request that each regional
'select the sample of locals to be interviewed. However,
given that some of the vertical coordination issues dealt
with the relationships between these firms, it was felt
that regionals might have cause to select locals that were
particularly loyal. The research required interviewing
both loyal and disloyal members. Consequently this was not
an acceptable method. In the end, the Agricultural
Cooperative Service (ACS), with its comprehensive knowledge
of farm supply cooperatives (and management personnel), was
able to develop a "short list" of local firms that met the
aforementioned criteria. Final selection was based on the
local's proximity to the regional. In other words, to

avoid needless expenditures of time and money, locals that

66

fell within a predetermined distance from the regional were
selected.
§a_izazmar_§aiagtigna These were accomplished by
requesting the general manager to arrange an interview with
at least two farmers.1 The only criterion was that the
farmers' major income be generated on-farm (to avoid
obtaining co-op employees, which was the managers' first
inclination). It was felt that since off-farm income would
act as a cushion against economic conditions, ”hobby
farmers” would not be sufficiently aware of key issues and
problems.

Table 3.1 summarizes the three categories of

respondents and lists the number of persons interviewed.

3.34 The Interview Process

Once the appropriate firms and individuals were
identified, an interview request was made. This was done
by phone and was followed up with a letter confirming the
date and time as well as information on the purpose and
approximate subject matter of the interview. A
questionnaire had been developed for the interview that
included both closed and open-ended questions. The letter

and the questionnaire can be found in the appendix.

 

1The researcher acknowledges that the same potential
for sample bias is present in farmer selection. However,
given constraints of time and money, there simply was no
feasible way to select farmers except through the general
managers.

67

Table 3.1. Interview Breakdown for Case Studies.

 

Cooperative and Number Persons Interviewed

 

 

Regional____N21 Lesal____N91 farmer___ngl
A 1 A1 1 A1 3
A2 1 A2 2
__ A3 .1 A3 _;
Subtotal 1 3 3
3 1 31 1 31 3
32 1 32 2
__ 33 .1 33 _o 1
Subtotal 1 3 s
c 1 c1 1 c1 3
c2 1 c2 0 1
__ c3 .1 C3 _2
Subtotal 1 3 5
Total 3 9 18

 

IFor various reasons, farmers were not available.

and I
latte
issue
Becaz
state
inteI
inclI

were

did I
the I
the j
inteI
reSpc
tapil
the I
the I
VOUII

SCne

68

Two separate questionnaires were used, one for local
and regional firms, the other specific to farmers. The
latter questionnaire was much smaller in that only those
issues that involved the farmer directly were asked.
Because of the large geographic area to be covered (five
states) and the total number of interviews, two sets of
interviews in the midwest were covered each day. A "set"
included both a manager and two or more farmers. Managers
‘were interviewed individually: farmers as a rule were not.
Local manager interviews took approximately two hours (as
did the regionals) and farmers, 30-45 minutes. Because of
the breadth and depth of the questionnaire and because of
the interview schedule, a request was made to tape the
interview conditional upon confidentiality. All
respondents graciously complied. An important benefit from
taping was that the interviewer was able to concentrate on
the quality of answers (i.e., did they adequately address
the question?). Undoubtedly there was information that
would have been lost had the interview process relied on

some form of written response or notetaking.

CHAPTER 4

PATRON-OWNER COMMITMENT AND VERTICAL COORDINATION
4.1 The Commitment Dilemma

This chapter begins a discussion of coordination issues
gleaned from case studies and lays the foundation for most
of the remaining chapters. It has two major sections. The
purpose of the first section is to verify the problem of
cooperative patron-owner commitment. It draws on the
expertise of management personnel of local and regional
farm supply cooperatives. The second section lays out
management's perceptions regarding the effects of
diminishing patron-owner commitment on the coordination and
performance of cOOperative firms and the larger cooperative

system.

4.11 Patronage and Cemnitment
A. Farmers' Patronizing their Local Cooperative

Senior management of the regional firms interviewed
were unanimous in their opinion that farmers "shop around"
more now than they did ten years ago. Farmers as a group
are presently viewed to exhibit less loyalty to their
cooperative than they had in the past. When asked to
identify the major alternative suppliers farmers were

frequenting, perceptions differed (Table 4.1). The

69

70

Table 4.1 Regional and Local Cooperative Managers'
Perceptions of Farmers' Alternative Sources of Input
Supplies.

 

Cooperative View

 

 

 

Alternative Suppliers Number
W Regional Local
Primarily IOFs - 3
IOFs and Locals 2 4
Primarily Locals 1 2

 

Table 4.2 Regional and Local Cooperative Managers'
Perceptions of Locals' Alternative Sources of Input
Supplies.

 

Cooperative View

 

 

 

Alternative Suppliers iNumher
We Regional Local
Primarily IOFs 1 5
IOFs and Regionals 2 2
Primarily Regionals - 2

 

71
senior manager of one regional thought that other local
cooperatives constituted the primary source of alternative
supplies. The remaining two believed that both other co-
ops and independents (i.e., IOFs) constituted the local
firms' competition.

Local managers also strongly affirmed that farmers tend
to shop around more now than they did in the past. Like
the regionals, however, perceptions differ as to whether
their primary competition is other independents or simply

other cooperative firms (Table 4.1).

B. Local Cooperatives Patronizing their Regional

Most respondents believed that the loyalty problem as
expressed through patronage is also significant at the
local-regional level. Some local managers commented that
not only is it highly advisable to shop around, but that
members actually expect them to behave in this manner.
Others asserted that such behavior by locals is
counterproductive but pointed out that regionals compound
the problem by competing with one another. Simply put, not
only do many farmer and local cooperative philosophies
underscore the economic benefits derived from uncommitted
behavior, but ironically the regionals seem to encourage it
actively by competing for the same customers.

Both the local and the regional respondents were split

as to the source of locals' alternative supplies. This is

SEC‘
in I
new,
some
qtes
exte
stud

of t
to 0-
Ithre
statl

°Pera

72
apparently due in part to geographic circumstances. In
some regions of the midwest, proprietary firms tend to
dominate the wholesale and retail input markets whereas in
other areas cooperatives do. Referring to table 4.2, three
of the five locals identifying IOFs as their primary
competitors are positioned in the same geographic area as

the one regional in that same category.

4.12 Capitalization and Commitment1
A. Farmer Investment in Local Co-ops: A Local Perspective
Two-thirds of local managers agreed that equity levels
among local cooperatives are (generally) inadequate for
meeting current needs (Table 4.3).2 A prevailing sentiment
was that even though healthy firms may operate
efficaciously,3 a major weakness of the cooperative
institution lies in its inability to infuse additional

capital into the system. Equity levels are determined by

 

1The reader should recognize that, although this
section recounts the opinions of case study respondents and
in this sense is original, the findings themselves are not
new. A more exhaustive study was conducted by Cobia et al.
some years prior to this research. The reason these
questions are reiterated in this study is to establish the
extent to which these problems are present within the case-
study firms.

2This perception held in spite of the fact that most
of these firms were well-financed. Their experience related
to other local firms in the area and general views heard
"through the grapevine". Of those that disagreed with the
statement, all were financially healthy firms.

3That is, healthy firms had adequate equity to meet
operating capital needs and still revolve equity accounts.

‘—

6».

IF

.Ql
Ed

the

pa:

p
I

Ma

agr

for

red

COC

Rho

dis

ter

W."

9nd

may

tern

ent

— .I 56
at

any. 4.

73

Table 4.3 Regional and Local Cooperative Managers' Views
on Equity Investment and Redemption Practices.

 

Cooperative View'

W __Eegi_enal_ __lo_eal__
Investment Practices Agree Disagree Agree Disagree
0 6 3

a) Inadequate 3

b) Misdirected 3 0 9 0
Redemption Practices

a) Inadequate 3 0 8 1

 

* Agree column includes those respondents that agree

strongly plus those that agree. Disagree column includes
those respondents that disagree strongly plus those that
disagree.

the firm's capacity to generate net earnings and the
particular equity redemption program it has adopted.
Managers pointed out, however, that with a tightened
agricultural economy and intense price competition, margins
for many inputs have diminished. Lower margins imply a
reduction in net margins that are used to build up
cooperative equity through retained patronage refunds.
Another important element of low net margins is the
disparity it creates between new, large entrants and long-
term (older) members. Many of the older members have
accumulated substantial equity from years when cooperatives
enjoyed sizable margins. At the same time, these members
may also be paring down operations as they approach the
terminus of their economic life cycle. Conversely,

entrants who have come on-line in the past 5-6 years may

74

be aggressively patronizing their cooperative but, because
net earnings (and concomitantly, retained patronage
refunds) are low, these patrons fail to accumulate equity
capital.4 Hence, managers complain that some members who
are the largest users of the cooperative are grossly angaa;
inyastag whereas other older members who may be downsizing
operations are substantially gyarzinyaatada More than one-
third of these local managers suggested instituting sizable
front-end (direct) investments based on proportionality as
a mechanism for rectifying this inequity. Others agreed in
principle but felt that direct investments would be

extremely difficult to implement.

B. Local Investment in the Regional Firm: A Regional
Perspective

As Table 4.3 indicates, senior management of regional
cooperatives believed unanimously that equity levels are
inadequate based on regional firms needs. Furthermore,
according to one individual, substantial investment
inequities persist among local membership. In particular,
patronage-to-equity ratios are severely misaligned by both
farmer and local members--significantly more so now than in

the past. A disparity between large under-invested new

 

4A major flaw of retained patronage refunds is their
dependence on net earnings, which fluctuate with the
fortunes of the cooperative. Hence, in a period when a
cooperative is financially stagnant, accumulation of equity
capital through retained patronage refunds is negligible.

75

entrants and smaller, over-invested long-term members is an
area of growing discord among local and regional
cooperatives.5

Another senior management view is that locals have a
poor understanding of a regional firm's need for equity.
Even though many local co-ops have substantial equity
invested in their regional, a regional's financial
requirements (like costly but necessary advertising
programs) often exceed its ability to acquire additional
equity capital.6 This argument is considered even more
salient when one accounts for the growing concentration of
most input markets. To ameliorate this capital constraint,
one regional is creating subsidiary organizations with some
of its more successful business lines for purposes of
selling stock to the public while retaining majority
ownership. This practice, however, is seen as only a

partial solution to deficient capital resources.

 

5Case study regionals are aggressively trying to
resolve their equity investment dilemma. One in particular
is examining alternative programs and doing so in
conjunction with its members. A base capital plan is one
method that is currently under consideration for this
regional. Some local managers who were knowledgeable of
this plan viewed it favorably but had reservations
regarding implementation because they felt young farmers
would be unable to provide the capital requirements. This
is consistent with findings from Cobia, et al.

6Advertising is made even more ”necessary" by the
practice of inter-cooperative competition. This is a good
example of how individual (micro) behavior has deleterious
system-wide (macro) consequences.

76
C. Equity Redemption Programs

Although regional cooperatives recognize their equity
redemption programs are inadequate in some areas, their
perception is that current difficulties are more pronounced
at the local level. According to one senior executive,
redemption programs for the cooperative system as a whole
are basically unsound. A complicating feature is the
di1faranga_in_mambar§nip_ba§a between regional and local
firms. A membership base at the local level is defined by
the farmer-member, who has a limited lifetime. There are
three components of redemption programs that exert pressure
on a local cooperative's equity capital. The first
concerns patron-owner demands for their investments as they
near retirement. The second is the growing insistence by
younger farmers that their equity accounts he revolved in a
more timely and systematic manner. Unlike their parents,
many are unwilling to be placed in a situation where they
must ”die to get it." A third component that can severely
strain a cooperative's equity balance involves settling the
estates of deceased members. Some of these accounts
constitute prodigious amounts of investment capital.

In short, the membership base at the local level is
characterized by a growing insistence of patron-owners to
have their investments returned to them in a more expedient
and systematic fashion. This entails: (1) revolving

equities more frequently, (2) returning member investments

77

at retirement, and (3) settling estates propitiously. All
three areas of contention place acute pressure on local
management and directors to divest the firm's scarce cash
resources.7

Conversely, the regional firm is not constrained by
this human economic lifecycle. A regional farm supply
cooperative has local organizations for its members, which,
for all practical purposes, have no lifetime limit. Hence,
equity redemption is not deemed as critical an issue at
this level--i.e., regional firms are not pressured to
retire equities to the same degree and with the same sense
of urgency that are local firms.8 As a consequence, local
equity capital invested in the regional accumulates as non-
cash assets and shows up in the their balance sheets. In

the opinion of one senior executive, this discrepancy in

 

7These issues are indicative of the "horizon problem"
discussed by Staatz (1984, pp. 96-106). The core of the
problem lies with the lack of a secondary market for
c00perative equity certificates. Therefore, the stock
grants to the holder a residual claim on the earnings of
the firm only so long as s/he patronizes the co-op and if
management and the board of directors deems the move in the
best interest of the firm (i.e., does not jeopardize the
co-op). Hence, the lack of a secondary market for
cooperative stock prevents the smooth intergenerational
transfer of ownership of the firm and leads members to push
for the development of mechanisms to increase the liquidity
of their investment in the cooperative.

8This may be true to an extent, but locals are
shifting this pressure upward as farmers become
increasingly adamant about the future of their investments.
Also, patron-owners may view failure to revolve equities as
a rationalization since, at the time of these interviews,
all three regional firms had still not resumed redeeming
equity to their members.

78
membership base partially explains why equity redemption is
currently a source of friction between regional and local
firms.

Another regional vice president acknowledged that his
firm had recently ceased retiring equities--a move prompted
by a more urgent need to meet certain financial goals. One
pertains to improving the regional's financial position by
reducing its debt-to-equity ratio. The second is linked
with a recent policy of moving to aaaata_prggram§ where 100
percent of deceased farmers' investments in the regional
are returned to families of deceased members.9 In some
ways this policy is considered to be a ”financial
millstone" for the regional, as the refundable amount under
the estate program can equal the total equity redemption
funds available to the firm.

Local managers' views concerning equity redemption
programs are consistent with respect to the desirability of
ayaaamatig programs but differ in terms of how these

 

9A farmer indirectly invests in the regional through
investment in the local cooperative. Through patronage, the
local acquires equity in the regional firm, just as a
farmer accumulates equity in the local firm. When a local
co-op decides to settle an estate, it redeems to the
member's survivors the appropriate amount of qualified
equity. In addition, the regional redeems a proportion of
the equity equal to the ratio of the local's investment in
the regional to the local's total allocated equity.

A local co-op with total allocated equity of $100,000
and an investment of $20,000 in the regional would receive
$2,000 in equity redemption from the regional when faced
with redeeming $10,000 held by an estate.

79

programs should be financed.10 A few mentioned that their
practice of redeeming equities at age 65 is not fair to
members (i.e.,because of the time value of money, equity
should be revolved on a more frequent basis), but perceive
no feasible alternative unless effective proportionality is
instituted.11 Another general manager was insistent that
equity redemption should come from net earnings and not
from direct investments by members. In other words, if the
co-op is managed properly (and assuming "normal” economic
conditions), redeeming equities would not be an issue among
membership. An exception might be at the regional level,
where new ventures could dictate the need for an infusion
of patron-owner capital through direct investments.

Two less viable local co-ops admitted to having no
systematic program but contend that they need fiiaxibiiiay

 

10There are good reasons why some managers' hesitate
to implement equity redemption programs. Barton has shown
that some types of equity redemption methods actually
determine the financial structure, especially of local
cooperatives. More succinctly, some redemption methods
(e.g., estate only and age of patron) reduce the control
the co-op has over its own financial structure because the
amount of equity tends to be predetermined by the method.

11Proportionality simply infers that members' equity
investment should be aligned with their use of the
cooperative. A current complaint among regionals is that a
severe misalignment has developed, largely because of the
recent low earnings of cooperatives. Further, many of the
chronically underinvested members are large, new entrants.
To the extent this is true, these members are receiving
benefits from patronage without providing equity or risk
capital (financing the co-op) in the same proportion.

80
to adjust to big swings in earnings.12 They argued (as did
managers of other locals) that handling estates is an
important issue among farmers, and yet it has significant
adverse effects on their capacity to redeem equity
accounts. Many local managers mentioned that some
ingiyignai farmer accounts were between $100,000 and
$200,000--an amount sufficiently large to financially
cripple many smaller cooperatives.

A final opinion places the onus of responsibility on
regional firms. According to the argument, these firms are
financially impaired to the point they are unable to retire
their stock within a reasonable time period. A few managers
noted that some stock had not been retired in more than 20
years. A general consensus of local managers was that
regionals should write down their stock to reflect
accurately the current value of assets because the stocks
inflated value has adverse affects on their borrowing
capacity. For instance, local managers complained that,
due to over-valued regional stocks, lending institutions
are highly reluctant to consider these stocks in a local's

balance sheet (i.e., as assets). Since many locals are

 

12This belief was affirmed by nearly all cooperatives,
even the largest and most successful of the locals.
Regional firms also subscribed to this "flexibility policy"
where equity retirement is at the discretion of the board
of directors.

81
invested 25-30 percent in their regional,13 a stock
devaluation could destroy poorly performing locals, but it
would also give surviving firms a more promising future.
But local respondents assert that regionals resist this
stratagem because it underscores faulty management
practices that caused the depreciated assets in the first

place.

D. iMisdirected Investment Policies

Personnel interviewed at both the regional and local
levels acknowledged that in recent years cooperatives have
made many unsound investments (Table 4.3). Poor investment
policies are attributed to both regional and local firms.
Regionals have over-invested in costly plant and equipment
for basic sources of supplies (e.g., mining and
manufacturing). Local cooperatives have over-invested in a
wide range of input services, including fertilizer mixing
and feed blending plants, as well as unit train facilities
like trackage, loading equipment, and storage units. One
regional respondent believes that the underlying impetus
for this behavior is farmers' preoccupation with fixed
assets. From a farmer's point of view, physical capital is
tangible and represents substantive proof that his or her

money is at work. The problem is that decisionmakers

 

13That is, 25-30 percent of a local's total assets are
invested in the regional firm.

82
employed little discriminatory behavior in that any
investment was considered good. Now, in hindsight, the
consensus among respondents is that many of these
cooperative investments were not a very wise use of

farmers' money.

4.2 Member Commitment and Economic Coordination
This section discusses local and regional cooperative
views on the impact member commitment has on the
coordination and performance of their firms. Commitment
effects are evaluated through patronage loyalty and member

investment in the cooperative system.

4.21 Commitment through Patronage
A. A.Regional Perspective

Senior management of regionals are acutely aware of the
consequences an absence of local cooperative commitment has
on the economic performance of their firms and the larger
system they serve. According to those interviewed, the
effects of "shopping around" influence all aspects of
production and distribution of farm supplies. At the most
basic level, this behavior limits a regional firm's ability
to plan--a procedure that is vital to the efficient running

of any complex organization. Absent effective planning,

83
scarce resources like time, money, and materials are used
to develop costly contingencies because future demand is
both volatile and uncertain. Erratic fluctuations in
volume purchases raise per-unit manufacturing costs because
capacity is set at a predetermined level. Plant and
equipment is designed optimally to handle a certain level
of output. Purchase orders for manufacturing inputs, once
implemented, are difficult to alter. Personnel policy is
also geared for longer term conditions since repeated
hiring and firing can be an expensive and time-consuming
process. It also undermines the morale and subsequent
productivity of employees. Further, controlling
inventories is a more problematic and expensive process
since the likelihood of being long or short on basic
supplies is a greater possibility. "Specialty" items--
those inputs that are less common because of their
specialized functions--become more risky to handle.14 From
the respondents' point of view, price is the critical
factor leading to the commitment problem. Individuals or

firms that exhibit disloyal behavior appear to be sensitive

 

14Specialty items are generally characterized by low
margins at the wholesale and retail levels. Large margins
are said to exist at the manufacturing stage for this class
of inputs. Respondents stated that basic supplies like
fertilizer or feed may have a 10-15 percent (or more)
margin whereas ”specialty" items are closer to 3-5 percent.
This suggests that the manager has less price flexibility
when reacting to competition for the specialty items. A
constrained ability to adjust price increases the odds of
”carryover" stock hence the risk associated with these
costly, low-margin items.

84

to small changes in input prices. However, because
cooperatives (as a rule) carry a full line of products and
services, it is impossible to consistently have the lowest
price on every product. This suggests that current
cooperative policy may be incompatible with the goals and
objectives of this class of patron-owners. Conventional
wisdom purports that "shopping around” makes cooperatives
more competitive--it is the stick patron-owners use to
maintain acceptable performance. In practice, however, it
may make cooperatives less competitive because cost
structures at every stage of the production-distribution
system are adversely affected due to poorly coordinated
economic functions and activities. Furthermore, the
consequences of this behavior eventually filters down and
throughout the entire cooperative system.

The preceding discussion is a rather orthodox view of
how competitive behavior affects coordination in a
cooperative system. It does not account for how competition
influences factors like x-inefficiency within the firm.
Numerous times respondents noted that competition is
primarily responsible for the improvement in management
performance at the regional level. Some respondents
(including regional managers) argued that mismanagement and
excessive slack within the regional organization is just as
detrimental to performance as is poor vertical

coordination. Hence, the combination of financial duress

85
(due to both internal and external forces) and outside
competition can also be construed as a positive influence
on cooperatives if it improves the organizational
performance of the firm.

Another concern is that commitment is often uni-
directional. Regional respondents noted that for a long
time local co-ops insisted that regionals limit input sales
only to members. The impetus behind this demand was to
mitigate the threat of competition at the local level. At
the same time, however, these members were practicing the
option of purchasing again supplies from the regional's
competitors. Hence, locals wanted a firm commitment from
the regionals but they were unwilling to impose that same
restriction upon themselves. This practice effectively
tied the regionals' hands by restricting their marketing
options. By focusing exclusively on their membership these
firms were forced to raise or lower volumes based on
uncertain supply and demand conditions while still trying
to swing their prices with the market to remain
competitive.15 The end result was that earnings fluctuated
substantially. This was because these regionals were heavy
into manufacturing and were forced to contend with the
rigidity of fixed costs. When a period developed where

their prices were non-competitive, volume fell, thereby

 

15In the absence of this agreement the regional can
better stabilize volume by arranging for alternative demand
sources, like domestic IOFs and international markets.

86
raising unit manufacturing costs. Higher costs eventually
translated into higher prices and lower margins, which
created additional incentives for members to purchase
elsewhere. As a consequence, regional management was
eventually able to convince the board of directors to

change this policy of selling only to members.

B. IA Local Perspective

Local views on the commitment issue appear to take two
polar positions--either local managers believe in
commitment (and practice it) or they don't. One third of
the local managers interviewed were in this latter
category. Farmers as a rule were perceived to be much less
loyal to their local cooperative than were locals to their
regionals. This observation was iterated consistently by
all respondents. Commitment is currently one of the most
talked about and controversial words in the cooperative
vocabulary.

Respondents who support a farmer's or local manager's
decision to shop around justify the behavior by asserting a
simple but far-reaching tenet. There are two aspects to
the argument. First, uncommitted patrons keep management
"on their toes”. The only way cooperatives can attract
uncommitted patrons is by having the lowest prices and
highest quality products. Managers acknowledge that it is

impossible to continually have the lowest prices across all

87
product lines, but they also believe farmers recognize
this. A more reasonable efficiency target takes into
account the larger "cooperative package." In other words,
when one averages out prices and takes into account
patronage refunds and cooperative services, this "package"
should be the most attractive alternative available to
customers.

The second argument for condoning uncommitted behavior
is essentially a special case of the first-~that it
strengthens cooperatives at all levels through more
informed decision making.16 Informed decisionmakers are
more efficient and therefore more competitive. At the
farmer level, for instance, knowledgeable producers put
pressure on local management to be informed through
competitive purchasing practices. In turn, this behavior
by locals exerts pressure on their regionals to be
efficient, low-cost suppliers. The view asserts that well-
informed participants both promote and facilitate improved
performance in the cooperative system. On the contrary,
commitment tends to breed complacency, which undermines the

system's capacity to perform efficaciously.

 

16Apparently informed decisions are highly valued by
many patron-owners. Even though they may trust their co-op,
information is viewed analogous to an insurance policy as
protection against unfavorable performance. This trust
varies significantly across membership. One manager stated
that his farmers knew the price of basic inputs in a 60
mile radius of their cooperative and knew the price of farm
equipment across the entire state.

88

Local managers who adhere to the commitment philosophy
recognize that shopping around may keep firms more alert
but believe the costs of this behavior greatly exceed its
benefits. Their concern is that many farmers lack an
adequate understanding of the cooperative's economic role
in the input industry and the agricultural sector in
general. In other words, they fail to consider what
alternative market structures might develop in the ahaanga
gf_aha_gggpazaaiya. According to these managers, farmers
are unduly concerned about price as the prime indicator of
performance and in the process overlook vital services
offered by cooperatives. For instance, local managers
complained that some farmers will buy inputs elsewhere if
prices are even marginally lower, and then request special
cooperative services (like tire repairs and soil analysis)
that did not accompany their purchases.17 Managers who
adhere to the commitment philosophy believe that the time
has come for farmers (and the system in general) to
reevaluate the types of functions and activities that are
feasible for co-ops in today's competitive environment.
Farmers should not expect their cooperatives to have the
lowest prices on all their inputs and still maintain a

complementary line of services.

 

17Some managers believe that the price issue was
instigated by IOFs since they generally specialize along
one or two product lines, offer fewer services than co-ops
and then concentrate on being the lowest priced suppliers.

89

Most local managers echoed their regional counterparts
in stating that, with membership demand volatile, firms'
pianning_§apaaity is compromised. If a local co-op's
customers are consistent buyers, for example, the manager
is better able to determine manpower needs, equipment
needs, and inventory levels. Other tasks like employee
work loads, the distribution of products, and the execution
of service functions can be scheduled more efficiently. A
component of the ”demand volatility" problem is the fairly
common practice of farmers joining more than one
cooperative. For instance, some farmers were said to be
members of five different cooperatives. Under these
conditions, management planning strategies can be impaired
seriously. It also means that all five cooperatives are
expending resources (and increasing their costs) in efforts
to lure customers to their association.

In conclusion, case study interviews confirmed that
uncommitted member behavior as expressed through patronage
severely impedes the harmonization process (i.e.,
routinizing and stabilizing various economic activities) of
the cooperative system. At the firm level, logistical
coordination of human and physical capital resources is
weakened at each stage in the production and marketing
chain. This results in needless inefficiencies like under-
utilized plant and equipment, over or under stockage of

inventories, and a lower productivity of employees through

90
a less efficient use of their time.18 From a systems
perspective, the practice of "shopping around" increases
the uncertainty of demand at each major stage. Regional
firms are less sure of local cooperative needs and local
managers are less sure of farmer-member needs. The entire

system performs at a reduced capacity.

4.22 Equity Capital and Coordination Issues
A. Regional Effects

At the time these interviews were conducted, regional
firms were still in the process of restructuring and
revitalizing (i.e., redeploying assets) their
organizations. They were keenly aware of the consequences
of poor firm financial health and the various constraints
imposed on cooperatives in their efforts at generating
capital. They were also cognizant of the many financial
opportunities available to their proprietary competitors.
A theme frequently enunciated by regional respondents was
the double burden that attends highly leveraged
cooperatives--financial impairment is both a source and a
cause of poor performance. On the one hand, because the
firm is weak, few credit institutions are willing to risk
lending additional capital. When (or if) the leveraged

 

18Understockage or "stockouts" are considered more
detrimental to a firm in the longer-run than is
overstockage. This is because market share is affected by
the former. A customer is ia§§_iikaiy to return to a firm
when a desired commodity is unavailable.

91
firm locates a capital source, it invariably comes at a
high cost. On the other hand, agnars of the cooperative
are also reluctant to invest additional (equity) capital
into a venture that could turn into another “sunk cost”.
Hence, the available aappiy of both debt and equity
capital is severely restricted.

Another assertion of respondents was that cooperatives
experience a greater ganand on their cash resources than do
their proprietary counterparts. A regional's earnings are
usually apportioned across some or all of the following
alternatives: (1) improving the balance sheet by increasing
capital investment, (2) paying cash patronage refunds, (3)
revolving equities and, (4) settling estates. Because of
different organizational characteristics, IOFs face only
the first decision and the need to pay dividends. The
reason the latter three constitute a cash demand for co-ops
is because cooperatives have not instituted equity
appreciation opportunities. The only cash owners receive
is in the form of patronage refunds and equity redemption.
Conversely, IOFs allow equity markets to appreciate the
value of their stocks while still retaining their cash
earnings. This practice allows IOFs to pay relatively
small stock dividends since equity markets serve to pacify

their owners.19

 

19This was particularly true in the past when the tax
rate on capital gains was less than that on ordinary
income, such as dividends.

92

In summary, regionals respondents argue there are
effectively two opposite financial forces that disadvantage
them in the market place--a restricted supply of money and
a significant (owner) demand for cash balances. Because of
poor performance, debt capital is both scarce and costly.
Similarly, patron-owners of regional firms resist
committing additional funds that may never be remitted.
Regionals further assert that the demand for net earnings
are greater for cooperatives than for their IOF
counterparts. The combination of these “supply-demand"
constraints greatly hinders the performance goals of
regional firms and creates incentives for additional

members to indulge in ”disloyal" pursuits.

B. Local Effects

A weak financial structure affects local firms in much
the same manner it does regionals. Both short- and long-
run economic performance is impaired by this "supply-
demand" squeeze mentioned above. Not only does this place
upward pressure on the firm's cost structure but it
inhibits the firm's ability to capitalize on specialized
purchasing options like forward contracting.20 One short-
run benefit of forward contracting is that it contributes

to the cooperative's competitive position through the

 

20Forward contracting as a coordinating mechanism is
discussed extensively in chapter 6.

93

acquisition of (generally) lower cost farm supplies (i.e.,
lower cost than may be experienced through spot purchases
immediately prior to or during planting season). It also
positions the local well in terms of supply logistics.
Input shortages at planting time (when demand is greatest)
were mentioned as a key source of concern at both the
wholesale and retail levels. Positioning input supplies in
strategic locations prior to the planting season
strengthens a firm's competitive edge by reducing the time
required to satisfy unexpected demand. For instance, this
strategy can be crucial in years when the crop season
begins early. Firms with well-positioned inventories will
capture a good portion of their competitors' market share.

Longer run performance is similarly affected. For
instance, without access to affordable capital, a firm is
unable to take advantage of investment opportunities that
could diminish or spread risk--like forming a joint venture
with another cooperative, where project costs are shared,
or investing in new technology that could improve the
efficiency of operations. An example of the latter are
computerized merchandising and accounting systems that some
of the larger locals (super-locals) have installed.

Another observation was that poorly performing
cooperatives may respond to financial stress by terminating
their equity redemption programs. Managers noted that

these programs are generally eliminated first because they

94
are under the direct control of the firm.21 This type of
discretionary control also affords a certain amount of
financial flexibility during lean periods. Other capital
outflows, like paying employee salaries and servicing the
firm's debt, are associated with substantially less
discretionary slack. However, managers voiced concern that
paring back or eliminating redemption programs has a
debilitating effect on membership morale and undermines
farmers' incentives to do business with cooperatives.
Managers believe that equity must be perceived as a
reasonable investment alternative. This implies that
owners should systematically receive a financial return.
Failure to redeem equities of inactive and other
overinvested members means that incentives to invest in
cooperatives is undermined because the level of benefits
from the co-op are not contingent upon the level of capital
investment. As a consequence, the equitable implementation
of equity redemption programs is considered to strongly

influence farmer loyalty.

C. System Effects
The following synopsis represents a regional
perspective of capitalization issues and their effect on

the performance of the cooperative system.

 

21Another perspective is that retired members may have
lost their voting rights and, hence, are unable to pressure
the board of directors.

95

In a federated system, regional decisionmakers have a
degree of control over how cash resources flow (downward)
from the regional to the local to the farmer. This is
because the flow of money is determined by the patronage
refund policies and equity redemption programs instituted
by the regionals and locals. But there is no control
whatsoever with respect to the flow of resources in the
opposite (upward) direction. This is because there are no
federation by-laws that establish the amount of equity
capital farmers should invest in their local and the locals
in their regional.22 In the view of one regional
respondent, the cooperative federated system is designed
for "controlled liquidation'--the degree to which the
regional and the local can assuage member demands for cash
is the degree to which the cooperative avoids liquidation.
This situation is applicable to most federated systems and
it prevents cooperatives from evolving into more viable and
competitive forces in the market. The cooperative system
needs to develop the capacity to be responsive to a
changing economic environment. Inability to generate
adequate capital strongly impedes this adaptive process.

Absent some mechanism for infusing capital into the system,

 

22This is partially misleading. Membership policies of
cooperatives do establish how much new entrants must invest
in their co-op. The problem is that the amounts are so
small that they contribute little to the regional's equity
position. The membership fee for a local to join a regional
is typically $25 (as it has been for over 50 years) and a
farmer's fee to join a local is as low as $1.

96

cooperatives could continue to lose their competitive edge
and may, as a consequence, be relegated to carrying out
some secondary market function.23

In conclusion, capitalization issues hurt the agapaiya
component of coordination--the ability of a firm or the
system to adjust to changing economic conditions.
Cooperative respondents noted that capital constraints are
essentially due to the following conditions: (1) poor firm
performance: (2) difficulty in obtaining financial
resources (money supply constraint) when they are needed:
and (3) a large member demand for cooperative cash
resources. In the absence of sufficient equity capital,
money is purchased at a high cost which in turn raises a
firm's fixed costs and further deteriorates its competitive
position. More and more resources are consumed servicing
debt and meeting basic operating requirements rather than
being directed at new technology items that reduce unit
costs or investment opportunities that improve a firm's

market share and subsequent net earnings.

 

23This perception of some respondents indicates how
frustrated they are. This view varied considerably at the
local level (from strong concurrence to complete
disagreement), but was generally affirmed at the regional
level. This assertion also illuminates the fact that
managers have an inherent interest in increasing the
capitalization of the firm. A relevant question is, if this
horizon problem is endemic in co-ops, why have they
survived up to this point?

97
4.3 Chapter Summary

This chapter examines a key vertical coordination
problem currently afflicting many midwestern farm supply
cooperatives. The process involves two steps. First, the
research establishes the scope and depth of the prgbiam
among the cooperatives' interviewed. A second part delves
into the affagta of the problem on cooperative firms.

The vertical coordination problem is confirmed to be an
erosion of member commitment and is manifested in two
fundamental ways. The first is that, in recent years,
member patronaga of their cooperatives has fallen. A
tendency to ”shop around” has become a more prevalent and
time consuming practice at both the farmer and local
cooperative level.24 The second manner in which commitment
is manifested is through patron-owner financiai_§nppazt of
their cooperatives. Respondents confirmed that equity
management is a significant problem in the cooperative
system today. Both local and regional managers cite a
growing disparity in investment among its membership--
specifically, the trend towards over-investment among long-
term patrons and underinvestment among larger, relatively
new entrants. In other words, the practice of membership

financing their cooperative according to use has not been

 

24To a certain extent, this shopping around may be a
problem brought on by the cooperatives' success in making
input markets more competitive, thus giving farmers more
options.

98
effectively implemented and is a cause of growing concern
and dissension among cooperative participants. Even though
investment per member in the 1984-85 period was up for
farmer cooperatives as a whole, of the 10 types of co-ops
examined by Richardson, per member investment of farm
supply firms ranked ninth, nearly 70 percent paigg the
average (Richardson, 1986).

A related problem concerns equity redemption programs.
Both locals and regionals recognize that unfair redemption
practices are undermining the credibility of cooperatives.
Various reasons were given, including a difference in
membership base between locals and regionals and the need
to satisfy other more urgent goals, like improving the
financial structure of the firm.

The second section of the chapter examines the afifiaaaa
of an erosion of patron-owner commitment on cooperative
firms. In terms of commitment through patronage, the most
crucial way "shopping around” influences firm performance
is by a reduced planning capacity of firms. An ineffectual
planning mechanism raises cost structures through increased
inefficiencies within and among the various production and
distribution stages of the cooperative system. Performance
is affected adversely because both the firm and the system
are unable to routinize and stabilize fundamental economic
activities.

In terms of equity capital, regional firms believe

99
there is an inadequate supply of equity and an excessive
demand on existing cash resources. Local firms also
recognize these constraints, claiming that they affect both
the short- and long-term performance of cooperatives. A
major problem cited by regional managers is that, in
periods when the regional experiences low not margins,
equity control (patronage refunds and equity retirement) is
limited to the "outflow" component of the system (R»L+F),
but there is no effective control (infusion of capital) in
the opposite direction (F*LHR). In their view, failure to
reconcile this discrepancy has severely hindered the
system's ability to adapt to new economic conditions and
threatens the viability of the cooperative way of doing

business.

CHAPTER 5

PROBABLE CAUSES OF PARTICIPANT BEHAVIOR

Two different analytical frameworks are employed in
this chapter. The first is a game-theoretic approach that
examines certain behavioral characteristics of cooperative
members. The purpose of the approach is to reveal certain
economic incentives that help explain the economic behavior
of participants. There are two components to this section.
Each component investigates the commitment issue but as
expressed through two alternative mediums--either through
patronage or through equity investment.

Transaction cost economics is then used to investigate
additional factors that influence the coordination and
performance of farm supply cooperatives. Two important
areas considered under this framework are (1) asset fixity
and uncertainty and (2) external effects. The latter topic
discusses implications of externalities on the evolutionary

development of the cooperative organization.

5.1 The Structure of Incentives
In the second chapter an application of game theory to
farmer cooperatives was introduced. In particular, two

types of group behavior using the theory of nonzero-sum

100

101
games were presented. The first was called a "cooperative
game" because it involves a situation where members of a
group are able to communicate and make binding commitments
with one another. Within this framework there are gains
from joint action by a potential coalition of players but
participants must first agree on the distribution of the
potential payoff. Failure to agree on an allocation
prevents the coalition from developing. The second type of
group behavior is known as a "prisoner's dilemma," which is
a special case of a noncooperative game. This situation
can arise when, because of various impediments, like vested
interests or lack of trust, members of a potential
coalition eschew joint action and choose to act
independently (Staatz, 1987b).

There are two fundamental features that distinguish a
cooperative game from a prisoner's dilemma. In a
cooperative game there are rules that permit the players to
gammaniaaaa with one another and to make binding
gamniamanaa. For a noncooperative game, neither condition
is present. These rules have implications for examining
farmer cooperatives. In reality, because cooperatives
represent a legal and economic coalition of individuals or
firms, formation of the organization necessitates
communication among potential members. On the other hand,
there are few situations where cooperative members are

bound by a formal commitment to patronize or in any other

102
way support the firm.1 This absence of a mechanism to
enforce cooperation among members is key to the prisoner's
dilemma. A limitation of the static prisoner's dilemma
model in the context of farmer cooperatives is its single-
period application. Since the game is played only once,
patron-owners are not concerned with their reputations as
reliable members, for even if they defect, they will not
face reprisal from other members in the cooperative. An
alternative is to consider a supergame in which a single
period game is infinitely iterated and where the payoffs
are the net present values of the stream of payoffs from
the individual games (Staatz, 1987b). In a supergame,
binding commitments have less importance since, if one
member chooses to cheat, payoffs may be affected adversely
and the coalition could be destroyed.2 In other words, in
situations where the receipt of benefits is conditional on
the continued existence of the coalition, an implicit
commitment develops since it is in the players' self-

interest.

 

1An exception is when members do make explicit
agreements with their cooperative. An example would be a
production forward contract where the member agrees to
supply a specified quantity of a commodity at some future
date. A second example is an input contract where the
member forward buys a specific input for delivery at a
future date. These are both formal contracts with
enforcement clauses.

2Staatz discusses in some detail situations where a
prisoner's dilemma supergame reduces to a prisoner's
dilemma itself.

103

Staatz (1984) discusses one aspect of the supergame
that is particularly germane to this study--whether or not
mutual gangiaignai cooperation based on a ”tit-for-tat”
strategy is ever an equilibrium result.3 A player will
"conditionally cooperate" only so long as the other
players, or some critical mass of them, continue to
cooperate (1987b, p. 144). Staatz has shown that if
certain conditions are met, such an equilibrium outcome
will obtain. These conditions are represented

mathematically by the relationship:

81 2 x_:_x (1)
y — w

where: x is the payoff to each player if they both
cooperate, y is the payoff to a defecting player if his or
her partner does nag defect, and w is the payoff to each
player if both defect. The essential characteristic of a
prisoner's dilemma is that y > x > w, that is, each player
has an individual incentive to defect (since y > x) even
though if each defects they are both worse off than if both
had cooperated (since x > w).

Additionally, a1 is a discount parameter (one minus the

discount rate) of player i. From equation (1), it is

 

3A tit-for-tat strategy is one where the player first
chooses to cooperate, then s/he does whatever the partner
did on the previous move.

104
apparent that the equilibrium outcome depends upon the
value of the discount parameter (a) and the payoffs for
cooperation and defection in the constituent games. In
particular, if the discount rate is tag_high,4 then mutual
cooperation will not be a rational strategy in the
supergame. Secondly, the greater the inaanaiya for
defection in the constituent game (that is, the greater is
the payoff y - x) the less likely mutual cooperation will
emerge as an equilibrium outcome. Conversely, the greater
the panishmant that is inflicted on a defecting player by
the partner's defecting in subsequent games (that is, the
greater is the payoff y - w), the more likely mutual
cooperation will emerge as a final result (1984, p. 413).
As will be seen shortly, some of these very conditions
emerge as issues among case study cooperatives.

Within the context of this research and game theory,
one point should emphasized. It may not be appropriate to
view the entire vertical coordination issue as a prisoner's
dilemma supergame. The type of game that should be
employed depends on how one views players and which game
brings out best the fundamental issues surrounding the
arguement. For some players and in some circumstances it
is a prisoner's dilemma. For others it is a cooperative
game where the question is how best to apportion the new

pie. The point is, one obtains different incites into

 

4The discount rate equals 1 - ai

105
problems by viewing them from alternative perspectives.
Consequently, section 5.11 employs a supergame to analyze
an age-of-patron issue and 5.13 applies a cooperative game

to the size-of-patrons.

5.11 Commitment through Patronage
A. Farmer Commitment: A Farmer-Local Perspective

This section synthesizes the opinions of farmers and
general managers on issues influencing farmer commitment.
The intent is to identify incentives that help explain the
economic relationships of farmers with their cooperative.
Results indicate that incentives affecting farmer
commitment can be classified under two general headings:
the aga of patron and the aiza of the firm. Table 5.1
summarizes some of the key features that differentiate the
two groups within the age of patron category. Some
elaboration might be useful.

Older members are perceived as having a much larger
stake in the financial health of their cooperative. In the
first place, these members were responsible for the
original formation of their cooperative. Additionally, at
the cooperative's inception, these members may have had
opportunities to imbue the association with their own
ideological beliefs and economic priorities. Recognition
that one has influenced the philosophical and structural

underpinnings of an organization clearly enhances that

106

Table 5.1 Factors that Influence Commitment as Reflected by
Age of Patron.

 

 

Nature of Age of Patron
Incentivgs Old Ionng
Helped form co-op yes no
Investment in co-op large small
Exercise controlb significant negligible
Financial position strong weak

 

aThis has two connotations. First, by participating in the
formation of the cooperative, members have a greater
likelihood of ensuring that the firm's goals are consonant
with their own. Second, in the early days of the co-ops,
immediate benefits were in the form of improved price and
quality. Not only were these benefits tangible, they were
also significant.

bHistorically, older members have dominated the board of
directors. This practice is changing as some co-ops are

restricting the number of years a member can serve on the
board.

member's identification and subsequent loyalty to the firm.
Another factor influencing loyalty is the perception of the
benefits associated with the cooperative. Supply co-ops
were organized initially for three major reasons: to
provide a raiiabia source of gaaiiay inputs at a fair
price. Not only were these benefits readily apparent to
farmers, they were important because (in many cases) the
cooperative's presence altered undesirable behavior of
independent suppliers. Today these price and quality
advantages of cooperatives have been largely eliminated.

In fact, investor-owned firms quite often have input prices

lower than cooperatives. Remaining benefits that may be

107
specific to cooperatives are generally less tangible or are
taken for granted by members (e.g., services that may be
cross-subsidized by high-margin products).

Typically, because younger farmers are relatively
recent entrants, they have little capital invested in their
cooperative. There are at least two reasons for this.
First, the very fact that they are new entrants precludes
equity growth through patronage. Secondly, a firm's
capacity to generate net earnings also affects equity
levels of individual members (see chapter 4). Recent
agricultural difficulties have mitigated the performance of
many midwestern cooperatives. Entrants who have joined co-
ops during this period accrue equity at a lower rate than
those who arrived during a more profitable period.
Respondents noted that farmers with large investments in
their cooperative tend to support their organization to a
greater extent than do farmers with little invested.

A person's capacity to exercise control is a third
important determinant of loyalty. Farmers affirmed that
cooperative membership is preferable to an IOF affiliation
because they are given a voice in the organization through
their vote and through the board of directors. Young
farmers and most managers noted, however, that older
members often have more influence in these positions. As a
consequence, concerns and opinions of younger members are

at times ignored. Nearly all managers observed that this

108
discrepancy in control is driving a wedge between young
members and their c00perative. Some cooperatives have
responded by instituting a mandatory nine-year limit on
directorships.

Member loyalty is also affected by the overall wealth
of members. Older members who are near retirement have
usually secured their financial needs. As a consequence,
these members are less sensitive to unfavorable price
changes and are more apt to allow nonpecuniary payoffs like
ideological beliefs heavily influence their decision to
remain loyal.5 Conversely, younger farmers who may also be
highly leveraged can ill afford to subsidize a poorly run
cooperative. Their less-flexible economic position may
countermand any sense of loyalty that may persist.

A fifth variable that appears to have recently entered
the "loyalty equation" is a discrepancy in the pervading
attitudes between older and younger farmers. Farmers and
general managers claimed that, unlike their parents who
view farming as ”a way of life,"6 younger producers measure

the farm enterprise more in terms of its capacity to

 

5For example, they may derive utility by supporting
their cooperative, knowing that in the process they improve
the welfare of the larger community. This notion was
mentioned by a few older farmers who were interviewed.

6This class of farmers derive substantial utility from
the farm itself (owning the land and stewardship), the
"wholesome lifestyle,” and the deep-felt satisfaction that
attends the ritual of planting, cultivation and harvesting
of crops.

109
generate income. Stated differently, farming is perceived
of as a means to an end: if this "end“ is not met
adequately, alternative means of acquiring income should be
considered. This attitude takes into account both the farm
business and the cooperative in terms of their ability to
contribute to the operation's net earnings. Consequently,
loyalty to farming and the cooperative is linked directly
to a member's end-of-year income statement.

In a prisoner's dilemma, although the payoffs to each
player are greater if they both cooperate, the incentives
facing the players are such that they are encouraged to
defect, even though each knows his other opponent is acting
similarly. In the context of this research, cooperative
managers recognize that, if all members were perfectly
loyal, the cooperative and all its members would be better
off.7 As we shall see, however, their are numerous
conditions that create incentives for patron-owners to act
in a manner that prevents the actualization of this ideal

outcome.

W
1. WW- S'caatz (1987b) hypothesized

that a farmer's loyalty decreases as he or she becomes more

 

7This belief was affirmed most strongly by regional
respondents, somewhat less by general managers of locals,
and much less by farmers. In other words, system awareness
seemed to diminish as one moved closer to the end user.

110
highly leveraged. In the interview process, some young
farmers indicated that cash-flow constraints are a
recurring problem. Since most of their farm inputs are
parghaaag inputs and these inputs represent a sizable
investment, young farmers are less able to afford the same
degree of loyalty as are their older counterparts.
Furthermore, because cooperatives are not consistent low
cost suppliers fgr_aii inputs and because independent
suppliers (and other cooperatives) frequently engage in
intense price competition, well-informed farmers can
readily benefit from substantial savings on selected
inputs. Thus, in situations where young members have high
discount rates, the incentive to practice disloyal behavior
may overwhelm their belief in cooperative loyalty. This is
consistent with a large "a” value in equation (1).
2. Eaargi§a_gan§rai. Earlier it was noted that, in
contrast to their elder counterparts, younger members are
often not afforded the same degree of control (specifically
through the board of directors). This means they may have
little influence in key policy areas that directly affect
their welfare.8 As a consequence, not only is their

identification with the co-op mitigated, but their

 

8For example, investment options, patronage refund
policies (younger members who are highly leveraged are more
likely to argue for greater cash refunds than might older
members, who have interests in redeeming equities) and
equity redemption programs. It was also observed that
younger farmers tend to be less forgiving of poor
management performance.

111
financial position could be affected adversely by decisions
of older members. To the extent this is true, certain
actions by older members not only diminish the total size
of pie available to all players but they have distributed
smaller portions to the younger group of players. In game-
theoretic terms, even though the payoffs to the group as a
whole are higher if they both cooperate, the potential
coalition breaks down because one group (older members) has
effectively limited the size of the payoff to the other
group (younger members). Consequently, if younger members
perceive greater potential benefits outside the coalition,
this subcoalition has incentive to defect (i.e., practice
disloyal behavior by "shopping around"). Indeed, by
limiting the size of the payoff to this group (the
numerator in equation 1), older members have increased the
likelihood of defection by the younger members.
3. 1nyaa;man§_in_ag;gp. As a rule older members have
substantially more invested in the cooperative than do
younger members. This means that the safety of their
investments is related directly to the performance and
subsequent financial health of the cooperative. Equation 1
shows that member loyalty to the cooperative increases as
the penalties for disloyalty are increased (1987b, p.
131). Among the cooperative managers and farmers
interviewed, the consensus was that older members exhibit

the strongest sense of loyalty. They also have the most to

112
lose (their investments) in the event the cooperative
fails. Managers noted further that this same group of
members are currently placing considerable pressure on
cooperative decisionmakers to redeem equities summarily.
In those situations where patrons are large equity holders
but are also disloyal, one might hypothesize that they are
members of a highly leveraged cooperative and have dim
expectations regarding the co-ops longevity. For members
that view their investment as a sunk cost, there may be
little incentive to remain loyal to their cooperative.
Indeed, if investment losses can be mitigated by shopping
around, they are behaving rationally do so.
4. Haipgd_fgrn_tha_gg:gp. In some ways this is analogous
to the control issue mentioned above. One might anticipate
that loyalty would increase as one's opportunity to
influence the philosophy, goals, and policies of the
cooperative increased.9 Older members may negotiate to
increase the revolvement rate of redemption programs and
perhaps to improve the financial position of the
cooperative. Younger members might argue for higher cash
patronage refunds and investment in certain plant
facilities (e.g., grain drying equipment) to improve the
quality of their commodities. In cooperatives where

members g9 have an influence on cooperative policy, they

 

9Having helped form the co-op may also increase a
farmer's ideological commitment to the co-op and hence
his/her perceptions of the benefits derived from it.

113
might be more prone to utilize voice over exit in conflict
situations or if dissatisfied with the performance of the
firm (Hirschman).

A second subcoalition of disaffected members are iarga
farmara. This issue is prominent and a current source of
concern among local managers. Many local cooperatives are
now comprised of both large and small farms, with the
continued disappearance of the middle category. A number
of issues surface.
11_A_different_set_of_needsl First, large farms are
placing increasing pressure on management and the board of
directors to institute differential pricing of inputs.
Because of their size, not only does this class of firms
constitute the majority of business volume for many local
cooperatives, they also represent the least expensive
source of revenue (i.e., unit purchasing and handling costs
are appreciably lower for large volume). Although some of
the local co-ops acknowledged giving volume discounts, they
admit this practice does not fully address the "size" issue
confronting them. First of all, many cooperatives resist
giving substantial discounts to large farmers since this
conflicts with "equal" treatment. Secondly, managers of
co-ops that do differentiate prices claimed they were
constrained by board members from giving the full amount
they felt was justified. Board member resistance was

attributed to the fact that differential pricing had not

114
been explicitly endorsed by the membership and so exceeded
their limits of power.

A second point is that members with large operations
are requesting that input aaryigaa be based on actual cost.
Many large farms are moving towards custom application
services, particularly for fertilizers and chemicals. This
is because (a) inputs are becoming increasingly
specialized, requiring ever more sophisticated handling and
application procedures: (b) the equipment used to apply the
inputs has become highly use-specific and very costly: (c)
the rapid rate of technological development makes
unexpected obsolescence a very real concern. This trend
toward custom application is expected to continue as
pressure mounts to reduce groundwater contamination. Even
though service at cost is considered an essential
characteristic of cooperatives (Roy, p. 259), pricing is
implemented through a pooling mechanism in which each
member pays the average cost of service. Consequently,
depending on how broadly the pools are defined, large
members may be subsidizing the higher cost smaller patron.

Third, there is an "output" component that also affects
large members' income. Local cooperatives are increasingly
confronted with the realization that they serve no useful
purpose for some large farms. In some areas of the
midwest, the primary function of the co-op is to transport

grain to central terminals, where it is then sold through

115
the regional. Many large producers are large enough and
possess the resources to carry out this activity
independently of the local cooperative. Assuming they can
transport cheaper than the co-op, this practice allows them
to reduce costs (hence, realize a larger unit margin) by
avoiding a redundant activity.
WW Even though the small
producer contributes much less patronage to the
cooperative, has fewer market alternatives and faces less
on farm risk, cooperative control still resides with this
member. Managers concurred that the " 80/20" rule--where
80 percent of the volume is accounted for by 20 percent of
the patrons--is a very real phenomenon. Most cooperatives,
which rely on volume to generate earnings, could not
survive in the absence of the large producer. Benefits
that accrue to the cooperative through the patronage of
this class of patrons are shared by all members.

Large producers, who are the lifeblood of many
cooperatives, have many market alternatives. Manufacturers
are willing to service them directly and frequently strive
to establish purchasing agreements with them. Conversely,
the small member has fewer options and yet adamantly
resists relinquishing the one-member, one-vote principle.

Finally, those large producers who generate all (or
nearly all) their income from the farm face more risk than

do the small patrons, who often have supplementary off-farm

116
income.10 As a result, large producers' income could tend
to be more volatile over time, and in this sense,
mechanisms are needed to stabilize their earnings. Some
cooperatives recognize this need and are beginning to
develop programs that could ameliorate this problem.11
To summarize, cooperative members who operate large
farms are foregoing potential income or are otherwise
constrained by the following developments:
iii_a_airaamyan§ign_gpaign. First, absent appropriate
volume discounts from the local, this patron could obtain
input needs at a lower price by purchasing directly from
a regional or an independent manufacturer. Second, on
the output side, these producers often absorb needless
costs through superfluous cooperative functions.
circumventing the local and exchanging directly with
central terminals would eliminate this cost.
izi_§aryiga_ag_gg§t. Managers confirmed that unit costs
associated with servicing large operations are

substantially less than for smaller ones.

 

10It is doubtful that all large farmers are more
dependent on farm income than small farmers. A reasonable
conjecture is that a U-shaped relationship exists, with the
percent of nonfarm income being highest for very large and
very small farms, and those in the middle being most
dependent on farm income.

11Because of the size and scope of these large
producers, regional firms will have to assist the locals in
their efforts at instituting effective programs. Indeed,
one regional is currently in the process of initiating
programs of this nature.

11?
WW- some large producers.
those whose income is derived primarily from farm
sources, face greater risk than do smaller members with
multiple income sources.
W. The principle of
democratic rule ensures that the needs of small farmers
supersede those of larger farmers.12 This is coupled
with the fact that, in many ways, large producers are
less dependent on the cooperative for agricultural needs

than their smaller counterparts.

In terms of a game-theoretic analysis, a number of
points are now clear. First of all, growth in the size of
one subcoalition has altered the opportunity set it faces.
In particular, the opportunities available to the large
member have provided greater incentive for defection from
the coalition. In addition, defection by the former group
could severely impair many local cooperatives. Second, in
spite of this condition, small farmers currently resist
acceding to the demands of large producers. Most managers
attribute this to small farmers' lack of understanding of

the consequences of defection by large producers. Third,

 

12This may be a simplification. It assumes that
control comes largely through the board and there only
through one-member, one-vote. In reality, there are
multiple paths to influence both the management and the
board indirectly, and in most of these paths, large members
have certain advantages. Staatz discusses this in
considerable detail (1984).

118
if small farmers would accede to the demands of the large
ones, they would be better off, at least more so than in
the absence of the large producer. Fourth, given the
opportunities of large members and in the absence of
binding commitments, there will always be situations where
they can obtain a higher payoff outside the coalition.
Hence, in the absence of a binding commitment, the
incentive to defect will always threaten the stability of
the cooperative.

Pressure is mounting to alter the distribution of
benefits within the cooperative. It is becoming
increasingly apparent that defection by this class of
patrons will clearly result in a Pareto-inferior outcome
for all members, but more so for the subcoalition of small
patrons. It is also apparent (at least among those
interviewed) that large members enjoy strategic
opportunities for obtaining services outside the
cooperative that are not available to others. As a
consequence, these large members are exerting greater
pressure to receive ”equitable" treatment. Managers
strongly believe that intransigence on the part of small
members will result in nothing less than financial ruin for
many cooperatives. Most respondents affirmed that the
cooperative syatan has the gapagiay to satisfy the needs of

large members, but that time is fast running out.

119

B. Local Commitment: A Local-Regional Perspective

Some of the issues that surfaced at the farmer-local
level also appear as loyalty issues at the local-regional
level. Perhaps the most significant is a size
heterogeneity among local co-ops. Many of the same forces
that reshaped the distribution of farm size have also
affected cooperatives. In particular, as many smaller
locals are liquidated or acquired by larger, more viable
locals, the size distribution of cooperatives is becoming
bimodal. The advent and relative proliferation of super-
locals is indicative of this phenomenon. Accordingly,
local cooperatives are now delineated in two fundamental
ways. First, through growth, super-locals have market
opportunities that are unavailable to their smaller
counterparts. For instance, many large IOFs (and other
regional cooperatives) that are basic in manufacturing
cater to them aggressively. Secondly, through this
evolutionary growth, the needs of these cooperatives are
now much different from those of smaller firms. Many
traditional services and functions carried out by regionals
are superfluous to these firms. Regionals are in the
process of designing alternative programs to prevent the
disappearance of large producers from the system, but some
fundamental issues like one-member, one-vote are
unresolved. Hence, not only has the payoff matrix been

expanded for this subcoalition of locals (in terms of

120

potential earnings and market alternatives), but the "grand
coalition" has largely resisted meeting their demands
(i.e., differential treatment conflicts directly with the
principle of democratic rule).13

Another variable influencing the "loyalty equation"
regards the performance of the regional. This has two
major components:
(1) An Wise A contingent of
locals expressed past dissatisfaction with regionals'
reliability in delivering supplies.14 Locals depend
heavily on having inputs available to their farmers upon
request. After repeated supply disruptions, and in spite
of their vociferous complaints, these locals felt compelled
to turn elsewhere for some of their basic supplies.15
(2) Unggmpagitiya_prigaa. Largely because of mismanagement
(inefficient operations and unwise investment decisions),
cooperative prices became less competitive. Local managers
asserted that many previously loyal co-ops were "driven

from the fold” due to this unacceptable behavior.

 

13Another aspect is that the super-local constitutes
the majority of volume for the regional. In game theory,
this has importance in terms of the member's ability to
extract concessions from the regional.

14These same locals pointed out that regional
performance has improved in recent years. However, they
believe there remains substantial room for improvement.

15Failure to satisfy demand hurts the retail firm in
the short run through forgone sales and in the long run
through loss of market share as dissatisfied customers turn
to alternative suppliers.

121

A third major factor influencing the loyalty of local
cooperatives is a complaint of unaguai_traatman§. This was
experienced by two different categories of members. One
was new versus long-term members. Some managers noted that
regionals concentrate their best efforts on acquiring new
members and in the process take longer-term, loyal members
for granted. The second category includes large and small
members. A few managers of small co-ops complained that,
when supplies were tight, regionals reshuffled their
distribution. Some co-ops were left without supplies (in
the words of one manager, "They threw us a curve ball.”).

A change in the costs of disloyal behavior is a fourth
and final consideration. Even just a few decades ago,
transportation, information, and communication constraints
nearly ensured a member's loyalty. Today, technology has
greatly reduced the affects of these constraints on
members. The costs of shopping around are negligible and
the immediate savings are significant enough to rationally

justify the behavior.

5.12 Commitment through Equity Investment: A Synthesis
This section synthesizes key capitalization issues at
the farmer and local levels of the cooperative system. The
justification for this "aggregation" lies in the similarity
of issues between these two groups.
In an earlier chapter we discussed three traditional

methods of capital generation utilized by cooperatives: (1)

122
direct investments, (2) deferred patronage refunds plus
unallocated capital reserves, and (3) per unit capital
retains. Only the second method is actually relevant to
farm supply cooperatives.16 Furthermore, because there are
no opportunities for capital growth and there are
limitations on dividends, voting rights, and the transfer
of shares, capital stock of a cooperative has little appeal
to outside investors. In other words, because benefits of
stockholders are derived through patronage (as opposed to
an IOF that distributes them through dividends and the
value of its stock), the potential pool of investors is
limited.

Finally, certain financial decisions taken by regional
and local cooperatives have had an impact on both real and
perceived payoffs to members. The affects of these
decisions on the behavior of farmers and local cooperatives

are discussed below.

Explicatien
W In an effort to improve their

financial position, regional firms either terminated cash
patronage refunds or sharply reduced them. Prior to these

actions refunds ranged from 30 to 50 percent of qualified

 

16Per-unit capital retains are primarily used by
marketing cooperatives. Few supply co-ops utilize them as a
source equity. Direct investments are historically of
little value since amounts are negligible.

123
allocations and often constituted a large proportion of the
local's total net earnings.17 Many poorly performing
locals depended heavily on regional refunds and interest
earnings from their members' equity to maintain their
operations. This sudden termination of a reliable and
significant flow of income had a profound impact on the
financial welfare of many local cooperatives.
2i_3aygiyamgn§_gfi_agaityi Most cooperatives use the
revolving fund method to redeem investments (Cobia et al.:
Barton). A simple interpretation is that the method
retires equity investments to owners in the order they were
provided. Remittance, however, is conditional upon
approval by the board of directors, which evaluates the
financial needs of the cooperative, against the total value
of the investment. In 1976, the length of the revolving
period ranged from three to fifteen years (ACS, Report
No.1, Section 9, 1981). As co-ops began to experience
financial difficulties they extended this revolving period.
Today, many midwestern cooperatives have equity turnover

rates (annual equity redemption/total allocated equity) of

 

17A qualified allocation is a patronage refund that
the cooperative can exclude from its taxable income and
that the patron agrees to have taxed, as if received in
cash. At least 20% of a qualified patronage refund must be
paid in cash. In farm supply cooperatives, patronage
refunds are called "overpayments," after operating costs
and expenses have been deducted. Thus, unless there is a
net margin, there is no patronage refund (USDA, 1976, p.
479). At the time of these interviews the case-study
regionals that terminated refunds were not earning net
margins.

124
4 percent. This is equivalent to a 25-year revolving fund.
Given the time-value of money and the high discount rates
of some members, this practice is disconcerting and may
discourage potential members from joining the cooperative.
Wm Although the
regionals have bettered their financial position from the
early 1980s, there is still substantial room for
improvement. Poor performance and unsound investment
policies have contributed to a depreciation in regional and
local cooperative assets.18 For instance, one regional
wrote down its stock by 35 percent. Members of the other
two regionals believe their firms should respond similarly
even though (on paper) this represents a significant loss
of wealth.
W This practice is
considered an important problem at the local level. Nearly
all managers affirmed that some estates are so large that
they have the potential capacity to jeopardize the
financial integrity of their firms. In these circumstances
the co-op either remits what it can or totally reneges on

its financial obligation. Ironically, the growth of these

 

18Regional firms are still operating at a loss in some
business lines, most notably in their petroleum and
fertilizer operations. These firms depend on other
businesses (for example, food processing) and cash
patronage refunds from interregionals to offset these
losses. Respondents at both the local and regional level
consistently blamed management for the poor performance of
cooperatives.

125
estates is directly attributable to the exceptional loyalty
of these patron-owners. Failure to redeem these
investments effectively penalizes members for their
loyalty. Furthermore, to the extent that small estates
stem from disloyal behavior and are given precedence over
extremely large ones, one could argue that these members
are actually rewarded for their disloyalty. In this sense,
cooperative redemption practices appear to encourage

defection by its members.

5.13 Commitment: A Cooperative Game Analysis

The theory of cooperative games19 addresses the issue
of group choice "when the preferences of members are at
least partially conflicting” (Staatz, 1987b, p.118). The
game focuses on two major questions: (1) how do cooperative
policies affect the payoffs to various subcoalitions within
the cooperative: and (2) how does the payoff affect the
willingness of these subcoalitions to remain active in the
co-op, as opposed to obtaining their needs elsewhere?

A fundamental aspect of the cooperative game is the
characteristic function. Consider the two subcoalitions,
super-locals and locals (henceforth denoted as S-L and L,

respectively).20 For these players both to remain active

 

19This section draws heavily from Staatz, 1987b.

20Actually two different sets of subcoalitions have
been identified as affecting commitment--large vs. small
and young vs. old. It seems clear, however, that the former

126
in the cooperative, it is essential that they gain at least
as much in total by working together as they can by working
separately. This means that each subcoalition's individual
share of the joint ”pie" must exceed the payoffs each could
obtain by acting independently.

Under current cooperative policies, the following
observations are made with regard to the payoffs
confronting the two subcoalitions (S-L and L):

1. Market_a1tarnatiya§--Evaluating defection by either
subcoalition first requires differentiating between
aampgrary and parmanant defection. The first connotes a
free-rider behavior in which both subcoalitions face
incentives to "shop around"--i.e., selectively pick low-
cost products and services while still extracting the
remaining benefits of the cooperative. Permanent
defection is conditional upon feasible market
alternatives. Consequently, this is considered as an
option only for S-L. Furthermore, it is possible that
alternative payoffs facing large firms could exceed
current payoffs within the cooperative.

2. ggaparatiya_parfigrmanga--poor performance by regionals
and locals raises the costs to loyal members. In general

it is manifested in four major ways: a) unreliability of

 

is currently the major cause of concern to local and
regional cooperatives. Hence, the subsequent analysis
concentrates on this subcoalition of members and is
applicable to both local and regional firms.

127
products and services: b) uncompetitive prices: c)
devaluation of assets: and d) failure to respond
adequately to a changing membership.21,22 Hence, either
directly or indirectly, these four performance factors
have effectively reduced the "cooperative pie.” They may
also affect the core since, with a smaller pie, there may
be fewer alternative ways to slice the pie and keep the

coalition intact.

 

Since errant members do not face retribution from their
co-op,23 the major costs of temporary defection are the
costs involving information, communication and
transportation. In recent years, however, these costs
have been substantially reduced and no longer act as a

crucial barrier to uncommitted behavior.

 

21Poor performance is certainly not indicative of all
cooperative firms. Many perform at high standards and enjoy
a thriving business. The problems cited above surfaced as
contributing factors to the uncommitted behavior of
members. In general, problems (a), (b), and (c) are
attributed to one or more of the regional firms interviewed
and (d) is a problem for both regional and locals, but
primarily for locals.

22The emergence of the large member (farmer or local)
has created a fundamental difference in needs between the
two classes of patrons. When the cooperative fails to
satisfy these needs, the loyal member suffers through less
competitive performance.

23Recall that many farmers and managers fully endorse
a competitive ideology.

128
From these four observations, the following conclusions
can be drawn:

1. Differential pricing of products (inputs) and services
to members is, in the view of the respondents, essential
and probably inevitable if cooperative stability is to be
preserved. Both regional and local firms recognize that
not only do large members substantially influence their
cost functions, but they also enjoy strategic
opportunities outside the cooperative. Consequently,
large members have partially succeeded in extracting
concessions from their regional or local firm.24
2. Managers of regional and local co-ops believe it will
be necessary to revoke the one-member/one-vote principle
and replace it with a voting procedure based on
proportionality. In other words, they believe it will be
necessary to either introduce a mixture of one-member,
one-vote and patronage-based voting and/or to translate
equity investment into voting power but perhaps with less
weight than patronage. Failure to alter the political
distribution of power could, in the event the
subcoalition of small members still controls the

cooperative, result in the permanent defection of large

 

24"Partially” needs to be emphasized because currently
differential treatment is implemented on an ad hoc basis.
Members within the large coalition negotiate independently
for concessions. This is because the "grand coalition" is
still controlled by the small member who resists this
action. Hence, differential pricing cannot be institutionalized.

129
members.
3. As one would expect, both members and management
concurred that if the federated system would work as a
system, substantial benefits would accrue for all members
(an assurance that the core of the game is not empty).
More importantly, this implies that the primary task
facing cooperatives is one of ascertaining an aggapaabia
aiiggaaian of benefits and costs. Preferably this would
be implemented under a revised distribution of power
based on some form of proportionality. Failure to choose
an allocation that lies within the core and is acceptable
to both subcoalitions could result in members leaving the
cooperative.
4. To date the subcoalition comprised of smaller members
still controls the cooperative and has effectively
safeguarded their interests. A change in the voting
structure would likely shift the distribution of power
towards the larger member. Still, bargaining over the
”distribution of the pie” could be an intense and
exhaustive undertaking: however, it need not be.
Regionals (and most local managers) are convinced that
the potential benefits from a committed membership,
acting in a unified manner, would be substantial. In
game~theoretic terms, the opportunity to expand the core
of the game is present (i.e., convert an apparent zero-

sum game into a nonzero-sum game). Within this new

130
environment, even small members would have incentives to
support a specified allocation even though it may favor
the larger producer. This would be true if the gains to
small members from compliance exceed their potential

gains through noncompliance.

5.2 Asset Fixity and.Uncertainty

Recall the asset fixity and uncertainty principles
discussed in chapter 2. The asset fixity principle states
that as assets become increasingly specialized, the
desirability of the spot market as a mechanism for exchange
diminishes. similarly, the uncertainty principle asserts
that ”autonomous market contracting" becomes a less
preferred exchange mechanism as the uncertainty surrounding
the transaction increases (Williamson, 1981: 1979b). The
purpose of the forthcoming analysis is to illustrate how
conditions of asset fixity and uncertainty influence the
exchange process for buyers and sellers in the farm input
supply industry. The analysis is comprised of three
sections. Part one relates the "fungability"
characteristic of inputs to firms' management practices.
The second part examines the risks and costs to cooperative
system players and their behavioral responses when they
deal with asset-specific inputs. The third component
discusses the implications of specificity to economic

coordination of the cooperative input system.

131
5.21 Input Fungability and Management Practices
A. A Classification of Inputs

As a first step in analyzing the role and impact of
specificity on economic coordination, it is necessary to
establish the extent to which inputs carried by
cooperatives and used by farmers exhibit this
characteristic. Table 5.2 identifies major inputs of farm
supply cooperatives and ranks them according to their
degree of specificity. These rankings represent a
consensus opinion of experts within the farm supply
divisions of those regionals interviewed.

A simple definition of input fungability is the degree
to which an input is interchangeable across uses. However
there are at least three dimensions to fungability.

Perhaps the most common is in terms of the input's purpose
or fianaaian. Farm inputs are designed to fulfill a
particular role within the agricultural production process.
Seeds, for example, represent the most fundamental
ingredient in the production process because they actually
azaaaa the commodity: fertilizers enhance the growth and
production potential of the plant by providing naggignmana:
and chemicals prgtagt the plant from pests and in this way
increase the likelihood of maturation. The extent to which
these different inputs (with their idiosyncratic functions)
can be applied to diffarant_u§a§ characterizes their degree

of specificity. Tina, in the sense of an input's use-

132

Table 5.2 Major Farm Inputs of Farm Supply Cooperatives
and their Degree of Fungability.*

 

Type of Fungabilitv
Input GP MED .AS

 

1. Petroleum -----------------------------------------------
a) Oil x
b) Gas (liquid) x
c) LP x

2. Ag Chemicals --------------------------------------------
a) Insecticide
b) Herbicide
c) Fungicide

3. Fertilizer ----------------------------------------------
a) Nitrogen x
b) Potassium x
c) Phosphorous x

4. Feed ----------------------------------------------------
a) Complete feeds x
b) Supplements x
c) Premixes x

5. Seeds ---------------------------------------------------
a) Hybrids x
b) Other x

XXX

 

*This taxonomy of inputs represents general categories
only: it is not intended to be an exhaustive list. GP =
general purpose: Med = medium: As - asset-specific.

period, is a second crucial element affecting an input's
fungability. As inputs become more specialized, their use
is designed for a greater degree of precision. The input's
efficaciousness is increasingly conditional on the
punctilious timing of application. In this sense, the
length of an input's use period is inversely related to its
degree of specificity. A final dimension to input
fungability relates to physical iggatian and the extent to

133
which an input is interchangeable across geographic
regions. For instance, seeds are limited in terms of
geographic substitutability because of differences in plant
photosensitivity. Referring to table 5.2, petroleum is
classified as general purpose because it satisfies all
three dimensional requirements. It can be readily used in
any part of the country, for a large array of equipment and
at nearly any time of the year. Conversely, many
agricultural chemicals are designed for a specific crop, to
arrest a specific pest, and to be applied at a precise time
when the pest (i.e., bacterium, virus or insect) is most
vulnerable. Pre-emergence corn herbicide was developed for
corn and should be applied after seeding but prior to plant
emergence. This affords an effective use period of roughly
one week. Fertilizer, on the other hand, is
interchangeable among different crops although it is
moderately restricted by optimal application periods.
These periods constitute a window of a few weeks: hence,
this input falls within the middle category.

The prohibitive costs and risks associated with highly
specialized inputs have prevented their manufacture by
case-study firms. Respondents pointed out that
historically cooperatives have been averse to investing in
inputs involving high research and development (R&D) and
marketing costs--which are characteristic of specialized

inputs. The respondents attribute this behavior to

134
farmers' understanding of the government's role in
agriculture and the ownership of cooperatives by farmers.
Farmers believe strongly (perhaps due to years of positive
reinforcement) that government is responsible for
undertaking necessary but risky R80 to help mitigate the
risk inherent in agriculture. As a consequence,
cooperatives limit their marketing activities to
wholesaling and retailing of asset-specific inputs. Three
important components of wholesale and retail operations are
the planning process, alternative exchange arrangements and
handling practices. The following section examines how an
input's specificity affects various aspects of these three

marketing activities.

B. Management Effects
MAW
iizna_pianaing_paaaaa§. The planning component is very
important for inputs exhibiting a high degree of asset-
specificity. Because these inputs are designed for a
specific use, their duration of use may be extremely small.
This affects the reliability of forecasting demand for both
manufacturers and distributors. Manufacturers must
ascertain demand within the various segmented markets and,
depending on the type of input and its degree of asset-
specificity, account for the influence of unforeseen events

(like weather) that significantly alter this demand. They

135
must also contend with substitute products from competitors
that may be unknown to them at the decision-making period
(i.e., have competitors developed an effective
substitute?).

Distributors must deal primarily with iggiatigai
constraints. Regionals noted that the planning process
requires considerable time and expense because of the
highly differentiated markets associated with specialized
inputs.25 This differentiation is related directly to the
three dimensions of fungability mentioned earlier.
Decision makers must ascertain with more precision where
sales are apt to occur and what quantity will be demanded
in that market. These decisions affect strategic factors
like locating central distribution points and deciding on
the proportion of inventories to hold at central terminals
versus localized facilities. Clearly logistical tradeoffs
are involved. To the extent one anticipates demand
correctly, locating inventories close to the point of sale
is desirable. However, when demand estimates are wrong, it
is easier and quicker to readjust if inventories are more

centrally located. The problem is that the likelihood of

 

25Regional respondents pointed out that manufacturers
freely exchange market forecast information with them. The
motive for this behavior is that the regionals ara the
major distribution network of highly specialized farm
inputs. By minimizing logistical and demand forecast errors
for individual markets, the regional actually helps the
manufacturer achieve greater sales. (Since the manufacturer
still retains ownership of asset-specific inputs, over-
estimates of demand will not increase its total sales.)

an

an

136
incorrectly estimating demand increases with market
segmentation. Hence, not only is the probability of error
greater for asset-specific inputs, but the consequences of
error can be more significant than for general purpose
inputs.26
za_Exghaaga_azzangaman§§. Purchase commitments are useful
for all classes of inputs but are more desirable for
specialized inputs because of the greater inherent risks.
Manufacturers of specialized inputs and regional
cooperatives habitually establish written exchange
agreements prior to each production year. In addition to
specifying standard terms of trade (like price, quantity,
quality, and date of delivery), many of these contracts
include a stewardship arrangement. These arrangements
specify responsibilities of both parties (buyer and seller)
and often include safety, quality control, and technical
training. Largely through use of market power, regionals
have also succeeded in negotiating special arrangements to
mitigate some of the risks of purchasing these inputs. Two
inter-related arrangements are (1) a buyback or return
arrangement and (2) a credit rebill program. In a buyback

arrangement the buyer has an option to return some portion

 

26This significance is reflected in the specialized
function and limited application period of these inputs.
Failure to satisfy these constraints could eliminate
further opportunities to sell the product until the
following season. Unit costs of specialized inputs are
greater than general purpose inputs and therefore have a
larger opportunity cost.

137
of the total quantity of input purchased (usually 10-20
percent) to the manufacturer. This percentage is
renegotiated annually and is based on current market
conditions. Regionals may in turn pass this option on to
their local affiliates.27 The credit rebill program is a
subcomponent of the buyback agreement and was initiated to
eliminate needless movement of inventories. In the event
the regional has over-purchased inputs, the manufacturer
simply reimburses the regional for the amount remaining
unsold and the following season resubmits the bill for this
amount.
1a_nangiing_praatigas. There are two ways in which
handling practices differ between specialized and general
purpose inputs. Perhaps the most important has to do with
technical and safety procedures. Agricultural chemicals
are notable in this regard. Handling and storage of these
chemicals requires technical expertise both in terms of use
and safety. These precautions must be implemented
throughout the entire vertical system. All players at each
major stage must deal with the high cost of their care,
distribution and final application. A second manner in
which handling practices differ for asset-specific inputs
is inventory security. Costly inputs that have little

 

27To qualify for this buyback option, the local must
purchase 100 percent of the respective input from the
regional. Absent this safeguard, locals could easily return
supplies that were purchased elsewhere.

138
volume or mass are more subject to "opportunistic behavior"

than are low cost, bulky items.

LAW

General managers of local cooperatives are well aware
of the differences in the risks and costs between
specialized and general purpose inputs. Their perceptions
and responses differed little from their regional
counterparts. In terms of planning, local managers stated
that their purchasing practices are more conservative with
specialized inputs because demand is less predictable.
Another factor that influences inventory planning is that
the iifaapan of inputs is becoming shorter as new products
continually come on-line. Even though these products may
not be obsolete, manufacturers pare back promotional
activities on these items in favor of newer products.

Responses concerning exchange arrangements were also
consonant with regional firms. Most locals renegotiate
special return arrangements with their regionals (or other
firms) on an annual basis. They noted that regional
competition can be keen when offering special return
programs. One regional offered a 100 percent buyback
option to locals and in the process was able to attract
many new customers. This underscores the importance local
firms attribute to safeguards for risky inputs. It also

highlights the intense competitive behavior that persists

139

among regional firms.

5.22 Asset-specificity and Risk

This section synthesizes perceptions of regional,
local, and farmer respondents regarding the risks
associated with specialized inputs. This approach is used
because of the similarity in views among participants.
Risks are evaluated for the three major system players:

farmers, locals, and regional cooperatives.

A. Farmer Risk

There are different types of risk that participants
face depending on their location in the vertical system.
Currently there are three major risks confronting farmers
when using asset-specific inputs. The first is priaa_ri§k—
~the risk that prices may change unfavorably after the
input has been purchased. g§a_;i§k is a second concern of
farmers, and it has three components: (1) an inability to
utilize the input because of some unforeseen event, such as
bad weather: (ii) misapplication risk--because these inputs
are more concentrated, the likelihood of under- or over-
application is significant: and (iii) diagnostic error--
this is directly influenced by the continued proliferation
of highly specialized inputs. As this arsenal of inputs

continues to expand, the probability of judgement error is

140
more likely.28 Finally, the third risk farmers face is
"aarrygyar"--an unintended residual that may be
particularly harmful under extreme agro-climatic
conditions. For example, the combination of dense soils
and drought can result in an unanticipated herbicide
residue that could damage subsequent crops.

Farmers have no viable strategy to mitigate input price
risk when their response to "use risk” (21) is to delay
purchases until the last possible moment. This behavior
shifts the risk upwards to the local firm. Farmers have
adapted to misapplication and diagnostic errors by moving
towards custom application services. Even though immediate
costs may be higher, responsibility ultimately lies with
the applicator.

B. Local Risk

Inventory and misapplication risks were mentioned as
the two most important risks facing local cooperatives.
These firms also distinguish between (merely) specialized
and highly specialized inputs. The former category
constitute ”manageable" risks, in which adverse effects are
mitigated through special buyback or exchange programs.

The latter program is coordinated by the regional

 

28Trying to sort out all the possible combinations of
symptoms and treatments could be a daunting and
intimidating task. This is precisely why more and more
farmers are moving away from self-application to custom
services.

141
cooperative and involves a simple exchange (money for
inputs) between two or more locals that are either long
(surplus) or short on a specific commodity. Some general
managers have also instituted aggressive marketing programs
in efforts to reduce inventory errors. Field staff try to
accomplish this task by working closely with farmers to
ascertain their needs and offer information on products and
services available to them. In this manner cooperatives
are able to reduce some of the uncertainty surrounding
demand for specialized inputs. Highly asset-specific
inputs represent a second category of special concern to
local managers. The combination of high cost and uncertain
demand has relegated these inputs to a ”special order only"
distinction. In other words, these items are purchased
only upon request and are listed under a separate
accounting system in which costs are not pooled with
remaining inputs.

As locals move more into basic services like fertilizer
and chemical application in response to member demand,
these firms will face greater risks of making diagnostic
and application errors. Managers believe, however, that
given the trend toward growing agricultural specialization,
this venture is a necessary undertaking for cooperatives.
First of all, cooperatives have access to highly trained
technicians who have the knowledge and expertise to cope

with these problems effectively. Secondly, the growing

142
risks and costs to individuals can be substantially reduced

through a mechanism like cooperatives.

C. Regional Risk

A combination of high costs, high risks and low margins
has stimulated the development of very formalized exchange
arrangements between regional firms and manufacturers.
Regionals have been effective at shifting their risks to
manufacturers (as have locals and farmers), although this
has resulted in higher prices to buyers. All exchange
between these two parties is now undertaken on a written
contractual basis for asset-specific inputs. These
contracts are of two basic types. In the more traditional
agreement, the regional actually purchases the input and
negotiates for special programs that mitigate inventory
risks. Under the more recent arrangement, regionals act
merely as a distributing agent in which they contract to
handle certain inputs and for their services receive a
percentage of profits based on sales. Although the
regional never actually takes ownership of the supplies, it
actuates all other services (e.g., buyback programs) for
the manufacturer. Regional and local cooperatives are
satisfied with this latter arrangement, asserting that it
involves less risk, has good profits, and adequately meets

members' needs.

143

5.23 Input Fungability and Economic Coordination

Local and regional firms claim that manufacturers of
asset-specific inputs are trying to find new ways to
establish a more secure foothold in these markets. They
cite two major reasons for manufacturers' desire to
stabilize demand. One relates to the highly sensitive
nature of asset-specific inputs to "exogenous" forces.
(For farm inputs, these outside forces are largely weather
related.) These external forces cause demand to fluctuate
widely, thereby complicating production planning. Second,
despite a relatively concentrated industry, the environment
surrounding these inputs is surprisingly competitive.
Competition is considered intense because the user group
(farmers) is very tightly circumscribed and the seasonal
use period is so restrictive that even minor marketing
errors by input distributors can create major problems for
them.29

Since farmers are the primary users of specialized
agricultural inputs, cooperatives are clearly a crucial
element as a mechanism of exchange. Manufacturers
recognize that cooperatives represent a well established
and intricate network to the farmer market. This pipeline

is critical for specialized inputs when market

 

29For example, missing the strategic placement of an
agricultural chemical by even a few days may result in
losing that market altogether. This is particularly true
for pest infestations, where the window of opportunity is
often very small.

144

opportunities can come and go overnight. Given the intense
competition among independent manufacturers, cooperatives
should be ideally positioned to extract favorable
concessions. A limiting factor is that cooperative
federations (regional and local firms) do not represent a
unified coalition. Manufacturers have responded by
segmenting this federation and, consequently, undermining
the potential bargaining power of cooperatives.
Manufacturers approach cooperative federations in the
following manner. First, by means of a contractual
arrangement, they use regional firms as their primary
distribution and merchandising channel. But the IOFs
recognize that this market is essentially limited to "loyal
members". Hence, they capture the remaining market
(disloyal members) by selling directly to the local or to
the farmer. In the case of the former, manufacturers offer
three exchange options to potential buyers: (1) a forward
contract in which the buyer pays in advance of receipt of
goods, obtains a discount premium, and qualifies for a
buyback program: (2) a forward contract in which the buyer
pays on the date of delivery and qualifies for the buyback
program: (3) purchases on an as-needed basis, in which case
their is no buyback agreement.

Regional firms also offer these same programs to
locals, but many of these locals are not loyal customers,

usually because they are highly price-sensitive.

145
Manufacturers are ideally positioned to deal with these
buyers because of the price advantage they can offer them
(i.e., by eliminating the wholesale distribution step in
the distribution chain--also called circumvention).
Another aspect relates this practice to the competitive
market environment of highly specialized inputs. In other
words, ggmpating manufacturers may use extremely low prices
to undermine the contractual mechanism established by
his/her opponent. This rather common tactic allows a new

entrant to establish a foothold in a tightly-knit market.

At this point the coordination problem should be viewed
in terms of finding the most efficient method (in a system-
wide sense) of getting the input from the source (the
manufacturer) to the end user (the farmer). It is also
apparent that this coordination problem is exacerbated when
asset-specific inputs are involved. Let us review this
process by starting with the end user.

Farmers are the ultimate recipients of farm inputs.

For various reasons they choose to purchase the majority of
inputs on an ”as needed basis": this behavior is prominent
for asset-specific inputs. First of all, only that class

of producers who plan future operations in advance tend to

forward buy their inputs.30 Even those that do forward buy

 

30This is discussed in considerable detail in the
following chapter.

146
limit their advance purchases to inputs with relatively
little use-risk involved. Most chemicals, for example, are
specialized inputs. Herbicides fall into this category but
are generally used habitually each year. Insecticides have
extremely high use-risks because their use is based on
infestation of a particular pest which is flag a regularly
recurring event. Hence, because farmers have no advance
knowledge of when this need will materialize, they purchase
these inputs on an as-needed basis. Unfortunately, this
practice complicates the logistical procedures of
distributors considerably.

Local cooperatives note that in order to remain
competitive it is essential to position inventories in
advance as much as possible. However, because of the
inherent risks and costs of specialized inputs and the
unpredictable buying behavior of farmers, locals are
resigned to mimicking the same behavior as farmers--i.e.,
purchasing on an as-needed basis. This effectively shifts
supply and coordination responsibilities up to the regional
firm. Traditionally, regionals have purchased asset-
specific inputs from manufacturers using the best means at

their disposal to estimate future demand.31 But obstacles

 

31One method was already mentioned, exchanging
information with manufacturers. Regionals also utilize
private forecasting firms to obtain forecast estimates.
They complement this information with their own market
researchers who work with local firms and farmers. Finally
it was noted that some larger locals also have market
research programs which they may share with the regional.

147
to efficient distribution and merchandising of these inputs
are substantial. Because of the high-cost, low-margin
nature of these inputs, investments are both large and
risky. Purchasing practices of farmers and locals compound
the uncertainty of sales, which in turn complicates the
logistical placement and distribution of inputs. In
response, regional firms have turned to alternative
exchange arrangements with manufacturers. The most recent
is a written contractual agreement in which the regional's
primary function is to distribute and merchandize asset-
specific inputs with ownership retained by the
manufacturer. Under this strategy, all risks to the
regional are removed and the firm receives a percentage
profit based on sales.

Unfortunately, this is only a partial solution to the
coordination problem. Even though a more reliable and less
risky linkage has been established between the manufacturer
and the regional, no similar arrangement is present for the
other two participants in the vertical chain. The 999199
of the problem is the eleventh-hour buying decision of
farmers--and this is precisely what locals, regionals and
manufacturers must react to. The 9:9919m is that, with
asset-specific inputs, the closer the product moves to the

end user, the greater is the risk of 99mmi§mana because of

148
the non-substitutable nature of the input.32 Hence,
farmers are making rational decisions based on the needs of
their own farm operations, even though this behavior may
lead to greater costs to distributors and eventually

themselves.33

5.3 Chapter Summary
The purpose of this chapter is to reveal some of the
key incentives that might explain the adverse behavior of
certain cooperative participants. Two different
theoretical approaches are applied, game theory and
transaction cost economics. The findings in each section

suggest that participants are making rational short-run

 

32The three dimensions of fungability are directly
related to this problem. Although each participant is
affected by the non-substitutable nature of asset specific
inputs, the consequences become less severe as one moves up
the vertical system. When the manufacturer produces a
specialized input, options still exist in the event a
market becomes inaccessible (e.g., relocate the input).
Options are still available at the regional level, but less
so at the local level because of time and geographic
constraints. When the input reaches the farmer, those
options that were present for upper level participants are
now non-existent.

33For asset-specific inputs, forward commitment by the
farmer may not be entirely practical because of the use-
risk involved. However, if the local knew that, in the
event the farmer 91a need the input, it would be purchased
from that local, some preparations could be made. The point
is that use-risk facing the local is less than for the
farmer. Even if that particular farmer does not use it,
someone else will. Another aspect is that upper system
players may need to “up the ante" if they want more
commitment from farmers--in other words, compensate them
better for their risk.

149
decisions to maximize returns to their firm, but in the
longer run this behavior is jeopardizing the viability of
the cooperative system.

The game-theoretic approach looks at the structure of
incentives to bring to the fore the basic economic
rationale for uncommitted behavior by patron-owners. In
the process, two subcoalitions of disaffected members
surfaced. At the local level, there is a growing
disenchantment among younger members of cooperatives.

These members often have little influence in their
association and many believe that the current cooperative
system has failed to meet their economic needs. In
comparison to their older counterparts, young members are
generally more highly leveraged and have little invested in
their cooperative. As a consequence, they are extremely
responsive to a competitive market and are less affected by
an ideology based on loyalty.

Large patron-owners (either farmers or local firms) are
the second class of disaffected members. Even though they
contribute proportionately more patronage to the
cooperative than their smaller counterparts, they still
receive "equal" treatment. But pressure is mounting to
alter the current distribution of benefits. It is becoming
increasingly clear that defection by large members will
result in a Pareto-inferior outcome for all members, but

particularly for the small patron. This is because large

150
members enjoy strategic opportunities outside the
cooperative that are not available to others. In time, it
is anticipated that "equitable” treatment will supercede
the current practice of equal treatment.

Transaction-cost economics is the second approach used
in the analysis of member behavior. The approach shows how
conditions of asset fixity and uncertainty have influenced
the exchange process for buyers and sellers in the input
industry. Uncommitted behavior by farmers and local
cooperatives is shown to be a rational decision based on
the risks and costs associated with asset-specific inputs.
Specialized inputs have also greatly complicated the
coordination process among buyers and sellers. Upper-
level players in the vertical system must contend with the
risk-averse behavior of buyers and the rigid production and

marketing constraints inherent in specialized inputs.

CHAPTER 6

FORNARD CONTRACTING.AS AN EXCHANGE MECHANISM

Previous chapters have discussed how certain actions of
participants undermine the performance of supply
cooperatives. A fundamental problem is the inability of
decision makers to plan their activities in a manner that
facilitates the coordination of the input system's four
economic stages. The cooperative mode of organization has
potential for more effective micro coordination between
farmers and their local firms and between locals and their
regional firms. Shaffer believes that more specific
agreements between cooperatives and manufacturing IOFs offer
significant promise in this area. In particular, he has
recommended that more extensive use of contracts between
farmers and their supply cooperatives should be instituted.
This would allow participants to capture some of the
benefits of the vertically integrated firm while still
maintaining the advantages of decentralized decision making
(1987, p.83).

This chapter explores some of the obstacles and
opportunities for using forward contracting of inputs as a

mechanism of exchange. In the first section, forward

151

152
contracting is examined in the context of the larger
cooperative system. A major thesis of this research is
that, from a cooperative standpoint, the greatest potential
benefits could be derived from the application of forward
contracting on a system-wide basis. This means adoption and
implementation at each of the major stages in the input
system. But obstacles are anticipated as well. Impediments
to forward contracting are identified and examined in an
effort to isolate their location in the system and ascertain
appropriate steps for their removal.

A three-period mean-variance model of farmer decision
making is presented in the next section. Inasmuch as
farmers are the ultimate users of agricultural inputs, they
are considered the critical link in the cooperative system.
This theoretical model seeks to determine the incentives
that underlie farmers' decisions to forward contract for
inputs. The results of the model are tested empirically
using fertilizer and corn price data and from this
hypotheses are developed.

The final section uses case study information to test
the hypotheses set forth in the dynamic model. This
includes an assessment of changes in the distribution of
benefits and costs that could facilitate the adoption of

forward contracts.

153

6.1 Forward Contracting and the Cooperative System

A hypothesis of this research is that, for the benefits
of forward contracting to be maximally achieved,
implementation on a system-wide basis is essential. The
following section addresses this issue by presenting the
opinions of regional and local cooperative respondents.
These respondents all have direct experience with forward

contracting for inputs.

6.11 Benefits to Firms and the System

In one sense, forward contracting can be viewed as an
orderly marketing mechanism in that it is meant to increase
the likelihood that the correct amount of an input is
produced and distributed in a timely fashion to farmers.
Neoclassical theory suggests that prices convey the
necessary market signals to ensure that supply and demand
are equilibrated. A forward contract, however, represents a
fixed price and quantity for a certain period of time, which
constrains this adjustment role of prices. Hence, there are
tradeoffs involved when discussing the effects of "fixed"
and "flexible" prices. A fixed price can be associated with
reduced price uncertainty which implies lower search costs
for buyers. It also can facilitate the planning and
coordination of activities throughout the input system. On
the other hand, fixed prices may impair coordination if
their rigidity masks market signals so that inappropriate

154
levels of production occur or markets do not clear. Hence,
when considering the forward contract mechanism and its
coordinating role in the input market, it is important to
recognize the inherent tradeoffs between fixed and flexible

prices.

The cooperative input system is composed of four major
players--manufacturers (regional),1 wholesalers (regional or
super-local), retailers (super-local and local), and end-
users (farmer). Currently, forward contracting for inputs
is used at each of these economic stages. Respondents were
generally enthusiastic about the potential of this mechanism
to ameliorate some of their coordination problems. This
section discusses these potential benefits to farm supply
cooperatives. First, however, it may be helpful to identify
the aypaa of contracts that are currently in use.

Contracts differ in accordance with the level of
commitment that is agreed upon between the various parties.
Commitment in a forward contract is usually expressed in
terms of time and money. For instance, a fertilizer
manufacturer prefers contracts that are paid for and

consummated immediately after the fall harvest (usually

 

1Regional firms are established in the manufacturing
stage of the farm-input industry. Although they produce many
types of inputs, these are usually of a general purpose
nature. Highly specialized inputs that involve substantial
R&D expenditures are not in the production domain of
regionals. An exception are those inputs whose patents have
expired.

155

October or November) for delivery in March or April. This
degree of commitment can be difficult to extract from
buyers. Hence, in return for the advance payment,
manufacturers provide discount premiums that just exceed the
cost of money, usually some amount at or near the prime
interest rate. To illustrate, if a farmer purchases 50 tons
of fertilizer in December at $100 per ton for delivery in
March, and if the prime rate is 8 percent, the farmer would
receive at least a 2 percent discount below the December
market price. For additional incentive, some offer a
buyback option and price protection.2 A second class of
contracts consists of a down payment or "good faith" money.
The amount of the down payment may vary considerably,
although 10 percent is common. A "booking” is a final type
of forward contract, which simply signals an intent to buy.
No money changes hands and few concessions are given on the
part of the seller except the "booking price," which is the
price of the input at the time of the transaction. For all
three programs, concessions on the part of the seller are
reduced as the new season approaches.

Benefits of forward contracting are apparent at each of
the four economic stages. Regionals (that manufacture farm

inputs) believe that early commitments help them achieve

 

2All three components of this contract are negotiated
between buyer and seller. They are a function of current
supply/demand conditions in the market, behavior of other
firms, and the size or economic importance of the buyer.

156
their goal of cost minimization. When manufacturers are
able to cover a plant's fixed costs by ensuring a minimum
volume, the certainty of attaining capacity utilization
becomes less problematic. Inability to cover fixed costs is
considered to be a major contributor to the failure of many
fertilizer plants in the early-to-mid 1980s. A second
benefit of early commitment is that it allows firms to
smooth out their production over a longer time period. This
facilitates the efficient utilization of plant and
equipment, production materials and labor.

Planning is also an important benefit of forward buying
at the wholesale and retail levels. Regionals noted that
wholesaling is basically a logistics operation--the
objective is to be positioned in a manner that allows
products to be moved efficiently, quickly, and in a cost-
effective manner. Regionals utilize railcars, barges,
trucks and warehouses to move and store their products in
strategic locations. The crucial element is to have the
product available 3999 the customer wants it--which may
constitute a window of only two days. Firms caught out of
position may lose potential sales or be forced to absorb
higher costs as alternative means of transportation are
employed.

Local respondents noted that forward contracting gives
them more flexibility in terms of supply and price. By
early buying a portion of their needs, the co-op is

157

positioned well in the event the crop season begins early.
This practice can reduce price risk when they blend the
forward and spot market prices.3

Cooperative ayaaam benefits need to be visualized within
a "length of run" framework. For benefits actually to
accrue, it is essential that players at each economic stage
participate. Respondents conjecture that manufacturers
would gain the most in the short run from a comprehensive
forward purchasing program. This is because manufacturers
may have large investments in idiosyncratic equipment,
production materials and personnel. Once a binding purchase
commitment is made, the risk is automatically shifted g9yn
through the system. Regionals and locals would benefit
similarly in the short run. With binding commitments, risk
is passed on to the farmer. Nearly all the respondents
believe that, for most inputs, price risk is the primary

uncertainty facing farmers when they forward contract.4 But

 

3By and large, forward contracting between farmers and
local cooperatives is poorly established, with many locals
having minimal forward contract programs with their farmers.
Those co-ops that have established sizable contracts with
farmers noted that this exchange was limited mostly to large
producers. However, regardless of farmer participation, most
locals still use the contract mechanism to obtain supplies
from their suppliers in order to reduce the local's own
price risk.

4When a forward purchase specifies a fixag price at the
time the contract is signed, the buyer faces the risk that
prices will drop prior to planting. However, the farmer
faces the same price risk in the event s/he chooses to delay
purchases and buy on the spot market (i.e., by not forward
contracting, the farmer risks a price increase in a later
period).

158
this risk is considered negligible when weighed against the
potential benefits to the system. Furthermore, since
farmers own the cooperative and net savings are rebated to
members, in the long run farmers would be the ultimate

beneficiaries of forward contracting.

6.12 Obstacles to Forward Contracting

Respondents identified three factors that hinder the
effective application of forward contracting in the
cooperative system. The first is viewed as a risk problem
and it concerns the implications of selling a product (from
a manufacturer or distributor perspective) that, at the time
of the agreement, has yet to be produced. This practice
involves both output and input price risk. Output price
risk is important mainly to the extent it influences
production decisions. In other words, knowing axyanaa
whether the product's price (consider, for example,
fertilizer as the ”product") will be high or low can affect
decisions regarding production levels. Input price risk is
important because, under a forward contract, a manufacturer
agrees to supply an input at a fixed price without knowing
all the costs . If some inputs (like natural gas for
anhydrous ammonia) used in the manufacturing process are
subject to wide intra-year price fluctuations, this could
prove to be an important deterrant to a forward sell

agreement. At the wholesale and retail levels of the

159
system, this argument has less validity.

The second problem influencing efficacious application
of forward contracting is a lack of 99ntra9; 9nf9r99m9nt.
Like any form of exchange, contracting is conducted within a
competitive environment. Regional firms assert that forward
contracts are usually offered in surplus markets when there
is a need to reduce inventories. Under these conditions,
there are incentives on the part of contractors to make the
purchasing terms favorable to the buyer, i.e., making the
contract a less binding commitment. When competition is
intense among sellers, the integrity of these contracts may
be impaired significantly.5 Absent a viable enforcement
clause, forward agreements may be little better than a spot
market exchange. This statement, however, may be less true
in the context of farmer cooperatives. Since the customer
also owns the firm, the patron-owner may have more incentive
to honor the commitment than would a patron of an IOF.

Regional and local respondents hold that farmers not
only constitute the most critical link in the input system,
they are also the single greatest impediment to instituting
a viable contract mechanism. According to the respondents,
farmers as a whole do not like to forward commit. They view

contracting as an indulgence in speculation and, hence, an

 

5The purpose of a forward contract is to reduce the
uncertainty facing the seller. This facilitates the planning
process of these firms. When the contract is riddled with
escape clauses for purposes of attracting customers, the
actual worth of the agreement is highly doubtful.

160
unwarranted risk. Part of this aversion may be that farmers
simply do not understand the purpose and function of forward
purchasing or comprehend the significance of belonging to a
cooperative system. They are accused of focusing narrowly
on short-run profits at the expense of longer-term
cooperative growth. Yet the effective implementation of
forward contracting ultimately rests on the endorsement of
the farmer group. It is essential then to determine key
factors that infuence their decision to forward commit. The
following section is designed to explore these issues and
establish credible hypotheses regarding incentives to

forward purchase farm inputs.

6.2 Forward Contracting in Factor Markets6

Most research on alternative responses to agricultural
production risk has focused on the output side of the
production process, particularly when considering forward
contracts and futures contracts (e.g., McKinnon, 1967:
Chavas and Pope, 1982: Anderson and Danthine, 1983). There
has been some attention given to the impact of risk and
uncertainty on factors of production. For instance, Batra
and Ullah (1974) showed how introducing output price risk
into a certainty model altered output levels but left

 

6This section was a joint collaborative effort between
the author, Stanley R. Thompson and Robert J. Myers. The
paper was written for the NOR-134 meetings in St. Louis,
Mo., and presented April 27, 1988. The title of the paper is
identical to the heading for section 6.2.

161
relative input quantities unchanged. Robison and Barry
(1987) evaluated input demand under four conditions: (a)
output price risk, (b) input price risk, (c) quality of
input risk, and (d) production function risk. They also
introduced ”flexibility” [as have Hartman (1975) and
Holthausen (1976)] by allowing the firm to select one input
after the uncertainty is revealed. This approach allows the
decisionmaker to respond to new or changing conditions. In
each of these cases, however, the research has assumed spot
markets only, with no forward contracting of inputs. But
many farmers forward purchase some of their inputs in order
to manage price risk and ensure reliable supplies and
quality. This facilitates planning and allows farmers to
diversify their input purchases over time.

In this section the forward contracting of inputs is
incorporated into a three-period mean-variance model of
farmer decision making. Explicit in the model is the
tradeoff between the quantity of input to be purchased in
advance (prior to planting) at the forward price and the
remaining portion to be purchased subsequently on the spot
market. Empirical results are obtained using fertilizer and
corn price data.

In the first part, a descriptive analysis of the
forward contracting problem facing agricultural producers is
presented. Of major concern is the decision environment

facing the contract participants, the economic incentives

162
that underlie the agreement, and the possible tradeoffs
involved when operating in an uncertain environment. The
second section presents the model and derives decision rules
for optimal use of forward contracting of inputs. Finally,
an empirical application of the model is illustrated by
estimating an "optimal" forward contract ratio. This ratio
establishes the quantity of input that should be forward

purchased prior to planting.

6.21 Exchange in Forward Contracting for Inputs

As indicated above, forward contracting for farm inputs
is usually initiated by the manufacturer. The
manufacturer's primary incentive to forward sell is to
improve the firm's planning capability. For the
manufacturer, forward contracting may be analagous to
purchasing an insurance policy to cover operating expenses.
The insurance pramiam is the lower, fixed price necessary to
obtain a forward purchase from the farmer. On the other
hand, the farmer's incentive to forward purchase may be
attributable to the following inducements: (a) a certain
price: (b) a certain supply, and (c) a likelihood of cost
savings.

The forward contract price is largely a function of
manufacturing costs, current input prices and expected input
prices. Although contracts often vary across firms,

typically they are of short duration (less than one year),

163
have a fixed price, and may require up to a 100 percent
advance payment. This financial commitment by the purchaser
is compensated for by a price discount below the current
spot price. A five to ten percent discount is common. Once
the contract is consummated, a future increase in the market
price implies an ex-post consumer (farmer) gain whereas a
price decline implies an ex-post producer (manufacturer)
gain. Given the influence of seasonality on input prices,
the price usually rises.

Prices, however, do not always dominate farmers'
purchasing decisions. Supply assurance is also a highly
important consideration for essential inputs (Eversull,
1983). Input availability consists of four individual, yet
interrelated dimensions of coordination-- quantity, time,
form (quality) and place (location). Clearly perfect
coordination is not possible, or even desirable, since it
could very well be infinitely costly. Nevertheless, these
four components of coordination must enter into the decision
maker's production equation, at least within some acceptable
levels. These levels may differ considerably by the type of
input, its function, and the biological and agro-climatic
constraints imposed on the production process. For
instance, to achieve an effective "kill rate" for the pink
bollworm, insecticides must be applied at precisely the
right developmental stage of the larvae. This may

constitute a "window of opportunity" of only a few days, or

164
even less. Under these circumstances, supply certainty
takes on a more imposing and urgent function.

To investigate some of these issues further, consider a
simple two-period decision environment consisting of a
preplant period (t-O), a planting period (tal), and a
subsequent harvest period (t-2), in which all buying
decisions are restricted to the first two periods. Assuming
the farmer is limited to a single forward purchase, the
following choices are available at t-O: (1) forward
contract total input requirements, (2) forward contract no
inputs, or (3) forward contract a portion of total input
needs.

Each choice is influenced by current (tsO) input
prices, expected spot price of the input in period 1, and
the expected output price in period 2. Initially, the
decision maker must decide whether or not to forward
contract in the first period. Failure to contract indicates
the agent will postpone input purchases and, in effect,
speculate that prices will turn favorably by planting time.

An opposite approach is to forward purchase all input
needs during the preplanting period (t=0). This strategy
eliminates price uncertainty, although there still remains
some likelihood that prices will fall in the next period,
thereby making the farmer regret his or her decision, 93;
995;.

A final option is to spread risk over time by

165
purchasing some input in t-O and the remainder on the spot
market. In this situation, a proportion of total input

price is certain, while the balance remains uncertain.

6.22 The MOdel

The following model is based on the decision problem
discussed above. Assume there is some predetermined level
of output, y, that the decision maker intends to produce in
t=2. The production technology is defined by a Leontief,

fixed proportions production function:

y = min (ax, bz) (1)

where x is the total quantity of the input of interest used
in the production process, z is a vector of other inputs,
and a and b are input-output coefficients. Input x can be
purchased in two time periods, as a forward contract in t=0
or in the spot market one period later (t=1). Input levels

required to produce y with this technology are

x a y and z a y (2)

Furthermore, since y is fixed (and by definition so are x
and z), the farmer's decision problem is reduced to
determining the amount of input x to purchase at t=0

(i.e., x0) and the amount to purchase at t=1 (i.e., x1 =

166
x-xo). Therefore, the demand for x1, which is conditional

on x0 and y, can be expressed as

x a Y - x (3)

and z remains as defined in (2).

Profit in period 2 can be written

I = p y - w x - r z - w

1 1 oxo (4)

where r is a vector of gaaaain prices for other inputs, (2),
wl is the spot price of x at t=1 and wo is the forward
contract price of x at t=0. From (2) and (3) we know the
period 1 demand for inputs x1 and z, and by substituting
into (4) we obtain

r=py -w1[_i_-xo]-r1_X_-woxo (5)
a b

During the preplanting period (t-O) both p and “1 are
random elements in the decision process, while both r and y
are given. Thus the problem in the preplanting period is to
choose x0 so as to maximize a linear function of the mean
and variance of profit, conditional on information available
at t=0:
A

max E(x|00) - i (I) - _ Var (IIOO) (6)
2

167
where 00 is information available at t-O and A is a measure
of the agent's risk aversion. The mean and variance of

profit are:
E (also) = E (plea) y - E (who) [1. - x01
a

- r [_%_] - woxo: and (7a)

Var(1|00) = y2 Var(p|00) + [.Z. - x012 Var(w1|00)
a

‘ 2Y (.Z. - Xo]C°Vo(W1oP|00)) (7b)
a

The first order condition for this problem is

2_(Y

2
pw T - X0)Ow] g 0 (8)

E (wllflo) - wo - A[y o

where apw - Cov(w1,p|00) and as - Var(w1|00)

Solving for x0 we obtain the following input demand function

for x0.

E(w IO )-w y 0
x0 = y + 1 0 0_ pw (9)

a 102 02
w w
From an empirical perspective, it would be of value to
arrive at a decision rule for forward purchasing x. This
can be accomplished by implementing a "forward contract

ratio", where x0 is some proportion of total x. Dividing

(9) by x and recalling that x = y/a we obtain our optimal

168

contract ratio,

[E(w 0 )-w ]a a0
a 1 + 1' o O - pw . (10)

2
Aawy aw

 

"o
3:—

Notice from equation (10) that if the forward contract
price is equal to the expected future spot price then the

middle term drops out and we are left with the simple rule,

g 1 _ pw (11)

 

It is easily verified that (11) is also the forward contract
ratio that minimizes the variance of profits (ignoring
effects on expected profits). Given this simplified rule
(11), increases in the covariance between output and input
prices lead to reductions in risk and, hence, reductions in
the quantity forward contracted.7 Similarly, increases in
the variance of input prices, ceteris paribus, leads to an

increase in the amount forward contracted.8

 

7When the covariance between input and output prices
just offsets, in terms of profitability, the variance of
input prices (i.e., when a0 w = 02w ), then it does not pay
to forward contract. In thi case, if the input price
varies, the output price is expected to covary just enough
to leave profits unchanged-~hence, there is no incentive to
forward contract. In this sense, indexing the output price
to the input price (parity pricing) eliminates the farmer's
incentive to forward buy.

8These results assume apw > 0.

169

Returning to (10), now assume that the forward contract
price is at a discount to the expected future spot price,
that is, E(w1|00) > wo. Then for a given level of aapw/azw,
the larger the difference between E(w1|0) and wo, the
greater the incentive a risk neutral farmer would have to
forward contract. However, this is a risky strategy,
implying that the more risk averse a farmer is, the less
forward contracting the farmer would be willing to undertake

(i.e. dxo/dA < 0).

6.23 Empirical Results

In order to estimate the optimal forward contract
ratio, we need estimates of the parameters in equation 10.
Suppose initially that,

E(W1|00) - w (12)

0'

Then we get the simple decision rule (11), as before.
Equation (11) is also appropriate if the individual is
infinitely risk averse or if one pursues a minimum variance
objective.

To estimate the simple decision rule represented by
equation (11) we need the input—output coefficient, "a," and
the conditional covariance between input and output prices
along with the conditional variance of the input price. We
estimated these variables for the case of fertilizer used in

corn production on a representative corn belt farm.

170
Fertilizer data were obtained from two sources. Six years of
monthly spot price data were purchased through a private
fertilizer information service, and forward contract price
data were obtained direct from a fertilizer manufacturer.
The latter data however, were incomplete, and so were used
only to establish a range of discount values that comprise
the sensitivity analysis found in Table 6.2. These data
were not used in the actual regression analysis. Monthly
corn price data for the same period were obtained through
departmental sources (Michigan State University) who
collected the information from midwest grain elevators.

A plot of the estimated correlogram of the spot
fertilizer price data indicated the possibility of a
nonstationary data series. Dickey and Fuller suggest a
procedure to test the null hypothesis that the price level
has a unit root. The result of this test failed to reject
the null hypothesis and the conclusion of nonstationarity
was reached. Since the null hypothesis of unit roots could
not be rejected, a first difference specification was
estimated.

Assuming that the formation of both input and output
price expectations is based on the information set at
preplanting time (period 0), then the following estimation

models are specified:

171

s s
Awt = #10 + fillAwo + b12 Apo + elt' and (13a)
8 3
Apt - 820 + 821 Awo + 822 Apo + e2t' (13b)

where, Aw: a w: — w:_1 and Apt= pt - pt_1.

The null hypothesis of all the parameters in both (13a)
and (13b) equal to zero was rejected at the 5 percent error
level (Table 6.1).

To implement the optimal forward contract ratio
(equation 11) two estimates are needed. First is an
estimate of the ratio apw/ag. The residuals from (13a)
and (13b) were used to obtain estimates of these conditional
variances and covariances. Using the forecast errors from
equations (13a) and (13b), opw = 0.0597 and a: a 63.987:
hence, “pw/og u 0.00093. Myers and Thompson have
shown that this ratio can be equivalently obtained as the
estimate of in the following regression:

Apt- 80 + 61 Aw: + 82Aw:_1+ 83 Apt_1 + ”t . (14)

Second, the remaining unknown component in equation
(11) is an estimate of the production function parameter

"a". Given our problem, the parameter "a” in equation (1)

172

Table 6.1 Ordinary Least Squares (OLS) Estimates of
Fertilizer and Corn Price Expectations Models.

 

Independent Variables

 

 

S
Dependent Awt-1 APt-1 F-Statistic
Variable Constant (3,72)
Aws -0.340 0.469 8.345 9.85
(0.965) (0.107) (5.887)
Ap -0.003 0.005 0.017
t (0.019) (0.002) (0.114) 4.52

Where: Aw: = w: - w:_1, Apt = pt- pt_1 and

the numbers in parentheses are standard errors.

 

Table 6.2 Optimal Fertilizer Forward Contract Ratios Under
Alternative Degrees of Risk Aversion (A) and Discounts (a).

 

 

 

Risk Parameter Discount (0)
(A)
0.96 0.94 0.92 0.90
0.025 0.00a 0.00a 0.02 0.18
0.01 0.19 0.58 0.98 1.00b
0.0075 0.45 0.98 1.00b 1.00b

Where: a a negative values constrained to be zero, and

b - values greater than 1.0

 

173

is defined as an input-output coefficient: bushels of corn
per ton of nitrogen fertilizer. Based on a previous study
of the effect of nitrogen on corn yield by Vitosh, 9;.ai,
the application of 115 pounds of nitrogen per acre can be
expected to yield 100 bushels of corn.9 This relationship
implies a value of the parameter "a" of 1740. If "a" was as
large as 1740 and the covariance-variance ratio was 0.00093,
the optimal forward contract ratio would be negative. Since
we have not bounded our solution to lie between zero and
one, negative values are possible. However, this should be
interpreted as x080 since we want to rule out x0 < 0.

Initially, we believed that the decision maker's desire
to reduce risk would be an important element in the decision
to forward contract inputs. However, these results show
that for fertilizer used by corn producers, even highly risk
averse (variance minimizing) farmers would have little
incentive to forward contract.10 Given values of 03, apw
and ”a" estimated here, there appears to be very little the
farmer can do to reduce the variance of profit. In other

words, the large size of this ratio (opw/oz) relative to

 

9This study was considered to be representative of
conditions for a typical midwest corn producing farm. A
Michigan State University faculty member who has done
considerable work in this area recommended this publication.
The input/output levels picked were estimates for "average"
soil conditions and were typical of those found in the corn-
belt.

10Note that risk considerations would likely be much
more important for less fungible inputs, like certain
agricultural chemicals.

174
"a", reduces the incentive to forward contract, as increases
in the price of inputs are offset by increases in the price
of outputs. Given that forward contracting of fertilizer
occurs, one might conclude that the impetus is largely due
to the presence of discount premiums associated with these
forward purchases.

In this simple technology model, the influence of the
input-output coefficient for fertilizer was substantial. It
is important to recognize that input-output coefficients
will vary with the input employed, and hence so too will
their impact on the contract ratio. For example, one could
anticipate some agricultural chemicals have a very specific
role in risk management, possibly overriding price discounts
as the incentive to forward contract (i.e., °pw may be much
lower for these inputs).

Returning to the optimal contract ratio, if we assume
that the expected spot price exceeds the forward contract
price (i.e. E(w1|00) > wo), then equation (10) holds. By
using the limited forward contract data obtained from
manufacturers, discount premiums were determined for
purposes of obtaining the range of discounts.11 Using this
information, hypothetical discounts (a) and levels of risk

aversion (A) were chosen to illustrate forward contract

 

11Two and one-half years of forward contract data were
obtained. But this represented only October through January
data for each year--the usual contract period. This was
incompatible for regression needs, where monthly data were
used.

175
ratios (Table 6.2). Results support earlier conclusions
that the more risk averse a farmer is, the less forward
contracting s/he will undertake. This may be in part due to
the possibility of an unfavorable price change in the next
period. Also, the contract ratios increase with larger
alpha values, indicating that a major incentive to forward

purchase inputs is due to the presence of discount premiums.

6.3 Forward Contracting: Incentive Structure
and the Distribution of Benefits

6.31 A Farmer View

Two hypotheses developed in the preceding section are
that: (1) discount premiums are a major incentive for
farmers to forward contract, and (2) there is an inverse
relationship between farmers' risk-aversion and their
tendency to forward contract. The validity of these
hypotheses was then tested by a case study method based on
interviews with farmers.

Although farmers generally agreed that forward
contracting is a risky undertaking, the degree to which they
believed this to be true varied considerably. Some viewed
the forward contract as a useful mechanism to reduce risk
and facilitate the planning of their operations. For these
producers, the benefits associated with an input contract
exceeded the inherent risks. Others had a much less
favorable view. For them, a forward contract is synonomous

with speculation that involves large risks and returns

176
minimal benefits. In order to encourage forward commitment,
cooperatives would have to offer larger discount premiums or
institute more comprehensive price protection.

Farmers cited the impact of na99:§ain_9y9n§a as the
main reason some are reluctant to forward commit. An input
contract fixes the price, quantity, and date of delivery.
Farmers complained that the inflexibility of some contracts
is a deterrent to use. For instance, regionals pressure
locals that in turn pressure farmers to accept delivery on a
specified date.12 In 1987 some midwestern farmers had
contracted to accept delivery of fertilizer by March 15 but
were unable to initiate application because of incompatible
soil conditions. Farmers who lacked adequate storage
capacity were faced with the unpleasant task of resolving
this dilemma with their cooperative. Government is another
unknown quantity. Price support programs influence farmers'
crop mix strategies, and set-aside programs can heavily
affect input prices. When set-aside programs are large,
input prices tend to drop in the spring as firms compete to
reduce excess inventories. Looking into a forward contract
under this circumstance has obvious negative connotations
for a farm's earnings.

There are reasons other than risk that may discourage

the use of forward contracting for inputs. Developing a

 

12This practice is based on manufacturers' need to
relieve inventory pressures and to smooth out the
distribution process.

177
comprehensive production plan to ascertain forthcoming input
needs or to satisfy a credit institution is one such
deterrant. Apparently there are two distinct classes of
farmers in this regard--planners and non-planners. The
latter group's attitude is not consonant with the underlying
philosophy of forward contracting.

A third inhibitor is that many farmers are simply
unaware of forward contracting as a purchasing option. One
farmer stated that no one had ever sat down with him and
explained the purpose of the contract or the potential
benefits from its use. Indeed, even though forward
contracting is used between farmers and local cooperatives,
it is employed non-systematically and usually unobtrusively.

A final observation is that forward contracting is
really tailored for large farmers. Small producers realize
negligible savings because their volumes are inconsequential
although the transactions and the commitment that attend the
contract are significant. To illustrate, a producer who
saves $3 per ton of fertilizer on a purchase of 30 tons has
less incentive to forward contract than does a farmer who
buys 500 tons. This benefit disparity is even more
pronounced when one considers that the cost of the
transaction is nearly the same for each producer. For small
farmers, a spot market purchase involves less cost and
provides substantially more operating flexibility.

Farmers who forward contract offered three reasons in

178
support of this practice. The dominant rationale is the
999;:9ayingp that is reflected in the product's price. Due
to the seasonal nature of agricultural inputs, fall prices
are usually lower than those in the spring. A low price in
conjunction with a 9i§999n9_pzamian is adequate incentive to
offset the risk of an unfavorable price change in the
spring.

The benefits of planning were also cited as an
important incentive to forward contract. As mentioned
earlier, many producers have incorporated systematic
planning into their farm business, and forward buying
complements this practice. First of all, a contract
eliminates price and supply uncertainty from a good portion
of their farm expenditures. With margins continually
narrowing, these farmers view risk management as an
increasingly critical component of their operations.
Secondly, forward buying improves one's pin9_nanagan9nt by
distributing this resource more evenly across the year.
Time is a critical constraint at the onset of a new crop
season. Purchasing inputs places additional pressure on
farmers when they can least afford it. Early buying shifts
input purchases to a less demanding period of the year,
which frees the producer for more essential activities.

An income tax benefit was identified as a final
incentive to forward contract. By purchasing inputs early,

farmers list the input as a current expenditure even though

179
it is used the following season. The inducement is that
farmers deduct a portion of this expenditure from their
federal income tax. However, this "tax advantage" is an
advantage only if the farmer's tax rate this year is higher
than next year. This will occur if: (a) his/her income is
higher this year than next year, or (b) tax rates will fall

in the following year (as have occured in recent years).13

6.32 A Local View

Price incentives and supply assurance are the two major
reasons for locals to forward contract. As with farmers,
low fall or winter prices and the discount premium are the
major impetus to early purchase inputs. Depending on the
supply and demand conditions in the market, locals may also
try to negotiate some form of price protection. Under
intense competitive pressure, regionals may offer a free
price protection program even though their own price risk is
greater in surplus years. A more normal response is for
regionals to charge a premium for price protection in years
when large surplus conditions prevail. Competitive
behavior, especially among regionals, may cause them to
react differently. Supply assurance is a moderate

concern at the retail stage of the input system. The major

 

13Note that if inputs are purchased in the spring, they
still can be deducted from that year's taxable income. The
point is that the input's cost is deductable in the year it
is purchased.

180
benefit of buying early is that it provides security in
normal years and may give locals a strategic advantage in
years when the season begins earlier than expected.

In the opinion of general managers, the major obstacle
to system-wide contracting is its limited use among farmers.
Even though it is well-established between regional and
local firms, it is poorly employed at the local-farmer
level. Regionals stated that roughly one-third of total
factor sales are implemented through forward contracts. The
largest proportions are in the area of fertilizer and feed,
the smallest in agricultural chemicals.14 On the other
hand, local co-ops sell around ten percent of their supplies
to farmers on a forward contract basis. Hence, from the
cooperative system perspective, forward contracting is a
discontinuous and therefore imperfectly applied exchange
mechanism. Benefits that 99nl9 accrue to farmers and the
larger cooperative system are forgone.

General managers cite two reasons for this lack of use
at the farm level. One problem is that regional and local
co—ops have ineffectively disseminated information to
members on the benefits and opportunities of contracting
inputs. Many farmers are simply unaware that the exchange
option exists. A second reason is that farmers who are

conscious of the mechanism itself may still fail to

 

14Recall that agricultural chemicals are distributed
largely with regionals or IOF manufacturers bearing most of
the risk via buyback provisions.

181
comprehend its fundamental features. Many producers do not
recognize the tradeoff between the inherent price risk on
the one hand and the benefits of lower input prices and
improved management capabilities on the other. Even though
farming involves substantial risk, many producers view early
input contracting as a speculative mechanism that actually
annanpap risk. One might conclude that the combination of
these two factors is preventing a wider adoption of forward
contracts among farmers and, hence, through the entire

federated system.

6.33 A Regional View

Benefits from forward contracting at this level depend
on the particular economic function carried out by the
regional. If the regional is a manufacturer, the objective
of covering fixed costs is the most important reason to
institute forward selling. An equally important reason but
less urgent is the goal of cost minimization. Conversely,
if the regional purchases supplies from an interregional or
an IOF, then pnpply_a9§9;an99 becomes the critical feature
of forward buying. In either case this practice allows the
firm to be more competitive through improved performance,
which is disseminated down through the system.

A major shortcoming of current forward contracts is
that benefits from their use exhibit a public good

characteristic of non-excludability. More precisely, the

182

efficiency gains derived from forward contracts are
distributed only in the aggregate, which encourages free-
riders and hinders broader use of forward contracts. One
regional has responded by segregating services between
adopters versus non-adopters. Thus, a service incentive is
directed at those members who are willing to commit through
forward contracting.15

Regionals assert that currently the primary reason
locals and farmers forward purchase is because of the price
incentive and discount premium. They believe, however, that
as margins of producers continue to diminish, forward
contracting as a risk managment tool will soon become the
dominant incentive. This trend will also be the primary
impetus for its increased use at the cooperative system
level.

One final observation has to do with risk sharing among

the participants in the vertical system. There was a
consensus opinion that price uncertainty remains the key
risk factor influencing each economic stage. Farmers and
locals were quick to point out that a comprehensive price
protection program was the best way to expand the use of
forward contracting. This meant that (IOF) manufacturers or

regionals should compensate local cooperatives in the event

 

15These services include manpower assistance, financial
and technical support, and information services. Financial
support can be an important incentive to a highly leveraged
cooperative.

183
prices drop to a level palpy the contract price.
Interestingly, they elicited surprise when asked if they
were willing to compensate the regionals if prices rose
ap9y9 the contract price. Apparently risk sharing is an
unknown concept among many participants at the lower levels

of the system.

6.4 Chapter Summary

Three different aspects of forward contracting as a
mechanism of exchange are discussed in this chapter. In
the first section the emphasis is on system-wide
implications of forward contracting. This included
examining both the benefits that are derived from its
application and the obstacles that prevent its
implementation. In terms of the former, all four system
players benefit from forward contracting. Manufacturers
are better able to achieve their goal of cost minimization
by ensuring sufficient volume to cover fixed costs and by
extending the manufacturing period to utilize factors of
production more efficiently. Wholesalers and retailers
(regionals and locals) gain from more competitive prices
and an assured supply. Supply assurance can be critical at
the wholesale stage because volumes are large and movement
of supplies can be a time-consuming process. When the
season begins and demand suddenly mushrooms, it is crucial

that firms have strategically deployed their inputs to

184
maximize their sales. Finally farmers gain by the lower
input prices and the assured competitiveness of their
cooperative firm.

Farmers are the critical link in the cooperative system
but they also are recognized as the most significant
obstacle to effective implementation of forward contracts.
This is primarily because of their unwillingness to commit.
Price risk is usually the cause for this behavior by
farmers. But price risk is experienced by each major
player in the cooperative system, since players at the
bottom of the system have shifted much of this risk up.
Finally, a lack of contract enforcement is identified as
undermining the integrity of forward contracts. This form
of exchange is prompted in surplus periods when dealers try
to reduce inventories. One practice that entices customers
is to incorporate slack into the contract by offering a
less binding commitment. The problem is that when
sufficient numbers of firms engage in this behavior, the
effectiveness of contracting as a forward buying tool is
greatly jeopardized.

In light of the need to understand farmers' incentive
to forward contract better, a mean-variance model of farmer
decision making was used to derive an optimal decision rule
for forward contracting. By interpreting this rule, it was
discovered that a farmer's major incentive to forward

contract for fertilizer used on corn is the discount

185
premium or price incentive, and that risk management is of
minor importance. However, risk considerations could play
a much more dominant role for asset-specific inputs. A
second finding of the model is that there is an inverse
relationship between farmers' degree of risk aversion and
their decision to forward commit. In other words, greater
levels of risk aversion imply lower levels of forward
contracting.

The final section uses information from case studies to
test the two preceding hypotheses. Respondents concurred
that farmers' primary inducement to forward buy inputs is a
a price incentive, which can translate into an appreciable
savings. Respondents also confirmed that many farmers view
forward contracting as a speculative venture that entails
more risk than the spot market. This is largely attributed
to their lack of understanding of the input contract
mechanism. There is a consensus, however, that as farming
becomes more competitive and margins continue to narrow,
forward contracting as a risk management tool will become

increasingly prevalent.

CHAPTER 7

THE COOPERATIVE SYSTEM AND HORIZONTAL COORDINATION

7.1 Introduction

A continuing focus of cooperative strategy over the
next decade will be in balancing market power between
farmers and firms in the food system. This will
necessitate increasing horizontal coordination to maximize
the bargaining strength of farmers. Past efforts by the
cooperative system at increasing market share has not been
sufficient relative to the strength of investor-owned firm
competitors. Cooperatives must do a better job of
coordinating activities among themselves in a manner that
translates into a more efficient cooperative system. This
means eliminating needless duplication and increasing the
size and scope of their operations through orderly merger
or consolidation.

This research has concentrated on coordination problems
afflicting federated farm supply cooperatives. Federated
co-ops are viewed as being generally responsive to unique
local needs--at least this has been their affirmation. But
there are many opportunities of a horizontal nature facing

these firms that are largely ignored. Through joint-

186

187
ventures or mergers cooperatives can gain greater leverage
from their limited capital, pool risks, expand markets, and
enter activities that they may otherwise have to forego
(AC8, 1987). A combined organization may also be viewed as
less risky in the market place, leading to increased
availability of funds or improved lending rates, or both.
Better cash flow management may also occur through upgraded
accounting procedures. Improved accounting systems could
also enhance the new firms' planning and control.
Marketing and administrative areas also have synergistic
potential. For example, the new organization could unify
advertising and utilize the strength of individual product
lines to upgrade the overall marketing effort. Finally, in
the manufacturing area, synergistic effects may be
possible, but only in the longer term. This is because
activities like plant closures, construction of new
facilities, changes in production processes, and joining
operations of the combining cooperatives all take time and
effort (Swanson, 1985). In fact, it is precisely these
types of activities and the issues that underlie them that
hinders the inception of reorganization. But relentless
competition from IOFs is rapidly altering the nature of the
game in the input markets. Cooperatives are beginning to
feel this pressure and are recognizing that time to respond
is fast running out.

Reorganization is a major horizontal activity open to

188
cooperatives but they have yet to respond to the degree
that is necessary.1 Competition at the local and regional
levels is pervasive, as is the excessive and redundant
investment in facilities and distribution systems.2 It is
clearly one of the most significant dilemmas facing
cooperatives in this decade. This chapter will address
these and other issues relevant to horizontal coordination.
There are two components to the chapter. In the first
part, the emphasis is on identifying and examining
impediments to improved collective action among
cooperatives. Issues that surface are analyzed as a
prisoner's dilemma supergame and as a cooperative game.
The second and final section explores the structure of

incentives that may be inhibiting the performance of newly

 

1Merger , consolidation, and acquisition are the most
common forms of horizontal reorganization. Although these
terms are often used interchangeably, the terms refer to
different types of joining. Merger involves combining the
net assets of two or more firms, with one surviving. When
two or more firms consolidate, their net assets are
transferred to a new firm organized for this purpose.
Acquisition results in control of a purchased business. The
acquired organization may survive or be absorbed (Swanson,
1985).

2One general manager stated that a reorganization
feasibility study conducted for his cooperative by the ACS
found that a consolidation would save three local firms
$1.5 million in the first five years. Given the small size
of the co-ops, this was substantial. The manager further
stated that the board of directors blocked the
reorganization outright.

A regional respondent claimed that a study examining a
reorganization with two other midwest regionals found that
savings from a consolidation were in the neighborhood of
$400 million in the first five to ten years. Restructuring
negotiations are ongoing at this time.

189
reorganized firms, particularly joint-ventures and mergers

or consolidations.

7.11 Rationale for Behavior
A. A.Loca1 View

General managers of local cooperatives identified three
major reasons for the competitive behavior that pervades
the cooperative system. Perhaps the most obvious incentive
is simple 999n9ni9_n9999§ity. Three different dimensions
to cooperative competition are: (1) local to local, (2)
regional to regional, and (3) regional to local, or vice-
versa. All three relationships are driven by the same
underlying force-~economic survival. Cooperatives are
compelled to behave competitively because the number of
patron-owners is dwindling and the average farm size is
growing larger. Compared to the past, each current or
potential customer has a much greater impact on the
financial well-being of the cooperative. At the same time,
outside forces are adding pressure to keep costs low.
Supply cooperatives accomplish this through larger volumes,
but this implies infringing on territories of neighboring
cooperatives.

Competition among cooperatives is not limited to

parallel stages either. Regionals compete directly with
locals by selling supplies to large farmers (the

circumvention issue) or indirectly by providing financial

190
support to poorly performing firms. The former practice is
understandable when the needs of these patrons have
outgrown the local's ability to provide them. Traditional
methods or practices are no longer adequate for large
members. On the other hand, it is questionable whether a
regional that assists a financially impaired local does so
ostensibly for "the good of the system." Local managers
contend that the impetus is rather the regional's fear of
losing the customer to a competing regional. Hence, direct
regional to regional competition is also manifested
indirectly in a vertical sense between locals and
regionals. One consequence of this behavior is that
regionals may be perpetuating inefficiencies within their
federated system. Not only does this weaken the system's
overall competitive posture but it also prevents its
natural (and necessary) evolutionary development.

A competitive i999l99y is a second and perhaps the most
basic force that explains the behavior of farm supply
cooperatives. This fundamental, pervasive, and deep-
rooted belief of farmers may in part be traced back to the
early years of cooperatives when the input industry was
dominated by a few firms that often acted dishonestly. In
a larger context it may be attributed to the free
enterprise spirit of American society. The oft-recurring
antitrust legislation is testimony to this social concern.

Whatever the reasons, this ideology may be responsible for

191
the competitive posture cooperatives are in today.
Farmers, for instance, may join more than one cooperative
to encourage competition among local firms. Competition in
turn leads cooperatives to offer lower prices for certain
products or services, which creates incentive for patron-
owners to "shop around.” In addition, members pressure
management to adopt similar behavior with regard to their
regionals. Nearly all locals interviewed were members of
more than one regional firm. The following experience of
one manager may illustrate how deeply ingrained this
behavior is among farmers. When the manager first arrived
there were two cooperatives in the immediate area. The
community had two fertilizer mixing plants, two feed mills,
duplicate service equipment, and two-thirds of the farmers
were members of both cooperatives. Furthermore, neither
cooperative's investments were sufficiently utilized.
After surveying the situation the manager suggested that
the two cooperatives merge. Farmers were adamant in their
disapproval. Their response was "but if we merge, we won't
have any competition."

The third and final impediment to horizontal
cooperation is the effect of y9§§99_in99p9§p§. Vested
interests at the local level can be delineated according to
personal or community interests. Managers believe that
communities attach a tremendous weight to the economic role

and function of the cooperative. Rural areas in the

192
midwest are in a period of transition. Small towns are
disappearing as the farm population continues to dwindle.
Many communities have lost their schools, businesses and
even churches. One of the last vestiges of their past and
the last shield between themselves and economic obscurity
is the farmer cooperative. As a consequence, even though
the economics may dictate the necessity of consolidation,
board members usually resist this action outright.3 Every
local firm interviewed had at some point tried to merge,
consolidate, or form a joint-venture, but very few were
successful.

Personal interests are also a serious obstacle to
different forms of collective action. Vested interests are
most acute among managers and board of directors. Managers
have a strong incentive not to merge or consolidate since
doing so places their positions at risk. They are also
expected to supply low-cost items in a shrinking market.
Absent some form of joint-venture with another co-op, this
requires increasing volume, which further exacerbates the
competitive dilemma.

Vested interests among local board members is reflected
in their hesitancy to relinquish 99npp9l. Even though a
local board position has little direct remuneration, these

members are able to influence the investment, patronage,

 

3Mojdeh Hojjati found exactly the same barrier to the
consolidation of cooperative apple-packing stations in
Norway.

and
ind
the
inc
the

boa

f2

193
and equity redemption policies of their cooperative, which
indirectly affects their wealth. One might also argue that
they receive a certain amount of prestige or "psychic
income" from being a board member. As we shall soon see,
these interests appear to be more substantial for regional

board members.

B. A.Regional View

The understanding of regional respondents concerning
factors that impede horizontal coordination is consonant
with that of their local counterparts. The first key
problem is the practice of malpipl9_n9npap§nip.‘ Each
local and regional cooperative reacts to economic necessity
by striving to capture 100 percent of the same patron's
business. Consequently, these firms view each other as
their biggest competitors. Regionals attribute the panpa
of multiple membership to the low entry requirements of
cooperatives.

Despite the fact that members allow their competitive
ideology to dominate their behavior and influence the
practices of their cooperatives, this ideology is applied
inconsistently. One respondent highlighted the fickleness
of members--they wear two hats depending on their economic

circumstances. On the one hand, they wear a "customer hat"

 

4This practice is attributed to the competitive
ideology of farmers, as discussed in the preceding section.

in

of f
The
1191
re:
di

th

011

be

her.

194
in which they (erroneously) believe they are always better
off by instigating competition among their cooperatives.
They allow short-run gains to take precedence over long-
term performance. In 1980, for example, members of this
regional would not have approved a merger because the firm
did not appear to be in serious financial difficulty. On
the other hand, when financial hardships surface, members
quickly switch to their "owner hat." When their equity
investments are in jeopardy, they begin to discuss options
for interregional cooperation. In the words of one

respondent:

It has taken the failure of Agri Industries,
Farmarco, Illinois Grain Corporation, and the
near collapse of the Farm Credit Service to
enlighten them to the reality that the
cooperative system is in trouble. But when
the regionals are on their feet again, these
members will once again don their customer
hats.

It is interesting to note that this empirical
observation is related to a deduction in cooperative
theory. In his expanded review of co-op theory, Staatz
comments that the theoretical literature argues that
reaching an optimum in a co-op with respect to pricing and
output levels involves striking a balance between customer
benefits (as measured by consumer surplus) and owner

benefits (as measured by producer surplus).

yestgg_1ntg:§§t§ of regional management and board

me:
ho

ho

pr

be

of
EX‘

S/k
IDOL

195
members are another serious impediment to improved
horizontal coordination. Respondents pointed out that the
board's decision to reject or accept a reorganization
proposal is not a simple process. Some directors may favor
a merger, others will not. Clearly tradeoffs and
bargaining are involved. All perceive some benefits, but
some perceive a large ”collective" benefit relative to
their own potential loss, whereas others perceive the near
opposite.

There are three components to this gain/loss analysis
that are in the decision set of board members: (1) their
personal gain or loss: (2) the gain or loss of their
immediate constituency; and (3) the gain or loss to the
cooperative system. The weight they attach to these
components relative to other board members determines the
outcome of the group's decision. Personal stakes for
regional directors are considerably higher than for their
local counterparts. Not only do these directors have
opportunities to influence their well-being through the
control mechanism, they are also paid handsomely for
services rendered.5 Furthermore, because they are

representing local firms and not farmers directly, one

 

5Board members of regional firms earn in the vicinity
of $30,000 per annum in addition to per diem and travel
expenses. Actual time spent in board meetings is measured
in hours per month. However, depending on how seriously
s/he takes the job, a board member may spend several days a
month preparing for board meetings.

196
would anticipate that member pressure would be less severe
than for a local board. Hence, the benefits from oontrol
plus remuneration on the one hand, in addition to less
stringent demenoe from members on the other, could suggest
a disproportionate emphasis on ”personal gain." Simply
stated, regional board members have more incentive to
protect their vested interests than do directors of local
firms.

But by no means is this the end of the process. Even
if the board and the members agree in principle to merge or
consolidate, the major stumbling block still remains--
haggling over the dietriootion of gains and losses.
Negotiating issues range from the trivial to the
consequential.6 Board members or managers who may have
approved the collective action "in principle" can still use
the negotiating table to impede or eliminate altogether the
possibility of its immediate inception. To illustrate, it
is not unusual for intransigence over the firm's name to
cause the complete collapse of negotiations. Hence, absent
some outside force like financial duress or direct and
implacable pressure from members, a merger or consolidation

is unlikely to materialize. Recognizing this, some local

 

6Examples of negotiating issues are the name of the
new organization, its location, values of assets prior to
consolidation, size of the board of directors, a
determination of which directors will be moved immediately
to the newly reorganized firm versus those that must stand
for election, and who the CEO will be of the new
organization.

197
firms have instituted “area management councils." These are
coalitions of ten to thirty area managers who use this
council to address issues of concern. Typically these
councils are comprised of locals who are members of
competing regionals. This is because a major motivation
for their inception was the restructuring of their regional
firms. By speaking with one voice through this council (as
they have done), local cooperatives are able to exert
considerable pressure on regional decisionmakers.

Basically, the formation of these councils suggests
that members have little faith that they can assure good
performance of the co-op through the board. This is a
serious indictment of the co-op system and implies that
consolidation may need to be linked to better monitoring
and member-control mechanisms within the co-op.

Ironically, consolidation may lead to a "competitive
yardstick" problem just like the one that gave rise to co-
ops in the first place. Farmers may feel the need for some
competing firm (IOF or cooperative) to act as a competitive
yardstick to measure the performance of a large,

consolidated cooperative.

7.12 A.Noncooperative Game Analysis
This section examines the cooperative issues mentioned

above within the context of a prisoner's dilemma

198

supergame.7 This approach is particularly useful for
analyzing the behavior of members with their cooperative.
Unlike the patron of an IOF, a cooperative patron is also a
part owner of the firm and therefore may be more concerned
about preserving a long-term relationship. Thus,
opportunistic behavior by a member in one period may have
adverse consequences in the next. In spite of the "soft
hearted" reputation of farmers, it is not beyond
cooperatives to punish recalcitrant members.8

Staatz discusses situations where a supergame will
itself become a prisoner's dilemma. Three of these
situations were presented mathematically in chapter 5 and
are particularly germane to this analysis: (1) A supergame
will be a prisoner's dilemma if players fail to onnieh
those who defect or otherwise act disloyally in subsequent
iterations of the game: (2) Even if there is punishment, a

supergame is still a prisoner's dilemma if members have

 

7Recall that if a single-period "constituent” game is
infinitely iterated, this becomes a supergame in which the
payoffs are the net present values of the stream of payoffs
from the constituent games (Staatz, 1987b, p. 130).

3A general manager related an incident where his
cooperative had signed an acreage contract with a
processing firm. Under this agreement farmers were
obligated to deliver the total production from the
contracted acreage. A few farmers acted dishonestly by
selling part of their crop to another firm. When area
farmers learned of this behavior, they expelled these
individuals from their co-op and made it difficult for them
to become members of neighboring associations. This made it
very clear that reputations do matter in a cooperative
context.

199
sufficiently high discount rates. This is because a gain
from defection in the present period may exceed the
discounted value of the punishments in the subsequent
periods; and (3) The higher the return is for defection
relative to cooperation in the constituent game, the more
likely the supergame will be a prisoner's dilemma (1987b,
p. 130).

As mentioned above, the interviews uncovered three
socio-economic conditions that influence the behavior of
cooperative participants: eoononio neoeeeity, igeoiogy, and
yesteo intereete. Depending on how one conceptualizes who
the players are in the game, one could argue that these
conditions could represent either a prisoner's dilemma
supergame or a cooperative game. To a certain extent, the
different players correspond to the three above causes of
competition. In light of this, economic necessity is
examined within the context of a supergame, in which the
players are viewed as individual cooperatives (thereby
ignoring the divergent interests within each cooperative).
Ideology and vested interests are then evaluated in a
cooperative game analysis where the players are viewed as

individuals within their respective organizations.

it__£oonomio_neoeeeity. As the number of patron-owners

(farmers or local co-ops) continues to decline and the

average firm size increases, the economic significance of

200
each member becomes greater. These larger, fewer, and more
profitable accounts motivate cooperatives to compete
aggressively. Because any single member has a greater
impact on a co-op's financial welfare, its long-term
stability is now more precarious. Each cooperative seeks
to stabilize its market position by trying to secure 100
percent of the patron's business.9 Moreover, even though
cooperatives could gain more through collaboration, if they
view reorganization as an imminent development, they are
still motivated to strengthen their own position relative
to others orior_to the reorganization. Economic strength
determines a firm's ability to extract concessions and

obtain favorable outcomes in the negotiating process.

2t__1deoiooy. The pervasive belief among farmers that
competition is desirable, even in the context of their own
cooperatives, indicates a fundamental ieok_or_treet.
Patron-owners fear that by remaining perfectly loyal,
management will grow complacent, which will deleteriously
affect their own performance. Similarly, if area co-ops
join together to form a single organization, members are
concerned that, absent competition, which is a prime
guarantor of performance, this new firm will become less

reliable. In short, members are concerned that

 

9Recall that patron-owners are typically members of
more than one cooperative.

201
reorganization could lead to the same competitive yardstick

problems that gave rise to cooperatives in the first place.

Within a cooperative game analysis, players perceive,
because of their ideology, that the payoffs to them would
be lower both in the short-run and in the long-run if the
co-ops collaborated. Because the reorganization has
eliminated competition, there is no effective mechanism
(including the board of directors) to ensure that the
consolidated firm will perform well. As a consequence,

members block the ”grand coalition" from forming.

§t__yeeteo_1ntereete. It is important to distinguish

between "communal” and ”personal" vested interests. Both
are significant forces that potentially affect cooperative
horizontal coordination. commune; interests are more
relevant for local cooperatives and are addressed first.
Consider a situation where two or more locals residing
in different towns are confronted with the prospect of a
merger or consolidation. Assume that by restructuring
their firms, a synergy is achieved. Further, because the
co-ops are located in different towns, one must be
eliminated. A likely impact of a closure is that small
members would suffer more than their large counterparts.
Large patrons could gain from any size economies that were

produced by the reorganization. Respondents noted that

202
small producers generally rely on off-farm income to
maintain operations and to satisfy basic living needs. In
situations where the co-op is the most important source of
employment in a small town, the livelihood of many families
would be jeopardized in the event the firm is closed.
Hence, since they stand to lose more from the
reorganization, they oppose it.

In cooperative game terminology, the formation of a
grand coalition would mean that the slice of the new pie to
these members is smaller than their old slice. Also recall
that because of the one-member, one-vote principle, the
likelihood of small producers preventing the coalition from
forming is high.

Eereonei vested interests of managers and board members
are now discussed. Managers clearly face strong incentives
to oppose a merge or consolidation. Since managers earn
their income directly from the cooperative, their welfare
is jeopardized if a reorganization occurs. Their most
feasible options are: (a) try to become the manager of the
newly organized firm, or (b) find employment with another
cooperative. The expected value of either scenario would
certainly be disheartening in contrast to the value of
current welfare. Furthermore, the positive outcome of
either (a) or (b) becomes more uncertain as the number of
total cooperatives declines or if they are managers of

poorly performing firms.

203

Since remuneration is minimal for a local board member,
benefits are largely relegated to exeroieing_oontrol.
Directors can use their position to legislate policy that
is consonant with their own goals and objectives. The most
tangible benefits could accrue in the areas of patronage
refunds and equity redemption programs. One might
anticipate that board members of highly leveraged co-ops
are less inclined to support a merger than are members of
well positioned firms.10 In the negotiating process,
issues like the number of board members and other
cooperative personnel to be transferred from each
organization will likely tilt in favor of the stronger
firm.

In contrast to their counterparts, regional directors
of either healthy or impaired co-ops have greater
incentives to resist a reorganization. These members
receive substantial remuneration in addition to the
benefits that emanate from control. One might argue that,
because of this cash income, regional directors attach a
higher weight to their oereonei interests at the expense of

the cooperative and the larger system.11 By blocking a

 

10This may depend on how financially impaired the
weaker co-op is. If board members of that co-op have
substantial equity invested in the firm and if the options
are bankruptcy or merger, the board will likely embrace the
merger.

11This was strongly affirmed by both regional and
local respondents. General managers in particular
acknowledged that a regional directorship is a highly

204
reorganization, these directors preserve their remuneration
and their control. In a cooperative game analysis, players
(management and board of directors) see themselves being
worse off under a "grand coalition" (a merger or
consolidation) than in the previous situation, so they
block the new coalition from forming. If they do let it
form, one could conjecture that they will make sure they
are compensated for their loss of position and income.
This aspect will be discussed in the next section.

Another important element is that board members'
"payoff" is affected not just by actual benefits received
but also by the concessions their constituency can extract
from them.12 Because regional directors are more removed
from their members (i.e., they represent local firms
directly and farmers indirectly), they are likely to
encounter less pressure and therefore be more at liberty to
pursue personal concerns.

A recent development is changing this environment
considerably for both managers and board members of
regional firms. In their frustration over the performance
of the regionals, as well as the foot-dragging over

reorganization, local managers have formed "area manager

 

lucrative and desirable post and, that once elected,
directors have every incentive to maintain their position.

121f a director's constituency is comprised of an
aggressive membership, and their interests are at odds with
the director (e.g, patronage or equity redemption issues),
then his or her welfare could be affected adversely.

205
councils." By forming a coalition of twenty or more co-ops,
some of which are super-locals, this council is able to
exert considerable pressure on regional firms. If the
management and board choose to ignore the demands of the
council, they risk defection by this group, which could
significantly impair the regional firm as well as the
security of their own positions. Simply put, these
managers have raised the stakes in the benefit and cost
consideration of the opposing players. Even though the
benefits remain the same, the ooete associated with non-
compliance on the part of the board and management are now

considerable and could be prohibitive.

7.2 Horizontal Coordinating Mechanisms: Destabilizing
Forces

7.21 Introduction13

In the past, the major impetus for cooperatives to
reorganize was financial difficulty. Berry found that many
associations that elected to reorganize did so only after
all other alternatives were exhausted. Garoian and Cramer
conducted a case study of ten cooperative reorganizations
that occurred between 1956 and 1960. In nearly every case
the reorganizations were initiated by undercapitalized
cooperatives experiencing operational difficulties. All of

the firms were motivated to improve efficiencies by

 

13This section is a partial synthesis of Taitt's
review of the literature on cooperative reorganization studies.

206

achieving economies of size. The authors found that most
of these firms were more profitable before reorganization
than afterwards. Five to twelve years after the
reorganization had occurred, only three out of ten had
increased their profitability (measured as net earnings per
dollar of sales) above their pre-reorganization levels.

Haskell found similar results in a case study of four
local cooperatives that reorganized between 1964 and 1966.
Each reorganization involved a stronger firm merging with a
financially weaker firm. One to three years after
reorganization, all surviving cooperatives experienced a
reduction in profitability. A study by Swanson (1975)
compared the performance of 52 cooperative mergers, nine
acquisitions and four consolidations before and after
reorganization. The survivors of the mergers experienced
greater sales volume but a decrease in profitability and no
change in their leverage position one to three years after
reorganization. Results were similar for firms involved in
consolidations. Taitt analyzed the pre- and post-
reorganization performance of local farm supply, grain, and
petroleum cooperatives in Minnesota between 1979 and 1985.
Her results indicate that improved financial performance
was not achieved in the short run (one to three years)
after reorganization. Specifically, of the four

performance measures used, none was statistically

207
significant.14 A limitation of the these studies is their
inability to account for what would have happened in the
eteenoe of the reorganization. First of all, reorganizing
allowed these firms to continue to provide customer
services that may not have been available otherwise.
Secondly, conclusions on performance should be treated with
reservation because measurements were carried out in two
different environments and in two different points of time.
It is very difficult to say ex_ooet that performance of
reorganized firms is inadequate. However, in spite of
these limitations, there is general recognition that the
performance of reorganized cooperatives oonig in fact be
improved. Failure of these firms to dispose of redundant
assets once the reorganization has taken place is viewed as
a major cause of this poor performance. At issue now is
why? The following section addresses these questions by
identifying possible rationales for cooperative participant

behavior.

7.22 Incentives and Participant Behavior
Earlier it was noted that three major forms of
horizontal coordination undertaken by cooperatives are

joint-ventures, mergers and consolidations. Nearly all

 

14Performance measures were: (1) liquidity--acid test
ratio; (2) efficiency--salaries/sales ratio: (3) solvency--
total liability/local assets ratio: and (4) profitability--
local net margins/sales ratio.

208

respondents had some experience with one or more of these
coordinating mechanisms. Host agreed that newly
restructured firms frequently face obstacles that prevent
higher levels of performance. These obstacles fall under
the general classification of vested interests.

gonnnnei vested interests affect the performance of
restructured firms. Asset disposal is one of the most
contentious cooperative issues today, especially among
local firms. A regional cooperative may face resistance
terminating an entire business line but should face less
resistance disposing of redundant assets within that
business. Indeed, all three case study regionals have been
aggressively disposing of redundant assets in efforts to
ameliorate their debt/asset ratio. Davidson and Royer
(1987) note that this ratio improved 6.4 percent between
1982 and 1985 for the 100 largest cooperatives. A local
cooperative, however, faces a different environment. The
manager and board are accountable to specific interest
groups that have incentives to influence outcomes when
their welfare is threatened. In other words, actions taken
by a local manager or board members gireotiy affect the
welfare of the owners, whereas actions from their regional
counterparts are more removed. One general manager who has
participated in eight different mergers claims that in each
instance serious problems arose over elimination of assets

or services. In a few cases various groups became

209

deadlocked and were unable to agree on a liquidation
procedure. Three of these firms eventually went bankrupt.

Eereonei vested interests are a second class of
impediments to reorganized firms. Managers have vested
interests in maintaining the performance of their own firm.
To illustrate, consider a joint-venture between two
cooperatives. Respondents assert that parent organizations
may not infuse adequate capital into the new venture to
give the firm time to "get on its feet." Each organization
is concerned about the liquidity of its own firm and so
provides the minimum equity necessary to meet the joint-
venture's immegiete needs only. This is because the board
of directors of the joint-venture is composed of the
managers of the parent organizations. But these managers
are still accountable to the directors of their oxn firms.
This means that the performance of the parent organizations
is not directly linked to the performance of the joint-
venture. Rather than seek to minimize the enm_or_tne_ooete
of all three firms, each firm minimizes its own individual
costs. As a consequence, managers have incentives to
influence policies that are most favorable to themselves
and their cooperative, at the expense of the other firms.
Also, if parent firms have not invested equally in the
joint-venture, those with more invested may use this as a
fulcrum to extract additional benefits.

Failure to internalize the activities of cooperating

210
firms significantly undermines their potential performance.
Local managers related how some regionals had formed a
joint-venture agronomy division. The joint-venture was
established to carry out agronomic services like field
scouting for pests, pesticide recommendations and
application. Unfortunately, the regionals each maintain
their own agronomy programs and compete for the same
business. Structurally the firms cooperate but they still
remain operationally independent. Even the employees of
the joint venture are segregated according to their
regional affiliation.

Other local managers related how lack of cooperation is
often found within the same firm (intra-firm rivalry). The
above joint-venture has implemented a farm input
information system. The problem is that each division
within the joint venture has its ogn networking system that
includes both hardware and software. All three divisions
have attempted to sell their own non-compatible systems to
locals. In other words, there is no centralized control to
coordinate activities across divisions. These managers
believe that the joint-venture may have created more
inefficiencies than it originally started with.

In summary, there are three interrelated conditions
that mitigate the performance of some cooperatives engaged

in joint-ventures. First, the two parent organizations and

the joint-venture firm maintain eeoerete profit oentere.

211
Second, the original purpose of the joint-venture (reducing
the final costs of producing and delivering a product or
service to customers) never fully materializes if parent
organizations maintain gnoiioete functions and services.
This may be due to a fundamental lack of trust among
cooperatives or from pressure from owners or employees who
resist eliminating these activities. Third, the
pertormenoe inoentiye of each firm's manager predisposes
him or her to compete. Failure to perform adequately could
result in retribution by the owners. Hence, the confluence
of these three elements diminishes the performance levels
of each individual firm and the potential synergy from
cooperation.

Inefficiencies that result from a merger or
consolidation appear to be the result of two related
conditions. First, partners fail to establish explicitly
the terms of the venture prior to the reorganization. A
second problem is that participating firms fail to
institute a binfiing_egreement that is enforceable in a
court of law. Absent this commitment, even if firms had
agreed ex ante, there may be new incentives that may or may
not have been previously considered to behave
opportunistically in this new environment.

Both of these conditions could well be due to the
effect of vested interests of certain individuals. From a

cooperative game perspective, if certain members in

212
positions of power were unable to oreyent the grand
coalition from forming, they may have been able to obtain
compensation for their loss in position and income. This
explains why many of the potential benefits of the merger
or consolidation never materialize. Indeed, if these
individuals are sufficiently powerful, they may ensure that
they are overcompensated, leaving no net benefits to the

reorganized firm.15

7.3 Chapter Summary

This chapter examines the competitive behavior that
pervades the cooperative horizontal system. The two
questions of interest are: ”Why isn't there more
cooperation among cooperatives, especially when benefits
appear so significant?” What are the underlying forces
that may explain this behavior? Three reasons were
identified and analyzed using a prisoner's dilemma
supergame, and a cooperative game: economic necessity,
ideology, and vested interests.

Economic necessity is attributed to the continuing

phenomenon of fewer and larger patron-owners, each of whom

 

15One regional respondent commented that most senior
management and board members (of a regional) should have
little to fear from reorganization because, one way or
another, the co-op will take care of them. If this
statement is in fact true, it lends credence to the
preceding argument.

213
has a growing capacity to adversely affect their
cooperative. This is complicated by the fact that patron-
owners are members of more than one cooperative.
Therefore, each firm has a strong incentive to secure as
much of the patron's business as possible. This is
accomplished through head-to-head competition with other
cooperatives. Secondly, if a cooperative believes that a
merger or consolidation is imminent, it is in their
interest to strengthen their own position relative to
others orior_to the reorganization. This behavior improves
a firm's bargaining position at the negotiating table.

If farmers truly adhere to an ideology that cooperative
competition is "good for the patrons,“ its basis must be a
fundamental lack of trust, even in their cooperative
association. The opposite of competition is cooperation.

A much repeated concern of farmers is that multiple
cooperatives restructuring into one firm for purposes of
achieving size economies or improving capacity utilization
could be offset by poor performance. By preventing the
coalition from forming, farmers perceive they are
maximizing both short- and long-run benefits.

Vested interests can be either communal or individual.
In terms of the former, if these cooperatives are important
sources of income, reorganization will likely threaten the
welfare of at least one of the participating communities.

Communities with relatively poorer performing co-ops will

214
tend to resist a merger more than communities with a
financially sound cooperative. Personal vested interests
are most pronounced for managers of local firms and board
members of regional cooperatives. These individuals
receive (at least) a major source of their income through
the cooperative. As a consequence, they have a strong
incentive to resist a reorganization attempt. Another
factor that influences a director's incentive to resist a
reorganization is the pressure exerted on them by his or
her constituency. Because local board members represent
farmers directly, they have less capacity to allow personal
interests to supercede those of the members. Conversely,
regional directors are more removed from farmers and so
will have more incentive to allow personal interests to

take precedence over constituency interests.

The final section addresses the question of why
reorganized firms often perform below expectations. Three
reasons are identified in the case of joint-ventures.
First, both the parent organizations and the joint-venture
maintain separate profit centers. A financial linkage is
not established among the participating firms. Second (and
because of the first), managers of these respective firms
have incentive to improve their own firms' performance at
the expense of their partners. Third, perhaps because of a

lack of trust or because of pressure from owners and

215
employees, parent organizations often maintain the
operations that the joint venture was intended to replace.
Hence, the confluence of these three elements detracts from
the performance capacities of each individual firm and the

potential synergy from cooperation.

CHAPTER 8

OONCEUSIONS AND RECOMMENDATIONS

8.1 Purpose of Study and Approach

In a very real sense, the underlying purpose of this
study has been an exploratory mission. Many or most of the
problems facing farm supply cooperatives today have already
been identified in previous studies. This research
contributed little in this regard. The emphasis has rather
been to come to a better understanding of why many of the
cooperative coordination problems persist. To illuminate
these problems, cooperative coordination was viewed within
a systems context, which emphasizes that individual (micro)
decisions often have industry-wide (macro) consequences.
Further, two conceptual frameworks (game theory and
transaction cost economics) that are extremely useful for
analyzing the eonroee and ooneee of problems, were
employed.

The purpose of this chapter is to proceed one step
further by formulating conclusions and recommendations
based on the findings of the research. This is
accomplished by delineating cooperative coordination into
vertical and horizontal coordination issues. A discussion

of future research needs concludes the chapter.

216

217
8.2 vertical Coordination Issues
8.21 Callitlnnt
A. Major Findings

Commitment is expressed in terms of patronage and
equity investment. Case study respondents felt that
members tend to patronize their cooperative less frequently
now than they have in the past. In other words, ”shopping
around" is a more prevalent practice. Equity investment is
the other problem area for co-ops, but inadequate
investment is the fault of members only inasmuch as they
fail to patronize their cooperative. Other aspects are the
neoneniene employed by cooperatives to generate equity
capital (retained net earnings) in conjunction with the log
net_eerninge of many firms.

In the game-theoretic analysis, two classes of
disaffected members were analyzed: young versus old members
and large versus small members. There were two conditions
that affect the welfare of each group when they do business
with their co-op. The first is that each has a girrerent
get of neege. Young farmers are generally more highly
leveraged than their older counterparts and so have
periodic cash-flow problems. Their need for patronage
refunds is an over-riding concern. Older members, on the
other hand, are generally more solvent but, because they
are nearing retirement, their concern is more focused on

redeeming equities and the propitious settling of estates

218
in the event of death.

Large members have a different set of needs from small
members. Those large producers who obtain most of their
livelihood on the farm are interested in ways to etetiiize
their_inoone. Secondly, depending on how the co-op pools
its costs, the large producer may in some sense be
subsidizing higher-cost small producers (see below). To
the extent this is true, large producers are being
overcharged for doing business with the cooperative.

This problem of cross-subsidies and the desire by some
groups to institute differential pricing has been and will
undoubtedly continue to be an area of contention among
cooperative membership. Faulbauer addresses the cross-
subsidy issue in relation to public utilities. He states
that a set of prices are eoteigyerree if they provide no
group with the incentive to break away from the joint
utility and establish its own system. Within a cooperative
context, cross-subsidies exist if a particular group pays
more for a product or service than they would if they could
obtain it cheaper by purchasing elsewhere, or by forming
their own group (Staatz, 1984, p. 238). This is precisely
the charge made by large producers and they use it as an
argument to institute differential pricing.

Differential pricing introduces another dilemma for
cooperatives and it involves distinguishing between two

types of costs: (1) the direct attributable costs of

219
serving a particular type of client, and (2) the
attribution of indirect fixed costs like plant and
equipment. Schmid notes that any firm with a certain
capacity and high fixed costs (relative to total costs)
will have incentive to charge different prices to different
groups of consumers in order to expand capacity. The
problem of differential pricing is how to distinguish
between the intramarginal and extramarginal producer. The

crux of the problem is illuminated by Schmid:

Where marginal costs are falling, every
consumer wants to be the last one on the
plane or into the theater or hotel to pay
only the marginal cost while the
intramarginal consumers pay the fixed costs
among themselves. But it is the system of
property rights that determines who is the
likely marginal consumer. From a profit
standpoint, the producer may be indifferent
toward young or old, black or white, and will
charge among them on the basis of
administrative convenience. But if the
producer accommodates another of his tastes
(we often call them prejudices), the
situation is ripe for discrimination (Schmid,
1987).

Under current rules of competition, those with more
market options can capture more benefits. This begs the
question of whether we need economy-wide rules to enforce
different distributive rules? In their absence, the
incentive for cooperatives to differentiate prices is
largely determined by what their competitors (IOFs) do and

how this ultimately influences member behavior.

220

The eoiiity_to_exeroiee_oontroi is the other concern of
these two classes of disaffected members. Many
cooperatives have board of directors that are dominated by
older members. This can have two effects. First, one can
assume that legislated policy will tend to favor the
dominant group. Second, younger members will never feel as
much a "part of the co-op" if their voice is not heard
adequately. This has implications for the type of ideology
(loyalty vs. disloyalty) that the member develops. Having
a sense of belonging may increase members' ideological
commitment to the co-op and hence the perceptions of the
benefits derived from it.

Large members are confronted with a similar situation,
in which many of their needs are not met because of the
voting superiority of the smaller members. Even large,
loyal members may become disenchanted with the co-op if

this treatment persists.

B. Conclusions and Recommendations

A growing number of disaffected members is indicative
of some fundamental problems facing farm supply
cooperatives. These problems are of two types: (1)
Unacceptable performance of many cooperatives and difficult
times in agriculture have brought to the fore a previously
dormant competitive ideology among cooperative members.

(2) Failure to reconcile a divergence in membership needs

221
and the growing market alternatives available to many
members is lowering the "loyalty tolerance" of patron-
owners to their cooperative. In the event these problems
are not addressed satisfactorily, cooperatives can expect
this erosion of member commitment to continue and
eooeierete as their performance declines. In light of

this, the following recommendations are made:

1) MW. Equity

investment according to use is not effectively implemented.

There are too many under- or over-invested members, which

may discourage patronage by both new and existing entrants.

In other words, because cooperatives use retained patronage

refunds as a major source of equity, failure to redeem them

in a timely fashion could discourage future investments.

Regionals need to adopt an effective program, like a base

capital plan, that will better align investment with use of

the co-op (proportionality).

Secondly, regional firms especially should implement
some form of direct, front-end investment based on
proportionality. It is an accepted tenet among many
cooperative participants that member loyalty is positively
correlated with their level of investment. Direct
investments will benefit the cooperative in two other
related ways: (a) by improving the firm's balance sheet,

and (b) by raising the "entrance fee," members will be

222
discouraged from the practice of joining more than one
cooperative. One would anticipate, however, that
instituting direct investments could be difficult to
implement. While it may be in the interest of all
cooperatives to do this, each association faces individual
incentives to keep up-front fees low in order to attract
new members. Absent a merger or consolidation, instituting
direct investments may not be feasible. However, part of
the solution lies in the perceptions of the benefits that
could be derived from this practice. If the perceived
payoff is sufficiently large, it may not be too difficult
for regionei firms to agree on a uniform fee because of the
small numbers involved. This type of cooperation at the
local level where numerous firms are included could make
success more problematic.

Third, regional and local firms need a more reliable
mechanism for generating equity capital like per-unit
capital retains that are used by marketing co-ops. By
removing a fixed margin from each unit sold (unit tax),
proportionality would also be guaranteed. Implementing
this method may necessitate a reduction in net margins but,
if it stabilizes the flow of equity capital and enhances
the co-ops ability to revolve equity, this practice could
improve the long-run performance of the association.

Finally, regionals that have greater capital

requirements than local firms, may be motivated to

223
complement these mechanisms with alternative options for
generating capital, such as creating subsidiaries and
selling tradable stock. An ongoing concern, however, is
the extent to which this practice could compromise the
principles that distinguish cooperatives from investor-
owned firms. Cooperative decision makers should use this
mechanism with caution recognizing that generating capital
from within the system is still the mainstay for the

cooperative institution.

 

Cobia, et al. found that nearly one-third of sample
cooperatives had no equity redemption program whatsoever
and that 39 percent did not have a systematic program (p.
4). These findings were consistent with cooperatives
interviewed in this study. The important point is that
unfair redemption practices are undermining the credibility
of cooperatives. A viable equity investment program is
wholly contingent on an attractive equity redemption
program, at both the regional and local levels. Members
will be encouraged to invest in their association if their

investment is returned to them at a reasonable future date.

3.)

 

mentore. Cooperatives need to confront directly the large-

member issue before it is too late (prior to defection).

224
This involves addressing differential pricing and voting
policies that take into account a member's patronage and
investment (i.e., his or her economic worth to the

association).

4,) u- ;,u ,; .., ; . , . ; .,,. ,,. . ,- . 9 ‘; .,;.
membere. Many older members exhibit strong loyalty traits
to their cooperative because they participated in its
formation. This facilitates a member's identification with
his or her co-op. Some general managers have recognized
this problem and are using young members to devise programs
that will encourage participation from disaffected members.
This practice should be examined in greater detail with
efforts to enhance its potential for inculcating
cooperative loyalty to members. Regional firms in
particular should take a leadership role in program

development.

8.22 The Forward Contract Mechanism
A. Major Findings

Forward contracting for inputs is largely limited to
those exhibiting general purpose or moderately specialized
characteristics. Asset-specific inputs and their
implications for forward contracting will be discussed in
the following section.

Benefits of forward contracting are apparent at each of

225
the four major economic stages of the input system.
Manufacturers are better able to achieve their goal of cost
minimization by covering fixed costs and smoothing out
production runs. Wholesalers and retailers benefit through
enhanced logistical coordination. Forward contracting
facilitates the quick and efficient movement of supplies by
utilizing cost effective transportation methods. Secondly,
it affords the strategic positioning of supplies in the
event a crop season begins early. Finally, forward
contracting reduces price risk when distributors "blend"
contract supplies with spot purchases. Farmers benefit
directly from forward contracting through a more
efficiently run cooperative system that should lead to
lower prices: indirectly they gain through a better
performing firm that has more capacity of ensuring the
safety of member investments. Currently the major
incentive for farmers to forward contract for fertilizer
lies in the low price and discount premium. This
incentive, however, may be different for inputs with more
asset-specific characteristics. Also, if conjectures by
some industry leaders are correct that farmer margins will
continue to narrow,1 then forward contracting as a risk

management tool could increase in importance.

 

1Most case study respondents believe this phenomenon
is occurring. Additional opinions asserting this view were
found in the literature search (Hopkin and Associates;
Goldberg), although this study has no empirical evidence to
support the contention.

226

There are obstacles to forward contracting as well.
The two most significant impediments are output and input
price risk and problems associated with contract
enforcement. Apparently, there is great deal of latitude
in how these contracts are enforced. In spite of this
assertion, it is interesting to note that both regional and
local respondents stated that contract oomoiienoe was not a

problem with members who participated.

B. Conclusions and Recommendations

A number of conclusions surface with regard to forward
contracting as a mechanism for exchange and the cooperative
institution. First, because of the ownership relation
between customer and firm, cooperatives could possibly
implement this mechanism at less cost and risk than their
IOF counterparts. In other words, because members are also
owners, they should be less inclined to act
opportunistically against their cooperative. This implies
that the transaction costs associated with drafting,
enforcing, and monitoring the contracts would be less for
cooperative firms.

A second point is that, from a systems perspective,
farmers remain the critical link to forward contracting,
but they only imperfectly utilize it. Part of this is
explained by farmers' perceptions of the mechanism itself.

An over-riding concern of onoerteinty, especially from

227
weather, government or the demand patterns of consumers is
a major source of reluctance to forward commit. Indeed, if
weather or the government were the only source of
uncertainty, there would be little that could be done to
improve the situation apart from developing disease
resistance strains and improving our weather forecasting
abilities. It is important to recognize that the food
eyeten is comprised of an input and an output component,
and that decisions at one end of the system will eventually
reverberate back to the other. For farmers, many of the
decisions by consumers constitutes a formidable
uncertainty. Hence, locking into a rigid contract is
considered a risky endeavor since this limits one's ability
to respond to future events. Another important element is
that, due to the benefit and cost relationship of large
versus small purchases, forward contracts are designed more
for large farmers. But large farmers often constitute the
majority of sales for local firms. From a local
perspective, it makes sense to concentrate on implementing
attractive and efficacious contracts with this class of
members since per-unit costs would be low relative to other
members. One might conclude that there are sound economic
reasons why forward contracting is only "imperfectly
implemented”--because it is best suited for large patrons
and not worth the time of others.

A third conclusion is that it is probably undesirable

228
for a regional manufacturer to implement forward
contracting on a comprehensive scale. These firms may have
a goal of cost-minimization, but they also have a need for
sizable net margins to improve their equity capital
position. By forward contracting only enough to cover
fixed costs, manufacturers reduce production risks but, at
the same time, increase their net margins if spot prices
rise at the advent of the planting season.2 It is
therefore plausible that manufacturers have substantial
incentive to restrict the application of the forward
contract mechanism. A fourth conclusion is that forward
contracting by_fiernere for asset-specific agricultural
inputs is undesirable. This is not surprising even though
it eoneere to contradict a major premise of transaction
cost economics. In fact it does not. Because of the
presence of use-risk, the end-user needs as much operating
flexibility as possible. Spot purchases afford this
flexibility. Farmers neye instituted specialized
arrangements for asset-specific inputs and they have
implemented it through their cooperative. This is because
use-risk is most acute at the farmer-level. This
constraint is relaxed as one moves up the vertical system.

As a consequence, it makes a great deal of sense for the

 

2With the fertilizer data examined in this study,
prices rose in five out of six years between November and
March. In one of these years prices nearly doubled the
previous three years. In this situation, the price increase
more than offsets the cost of storage for this period.

229
input to be strategically positioned higher in the system
where it can be moved readily "as needed."

Since respondents generally agreed that forward
contracting for inputs offers appreciable net benefits to
all participants in the system, cooperatives should examine
this mechanism in greater detail and determine how it might
be optimally employed. Current application is not really
geared towards a systems approach, where it is uniformly
implemented through the system. Co-ops need to target (if
they have not already done so) the group best suited for
this mechanism (large members) and then institute it
systematically and uniformly throughout the system. Given
that cooperatives ney be able to implement forward
contracting at less cost than IOFs, this should be an
additional incentive to endorse a comprehensive evaluation

of the mechanism for farm inputs.

8.22 Farm Inputs and Asset-Specificity
A. Major Findings

Agricultural inputs are becoming increasingly
specialized and this is complicating the coordination
process from the manufacturer down to the final end-user
(the farmer). The major cause of the problem is
diminishing fungibility in terms of (a) the substitute uses
of the input, (b) the input's use-period, and (c) the
input's geographic substitutability. The effect is a

230
growing segmentation of factor markets. Manufacturers must
make production decisions based on demand within each
differentiated market. Distributors face logistical
coordination problems—-knowing when, where, and how much of
each input to locate in the various markets. With asset-
specific inputs, the closer one gets to the end-user, the
greater the use-risk the individual faces. Farmers have
responded by shifting this risk upwards in the vertical
system. Local and regional co-ops have behaved similarly.
Farmers have acted rationally by shifting this risk and
accepting subsequent higher prices for these inputs. From
a coordination standpoint, this practice does raise system
costs. Given the alternative (substantial probability of
non-use), however, it appears to be sensible behavior.
This is justified in that redistribution opportunities
increase as one moves upward in the system. Hence, even
though farmers have transferred this risk elsewhere in the
system, this practice mitigates the effect of non-
substitutability by positioning the input where it has a
greater likelihood of being redeployed if an unforeseen

event materializes.

B. Conclusions and Recommendations
The cooperative system has responded well to the
effects of asset-specific inputs. Manufacturers and

regional cooperatives have developed formalized

231
arrangements for dealing with these inputs. Both
manufacturer and distributor have something to offer. The
manufacturer provides the specialized input and, since it
maintains ownership of the product, accepts the ultimate
risk of nonesse. This risk is compensated for through
higher factor prices. On the other hand, regional firms
face little risk (they share some of the safety risk in
handling the product), but they carry out a key economic
function by making the input available to the farmer.
Also, to ensure that logistical mistakes are minimized,
manufacturers and regional cooperatives exonenge market
information.

Farmers are making rational decisions by delaying their
purchases of asset-specific inputs. Even though this
behavior means higher prices because of more costly
distribution mechanisms (like the ”redball express” that
delivers a product within twenty-four hours), they minimize
the probability of non-use. Further, because of the
increasing precision required in the application of
specialized inputs and their greater safety risks, farmers
have responded by utilizing custom diagnostic and
application services. This is also a rational decision in
that "experts" who possess the technical expertise and who
have access to costly and specialized application equipment
are better qualified to carry out this increasingly complex
task. Finally, this behavior is consistent with

232
Williamson's hypothesis regarding asset-specific inputs--
that specialized exchange arrangements will supplant the
spot market as a preferred medium of exchange when
idiosyncratic investments are involved. Farmers have
instituted these specialized arrangements through the
regional cooperatives they own.

Even though farmers have adapted well to the effects of
specialized inputs, they have done so imperfectly.
Cooperative federations do not represent a "unified
coalition.” The potential gains that cooperatives could
obtain through market power are mitigated by uncommitted
behavior of members. In other words, disloyal members give
IOFs opportunities to undermine farmer cooperatives by
selling directly to members. This may be justified for the
class of patrons who are large enough to warrant this
circumvention practice. Indeed, it is recommended that
cooperatives participate actively as a ”facilitator" for
these members. But certainly ell disloyal members do not
fall within this category. Cooperatives must improve their
performance through more proficient management and higher
quality services to attract disaffected members back to the
fold. Depending on how the cooperative is managed, they
should be in a more consolidated position to bargain
effectively with highly concentrated input manufacturers.
In the end farmers could benefit from this cooperative

effort.

233

The second aspect is that many of the programs offered
by manufacturers are not passed on in a systemstio_fesnion.
Even though regional firms have access to special programs
like price protection and buy-back options, these are not
passed on to all local cooperatives. Similarly, local
firms have unsystematically administered these programs to
farmer members. Not only would a more comprehensive
application of these programs increase the regionals
bargaining position through greater sales, more farmers
would benefit through lower prices and actual use of the
program. By implementing these programs through the

cooperative institution, member loyalty could be enhanced.

8.3 Horizontal Coordination Issues

8.31 Pre-reorganization Impediments

Three factors have been identified as being the major
impediments to greater inter-cooperative cooperation:
economic necessity, vested interests of individuals in
positions of power, and the competitive ideology that
permeates the cooperative institution. In spite of these
hindrances, respondents affirmed strongly that more
cooperation through joint ventures and reorganization
through merger or consolidation is a necessity. The
problem is, how to achieve it? Two conclusions immediately

come to mind. The first is that the incentive to cooperate

234
should ideally be generated from within the system (i.e.,
not mandated). This will occur if (1) certain leaders
within the cooperative institution take it upon themselves
to initiate such a program or, (2) in the event they do
not, firms that continue to perform poorly will eventually
have no recourse but to consider reorganization. The
second conclusion is that some acceptable "independent”
arbitrator like a financial institution (e.g., the Bank of
Cooperatives) may be needed to facilitate the
reorganization. One would anticipate a certain degree of
resistance to an outside authority intervening in the
affairs of members: however, given the urgenoy of many
cooperatives to restructure and the obstacles that prevent
the restructuring, this option may not be unrealistic. For
recalcitrant firms that are experiencing financial duress,
the primary lending institution (which is probably the Bank
of Cooperatives) may have to provide some form of gentle
nudging. Simply put, the alternatives for many firms are
fast running out and some sort of positive action should be
implemented before its too late.

A third conclusion is that the resurgence of the
competitive ideology and the development of "area
management councils" suggest that reorganizing may need to
be linked to improved monitoring and member control
mechanisms to ensure an acceptable level of performance.

One possibility would be to utilize a committee analogous

235
to the area manager council in which locals, which have a
direct interest in regional performance, would monitor co-
op performance. A second alternative would be to adopt the
practice of some European cooperatives that attach a
subsidiary firm to their major businesses and where
tradable stock is available to the public. In this
situation, stock values would be a gauge for firm
performance, just as they are currently for IOFs.
Cooperatives need to be sensitive to the consequences of
this action (on the nature of the institution) and do so
only if another more feasible control mechanism cannot be

found.

8.32 Post-reorganization Impediments

Cooperative joint ventures, while a step in the right
direction, only imperfectly address the competitive
dilemma. This is due in part to the structural
relationships that exist not only between parent firms but
also between the parent firms and the joint venture. The
second reason is that as long as members belong to more
than one cooperative there will always be incentives for
each firm to try and capture 100 percent of the members'
business.

If co-ops continue to pursue joint ventures, then they
need to address both inter- and intra-firm competition.

Forming a joint venture for purposes of gaining certain

236
efficiencies makes little sense if participating firms end
up creating more inefficiencies in the process. To address
intra-firm competition (inter-divisional competition),
federated cooperatives should begin considering more
centralized decision control that coordinates functions and
activities across divisions. Similarly, inter-firm
competition could be ameliorated by instituting a
centralized decision making body that would be responsible
for eliminating competition in the areas (product lines)
circumscribed by the joint venture. This would necessitate
defining, in very succinct terms, the activities and
functions of each firm.

Perhaps the single greatest hindrance to reorganized
firms is the failure to dispose of redundant assets, ex
post. There are two reasons why this outcome might
materialize. First, in spite of a possible feasibility
study identifying the costs and benefits of reorganization,
the participating firms failed to agree, ex ante, on who
would dispose of what. Participating firms, for instance,
may be frustrated from the negotiating process and agree
only in principle to dispose of redundant assets. This is
an easy way out that may facilitate the restructuring but
do so at the expense of performance, ex_post. Second, even
if they did agree, they failed to institute a binding
commitment to ensure that disposal would occur. If both of

these are carried out, the reorganization could perform as

237
anticipated. Given the vested interests that are inherent
in these situations, it may be necessary to employ a third
party arbitrator, preferably one with a financial
background, to facilitate the implementation of the

restructuring.

8.4 Future Research

At this juncture it is helpful to consider what aspects
of the research are worth pursuing and developing in a more
complete fashion. At the beginning of this chapter it was
stated that this study is largely an exploratory effort in
which some hypotheses were tested and others formed. In
other words, a first step in research is to form some
credible hypotheses concerning the subject matter one is
studying. This necessitates implementing an analysis in
which breadth of understanding (obtained from a large
sample) is superseded by depth. A case-study approach is
useful in this regard. But because the sample is extremely
small, the generalizability of the research findings is
really unknown. In this sense, research findings from a
case study should be kept in perspective. A logical next
step is to take the "credible hypotheses” and subject them
to empirical testing through implementation of a broader-
based survey, perhaps utilizing a mail questionnaire. In
the case of this research, some of the findings and

conclusions under both vertical and horizontal dimensions

238
could use additional testing (i.e., those highlighted in
the sections above). More precise recommendations are now

discussed.

1. Hieroenioro_issnes. This research emphasized micro and

macro aspects to coordination, with little attention
directed at intra-firm problems. In spite of this, intra-
firm problems surfaced in the research process. One senior
manager of a regional firm noted that internal management
inefficiencies were as much a problem for cooperative
performance as were inter-firm problems. This became an
oft-repeated concern among regional and local respondents
alike. An entire research project could be undertaken on
micro-micro issues that affect cooperative firm

performance.

2- W. Early on in the

research some attention was given to the organizational
structure of cooperatives and the effect this has on
coordination and performance. There are tradeoffs involved
in each structural form depending on the particular
environment the firm is in. Currently, a combination of
forces is placing extreme pressure on multi-level
cooperative systems to reduce costs and strengthen
coordination and controls within the systems. This was

extremely apparent in this research. Recognizing their

239
problems, federated cooperatives have begun employing
mechanisms to increase control over product flow through
the system. But this is only a partial solution. The
critical structural issue facing federated cooperatives is
how to design the least-cost system for serving farmers'
needs. Centralization and decentralization lie at the
heart of these questions. For instance, circumvention is a
growing practice by large farmers and super-locals, and
there are good economic reasons to do so. Federated
cooperatives must face this issue recognizing that, if they
wish to keep the large member in the federation, the
cooperative system must develop mechanisms to deal with it
effectively. But within most current federated structures,
circumvention has a detrimental affect on the local or
regional firm that is by-passed. In a centralized system,
this effect would not be felt at the intermediate marketing
stages since ownership and control are from the top down.

Hence, these types of issues warrant further investigation.

3. WW:- This is an ilportant
activity of many cooperatives and IOF's and it should be

examined in greater detail. One need is to ascertain the
extent to which forward contracting for inputs is used
within the input industry and how and in what ways do the
terms of the contract differ.

In terms of the mean-variance model developed for this

240
research, it could also benefit from a few modifications.
First of all, it would be useful to obtain more extensive
contract data from various firms and for a longer time
period. This is necessary to achieve a better
understanding of the relationship between spot and forward
prices. Secondly, the model should be applied to different
inputs to determine how contract decisions differ across
inputs. Third, it would be useful to employ a production
function that exhibits some degree of diminishing returns
and evaluate the affect on the forward contract ratio and

an individual's risk preference function.

4. Exonenge_nrrengements. This study considered how the
nature of transactions change with the specificity of the

input. But the sample was small and most of the
respondents had incomplete knowledge regarding some of the
finer details of specialized inputs and the transactions
that attend them. An in-depth analysis should uncover some
interesting results. Findings from this research lay
credence to the growing importance and role of asset-
specific inputs in U.S. agriculture, but little information

is written on them. More research is needed in this area.

APPENDIX
Cooperative Questionnaire

For questions ending with an underline ( ), use the
following scale to show how much you agree or disagree
with the statements. Address all other statements as
indicated.

13 Strongly agree: 2= Agree: 3= Neutral: 4=
Disagree: 5- Strongly disagree

I-éNICRO ISSUES

1. Problem: Commitment and Vertical Coordination
11A1_£atr9nags_1§susa_

1. Farmer commitment to locals: Compared to 10 years ago,
farmers "shop around more" prior to buying inputs i.e.,
less loyal

2. If yes, who are their major (alternative) suppliers?
Classify generally--other co-op: IOF: etc.

3. Local commitment to regional: compared to 10 years ago,
locals also shop around more--less loyalty?

 

4. If yes, who are their major (alternative) suppliers?

WW "how much do you agree or
disagree

1. In the co-op system, equity levels are inadequate
because many P-Os are underinvested in their co-op.

2. A policy of El proportional to patronage is needed.

3. Investment policies are often misdirected e.g., used to
purchase (duplicate) facilities or equipment in the spirit
of competition.

 

4. Equity redemption programs are often non-systematic or
unrealistic for P-O.

 

5. Identify other serious capitalization problems.

241

242
II. Coordination Effects from Lack of Commitment

1. Betronege_oomnitnenti When p-o "shop around" for their
inputs (rather than being a steady customer), how does this
affect the operations and performance of your co-op?

2. How does this behavior affect the performance of the
larger co-op system e.g., uncertain demand and the coordin
of (R'LPF)?

3. £inenoiel_isspesi If equity management is a problem, how
does this affect the performance of your co-op?

4. How does this affect the coordination and performance of
larger co-op system?

III. Probable Causes for Participant Behavior
III1A1_Structurs_2f_lnsenfixssi

1. Why are some farmers more committed to their cooperative
than others viz a viz patronage?

2. WHy are some locals more committed to their regional
than others viz a viz patronage?

3. Why are equity capital levels too low in many local co-
ops?

4. Why are equity capital levels too low at the regional
level?

lII1_Bi_2afrgn:91ner_netsresenei§x (Aq- Specialization)

1. Farmers are becoming more diverse by size and
performance?

 

2. As membership becomes more diversified, how does this
affect the task of carrying out the co-ops functions i.e.,
within your firm and at the system level (R-L-F)?

3. Are co-ops better suited for dealing with problems

associated with diverse membership than IOFs? Y N
In what ways?

III.C.1 Input Fungability and Management Practices

1. The costs and risks associated with AS inputs differ
importantly from GP inputs

 

243

2. Do any of the following categories differ for AS versus
GP inputs? If they do, explain.

a) The planning process

b) Production decisions (more/less risk averse)
c) Exchange arrangements (spot vs relational)
d) Handling practices a marketing strategies

e) Other

3. For the following, which inputs can be classified under
one or more of the ”fungability" categories.

INPUT 93L, AIED
1. Petroleum (oil, gas)

2. Ag Chemicals --------------------------------------------
a) Insecticide
b) Herbicide
c) Fungicide

3 e Fertilizer ----------------------------------------------
a) Nitrogen
b) Potassium
c) Phosphorous

4. Feed ----------------------------------------------------
a) Complete feeds
b) Supplements
c) Premixes

5. Seed ----------------------------------------------------
a) New Varieties
b) Other

fa

 

C.2 Asset Specificity and Risk

1. In your opinion, what are the types of risks and costs
fiermers_face with the purchase of AS inputs?

2. Identify the risks and costs looels face with the
purchase and sale of AS inputs.

3. Regional only-- do you manufacture As inputs? Y N
4. What are the risks and costs regionals face with the
(production) and sale of AS inputs.

C.3 Fungability and Coordination

1. Matching preferences. As agriculture and farm inputs
become more specialized, how does this affect the task of

for specific inputs, at the M; W; R; F
levels?

244

2. Coordinating economic stages. How has increasing
specialization of farm inputs affected the task of
manufacturing, distributing, and marketing these products
i.e., within and across MéW-R-F?

3. Are co-ops (potentially) better suited for handling
these AS inputs than IOFs? Explein

IV. PROBABLE EFFECTS OF FORNARD CONTRACTING

1. If you forward contract for inputs, what are your
reasons?

2. If you do not PC for inputs, why not?

3. Forward contracting--what are the current costs and
risks to

a) farmers

b) locals

c) regionals (or manufacturers)

4. Consider (R-L-F): who geins the most from PC and why?

5. Among (R-L—F), who would potentially lose the most and
why?

6. In what ways does/would FC improve co-op system
performance?

7. Loonl_1onlylz Could you identify some ways to improve
current PC for inputs, that is, what changes should be made
to make it attractive to you?

8. Because of their unique ownership characteristic, are
cooperatives better suited for FC than IOF (e.g. spec.
coord)?

9. W: Specify the important dinessiens of PC

that are critical to the success of this exchange mechanism
e.g., proportion of total sales: min. number months advance
commitment: payment terms, etc.

10. Are there opportunities other than PC that might
promote better “cooperation“ between locals and their
regional?

245

II--MACRO ooonnmxrxou
WW

1. From your experience, why isn't there more cooperation
among local co-ops? What is the driving force (incentives)
behind this competitive behavior?

2. More cooperation among regionals?

3. How important are vested interests in determining the
likelihood of an M, C, or JV?

4. How critical is the need for more cooperation at the
local and regional levels i.e., what are the potential
consequences to the cooperative system from lack of better
horizontal coordination?

WW

1. Some co-ops that form a "partnership" later compete
against one another within this new organization. Why?

2. What are the critical dimensions to a "successful"
partnership arrangement, like a JV?

3. Consider M or C.-- To what extent do you agree or
disagree with the following statements:

a) in the negotiating process, competing groups "argue
away" the integrity of the original plan

 

b) once the reorganization is in place, certain groups
resist disposal of redundant assets or personnel.

 

c) over concern for equal representation, the BOD is top-
heavy, impairing the decision making process

 

d)oflmr
4. Can anything be done to change this behavior?
5. Do you believe that local cooperatives should be
accountable at the system (regional) level for the external
consequences of their actions? I N If so, how?

6. What else can be done to reduce harmful co-op
competition?

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