farmers' cooperatives as market coordinating institutions

FARMERS’ COOPERATIVES AS MAR;KET COORDINATING INSTITUTIONS

bY Petri OLLILA

Academy of Finland

Cooperatives as market coordinating institutions have played an important role in agriculture during this century. In the Western countries, cooperatives are still predominant in various branches of agricultural production.

At the same time as cooperatives in many fields are increasing in size, becoming federated and conglomerated, some of them turning multinational, their initial form as cooperatives is fading. The cooperative form is often considered wold-fashioned. or at least cumbersome in modern market economy (Volk, 1988). Consequently in several countries, including Finland and Sweden, the trend is towards changing the form into a share company, perhaps keeping the cooperative as a holding institution.

Among the reasons for this kind of development might be that the cooperative is especially suited to only certain specific phases of market development, or that the potential benefits of cooperatives as market coordinating institutions are still not explicitly known. If the latter is true, it may be due to a lack of analytical tools for dealing with the phenomenon.

The development of new institutional economics sheds some additional light on the analysis of cooperatives. The following is an attempt to examine the potential of cooperatives as market coordinating institutions, using the costs of transacting as a n explanatmy factor.

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1 The Starting Point

Given the assumptions of neoclassical economic theory, the ques- t ion of cooperatives as coordinating inst i tut ions becomes uninteresting, since cooperatives possess no relative advantages compared to, e.g. Investor Owned Firms (IOFs). The characteristics of the real world, on the other hand, bring up properties in cooperatives which have relevance in coordinating exchange systems.

In a world of neoclassical economic theory, the problem of coordination is irrelevant. Perfect knowledge without uncertainty o r dishonesty, and with no cost transformable investments, leads by itself to the .optimal allocation of resourcesu. However, the problem of coordination becomes relevant if we allow actors to make mistakes in an uncertain environment, or break their promises, or if we accept that investments made for a certain purpose are not transformed into other uses without costs. All these factors of real life may result in biased resource allocation.

The purpose of this paper is to point out economic reasons for the existence of cooperatives'. For this type of study, the focus of analysis has been shifted from the costs of production to the costs of transacting. This makes i t necessary to shift from an analysis of the relations between actors and goods to an analysis of interaction between actors. The fact that the cooperative is an institution which gives high priority to member relations is another reason for analyzing the *mutually dependent interests. (Commons 1934, p.57) of actors, which are the origin of transaction costs. We will start by examining preference articulation (Hirschman 19701, and continue with the dimensions of transactions presented by Williamson (e.g. 1981) and the properties of institutions (North 1990) in lowering the costs of transacting.

1 By the cooperative mode is meant here an organization having at least the following properties: 1) membership open and voluntary, 2) surplus distributed to the membership according to the services used and 3) the ultimate governing body being the membership according to agreed rules. Despite the wide variation in cooperative principles applied in various countries and organizations these three are considered as most important for the purpose of this analysis.

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2 The Problem of Coordination

In a modern economy, the production and distribution of even a simple product is an outcome of the activities of numerous actors and resources. Such contributions are made in different places and may be scattered over a long period of time. Just think of a simple bag of potatoes. Before i t arrived on the supermarket shelf, somebody had put on a price label, transported i t to the right place, packaged and weighed it, stored, sorted and cleaned the potatoes, etc. The grower had made his decision to plant the potatoes perhaps the previous year and made the related investment decisions several years earlier. The fact that a bag of potatoes is available to the consumer in the right place at the right time may be the result of thousands of individual decisions over a long period of time. The question arises: how are these individual decisions coordinated?

The traditional answer to the question of coordination is that profits are maximized by equating marginal costs with marginal revenue. This rule leads to an optimal allocation of resources. I t could well be true in a situation where marginal costs and revenues are the same as expected, in other words, where there is no uncertainty. Uncertainty creates the possibility of mistakes, which in turn may lead to a random number table in resource allocation. Expectations regarding the economy are clearly not as uncertain as a random number table, but they are far from certain (Shaffer and Staatz 1985).

Uncertainty is a major cause of the problems of coordination relying solely on the price mechanism. The sources of uncertainty in the food system are much more varied than in many other sectors of production. The impact of weather conditions, unexpected forms of biological processes including product perishability, and the atomistic nature of the system especially in primary production, create additional problems for economical coordination. These must be among the reasons why the apuren market solution is not applied in many fields of agricultural production. Neither has the *pureu integrated solution proved successful, as has been demonstrated by the experiments in the former communist countries.

Cooperatives, on the other hand, seem to be dominant in various fields of agriculture. It may be supposed that in certain situations, cooperatives have properties that are superior to alternative ways of instituting agricultural exchange2.

2 In fact, if the mismatch in coordination is defined as market failure,

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3 Coordinating Institutions and Preference Articulation

When examining the process of recuperation (to be able better to coordinate supply and demand), Hirschman (1970) presents the concept of two alternative ways of articulating preferences: *exit and *voice*. *Exit refers to the typical market behavior of a buyer choosing one good but not choosing another. If the buyer chooses a competitor’s product, the manufacturer should get information about the relative dissonances between his product and the buyer’s preference. This information should, after a certain threshold, facilitate recuperation. uVoicen refers to behavior in which the buyer (citizen, administrator, etc.) seeks to bring about favorable changes in the goods offered, by expressing hisher opinion to the servicing organization, According to Hirschman, voice - although it is usually more costly - provides more comprehensive information about preferences than exit.

Voice and exit affect the recuperation process in different ways. Changes will always be more or less resisted. Hirschman discusses the *management reaction function* as the threshold amount of information and pressure to alert the management of the need for readjustment. Voice may be richer in information but the representativeness of the voiced dissatisfaction cannot be determined and its opportunistic use may always be suspected. Exit provides *exact information about real behavior but does not tell anything about possible alternative behavior outside the existing opportunity set. If three varieties of cheese are available, the exit option is not able to tell whether a fourth would be the most preferred. I t is not uncommon in the practical business world that parties within a firm have differing opinions, e.g. about the causes of a decline in business. There is uncertainty about the real and, perhaps, varying reasons for exit, and it is easy to find causes for decline in circumstances outside the firm’s own organization. It is not unusual, either, for management to interpret criticism as the unrepresentative voice of an embittered minority.

some researchers think this is the only explanation for the existence of cooperatives. *All reasons of justifications for special policies to promote cooperatives can be traced back to such failure.. (Schrader 1989) Such failures are thus of transaction cost origin. 3 Relative dissonance refers to the best available good, not necessarily the best good.

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Exit without voice may be capable of coordinating alternatives in a closed system. But when preferences would best be satisfied by a good that is outside the available alternatives, some kind of voice is always needed to get these preferences articulated to the system. Voice, in turn, may not be effective if exit cannot be used as a threat to make the desired changes count. If the threat of exit is not possible, management could, choose to deal with angry customers or workers rather than change their own behavior. If exit is the only option for preference articulation, what is known is the extent of the mismatch in supply and demand, but the exit option does not tell the reason. The voice option in turn tells the reason, but not the extent. Thus, both options for preference articulation are needed in the coordination of supply and demand.

Hirschman considers the combination of voice and exit as the best situation in respect of market coordination. Almost all organizations have these two options open to them in principle, though not necessarily at equal transaction costs. I t i s possible to exit from a society either by moving to another country or by becoming alienated from the society. It is also possible to use voice in a well- functioning market, but the incentive to influence the market - once the transaction has occurred - is usually weak. Many different mechanisms combine voice and exit. Some business firms use customer committees to improve the voice option. Bureaucracies shorten their re-election periods to induce exit. Although many kinds of contracting forms combine voice and exit, the cooperative is the only organizational form in which both options are organized into the same institution and have an equal s ta tus in principle. In a cooperative i t should be possible to use either voice (political option) or exit (market option) to affect the recuperation (readjustment) of the institution. Schmid (1988) writes: *It is sometimes said that a co-op member is more likely to use voice in telling the co-op manager what is wrong rather than simply exiting. But, if it were only voice, the member could bring no cost to bear on the manager except scorn. ... Where the owner of the opportunity has objectives conflicting with the voiced request, the voice is likely to be rejected..

Cooperative members have the property right t o use voice. S k i r (1981, pp.74-75) states that, in principle, an individual only has three ways in which to influence decisions: political, professional and cooperative. Despite the observation that the cooperative is the shortest and the political the longest way of influence, he shows that the cooperative is the single institution in which an individual

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(member) has both influence and contract (voice and exit) built into the system.

In conclusion, cooperatives - havingboth voice and exit built into the system - should be more effective in preference articulation with lower transaction costs than either one of the extremes, the purely political organization or the pure market system.

4 Economic Coordination and the Cost of Transacting

As mentioned above, the problem of economic coordination is concerned with matching the supply and demand of a commodity at each level of its production and distribution chain in real world circumstances. The transaction - the unit of transferring the legal control of a resource -has been the ultimate unit of economic coordination since the early stage of institutional economics (Commons 1934). In an environment of uncertainty this task is complex and difficult. The idea that the price mechanism should not be solely relied on in coordinating the exchange is not new either. In 1937, Coase wrote: *In view of the fact that while economists treat the price mechanism as a co-ordinating instrument, they also admit the coordinating function of the ‘entrepreneur’, it is surely important to enquire why co-ordination of the work of the price mechanism in one case and the entrepreneur in another.*

Coase’s interpretation of the problem of economic coordination may be described as the cost of using the price system, later defined as the cost of transacting. Williamson (1975, 1979, 1985) has made a substantial contribution in developing Coase’s analysis of economic coordination. His starting point in the analysis is to look at the production-distribution sequence as *technically separable interfa- ces*, i.e. separating the individual tasks and analyzing various ways of organizing the exchange between them.

4.1 Markets and Hierarchies

The base for Williamson’s analysis is his concept of human behavior, which differs from the neoclassical type. Instead of actors seeking rationality and utility, Williamson talks about actors with bounded rationality and opportunistic behavior (Williamson 1975). The actors may be in an environment with a varying degree of

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complexity and uncertainty, and the number of actors may vary. The initial step for Williamson was to analyze bilateral transactions by using two alternative ways of instituting them: a transaction in the market, and an organization’s internal transaction which he calls a transaction in hierarchy. His argument in .Organizational Failures’ Framework. is that in the absence of complexity and/or uncertainty in the environment, bounded rationality is not a problem, and in the absence of .small numbers., e.g. in a competitive environment, there is no chance for opportunistic behavior, and so the market transaction will function. However, in a complex or uncertain environment, actors with a bounded rationality will create a situation of market failure. A small number of actors makes i t possible to act opportunistically, e.g. to agree on prices, which leads to market failure. Williamson argues that transactions in the hierarchy instead of the market are able to prevent the impact of bounded rationality and opportunism because there is no incentive to utilize the information impactedness inside the same organization. Thus, these kinds of transaction tend to be instituted into the same organization.

Based on .Organizational Failures’ Framework. i t may be concluded that the market is the most effective way of conducting transactions if there are no sources of distortion. If distortions exist, moving from the market towards bureaucracies is likely. The advantages of bureaucracies include the following:

(1) When the circumstances of transactions are complex, sequential decision-making and the coordinated use of experts in a bureaucracy may economize bounded rationality significantly.

(2) Tasks guided by planning may reduce uncertainty when an organization is working towards a given goal, despite temporary changes in the environment.

Of the two basic modes of transactions and coordinating mechanisms market is considered to have superior coordinating properties in supplying information in a comparable form (prices) and in providing high-powered incentives (Williamson 1985, pp. 140-142) for the optimal allocation of resources. But all this requires well- functioning markets, where opportunism and bounded rationality could not significantly increase transaction costs.

Because of the uncertainty and complexity involved, i t is important to coordinate separable tasks through planning. Markets - e.g. spot market prices for already produced goods - provide a poor basis for this; rather, they reflect all the mistakes in planning of production

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in past periods based on unrealistic expectations (Shaffer and Staatz 1985, p. 55).

Hierarchy has properties by which to coordinate activities through internal organization and planning. When tasks can be coordinated through positions of authority, the transaction costs of safeguarding against uncertainty and opportunism can be considerably decreased. Substituting market transactions with internal transactions reduces uncertainty in the coordination of supply and demand. According to Shaffer and Staatz (1985, p. 561, vertical integration facilitates the coordination of inputs in the production-distribution sequence. Horizontal integration, which involves market power, facilitates the coordination of supply and demand. Gaining market power is thus a means of reducing uncertainty outside an integrated organization. Integration, in turn, causes problems in providing incentives to prevent dysfunctional pursuits. The cost of the control system, i.e. bureaucracy, is likely to grow faster than the gain from the reduction in uncertainty.

The cooperative is a special kind of transaction and coordination mode. The members of the cooperative, who, in principle, rule the cooperative, have a relationship with it which is close to integration, at least as a group. The cooperative has thus obligations toward its members. But the obligation is not reciprocal. The cooperative usually has no authority over its members (Rhodes 1985)‘. There is no question of vertical integration between member firms and the cooperative. Nor is the cooperative a mode of horizontal integration - although a bargaining cooperative may be close to it. The member firms are independently owned, represent independent profit centers and act independently, except when they have agreed on joint ownership of the cooperative’s firm(s) or have negotiated agreements to act collectively (Shaffer 1986).

The cooperative has, in a way, both markets and hierarchies within the same organization. Transactions between the cooperative and its members are internalized, but the members are still allowed to make market transactions. Figure 1 illustrates the dual nature of the cooperative as a coordinating institution.

4 This may not be the practical solution in many producer cooperatives which require obligatory delivery. However, this obligation is created by the organization, not by the initial properties of the cooperative institution. Usually it also concerns just a fraction of the members’ economy. Such an obligation may be considered as significantly diminishing the *competitive yardstick. feature of the cooperative.


Figure 1: The cooperative’s dual role as a coordinating institution

-b Integration

- - - - - - + Competition

Cooperatives a s transaction mechanisms have properties similar to both modes of transactions discussed above. Which one prevails will depend on the rules of the cooperative.

Cooperatives are organizations which have internalized transactions between a member and the organization. The members are, however, independent of each other. Thus, it is possible to reduce transaction costs and uncertainty through the cooperative and maintain the entrepreneurial incentives through the market at the same time.

Another conclusion that can be drawn from the *Organizational Failures’ Framework* is that a small firm cannot do what a big firm can, and a big firm is not necessarily able to do what a small firm can. This means that firms with widely differing economies of scale otherwise benefiting from integration are not able to do so. The economies of size of modem dairy plant are at a far higher point than the economies of size of a dairy farm. A cooperative is a way of combining both integration and independence.

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4.2 Transaction Cost Economics

A more comprehensive treatment of analyzing transactions was presented by Williamson later (Williamson 1979, 1981, 1985). The separation of the costs of production and the costs of transacting was now made more explicit. The total cost of a commodity is the sum of production costs and transaction costs, which include the costs of finding available alternatives, monitoring the processes, negotiation and executing the contract, etc6 Although both categories of costs are interrelated, the cost of transacting was stated to have a significant explanatory power over the institutional form of exchange. Towards the one extreme form, the market, the cost of uncertainty increases, and towards the other extreme, hierarchy, the cost of bureaucracy increases. Between these extremes there is an array of various organizational arrangements creating various sets of transaction and production costs.

Williamson considers three dimensions of transactions which explain the existence of the prevailing institutional arrangement (governance structure). These dimensions are: asset specificity, uncertainty, and frequency of transactions. Some situations in which cooperatives might coordinate the exchange at lower transaction costs than either one of the extremes-markets and hierarchies - are described below, using these dimensions of transactions.

4.2.1 Asset Specificity

Assets are transaction specific if their value in a second best alternative use is significantly lower than in their initial use. Why asset specificity is so important is that .when a transaction specific investment is made, the buyer and seller are in a bilateral (or at least quasi-bilateral) exchange relation for a considerable period thereafter.* (Williamson 1981)

Asset specificity is an important factor causing transaction costs in many fields of agriculture. Consider a buyer who asks a farmer to plant apple trees and promises to buy the apples produced at a price which sounds tempting to the farmer. After a couple of years when the trees start to produce fruit, the buyer comes back and says that he

5 (1989).

For further definitions of transaction costs see Eggertson (1992), Ollila

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made a mistake and is able to pay only half of what he promised. If no other alternative buyer exists, there is no choice for the farmer but to accept the new offer. The investment made in an orchard has no other value than that of low-grade firewood in the next best use. Knowing the situation (large numbers turned into small numbers), the buyer is able to act opportunistically and lower the price close to the variable cost. A similar situation occurs with investments in a dairy farm or in egg production. In the absence of alternative buyers, the second best option for the use of the investment is significantly less valuable.

Agricultural production is also site specific, which may limit the alternative business opportunities. Another factor which makes some lines of agricultural production open to opportunistic behavior is perishability. In the absence of safeguards, the only potential milk buyer might suggest to a dairy farmer that h e should accept half-price today instead of getting nothing tomorrow when the milk has gone sour.

All the features of asset specificity presented above would speak for integration. But because of very different economies of scale this does not seem possible. The period of investment is oRen so long that not even long-term contracting is feasible. In such cases the cooperative solution seems superior. This is especially true if there are transaction specific assets on both sides.

4.2.2 Uncertainty

As the sources of uncertainty may be various, so also the various institutional arrangements differ in their capability to deal with uncertainty. If the actor faces uncertainty, e.g. concerning the available alternatives in the market, uncertainty may be reduced by obtaining more information, but this also creates transaction costs6. Galbraith's (1967) technological imperatives in planning a r e safeguards against uncertainty in a changing environment during the long process of developing and testing a new product. In this sense advertising is a means of reducing the uncertainty of changing demand during this process. Uncertainty also creates costs of making mistakes.

6 information needed in production.

The information costs meant here are not the same as the costs of

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North (1990, p.126) discusses innovations in lowering information costs such as weights, measures, postal systems, currencies and exchange rates. Recent developments in information technology have significantly reduced the costs of uncertainty. Still in economies such as the former Communist Eastern European countries or in many developing countries, the high cost of information is a major hindrance to developing exchange systems. I t may be noted that the largest impact of high transaction costs due to high information costs are the transactions not occurred. North mentions that transforming uncertainty into a risk was a major innovation for reducing transaction costs caused by uncertainty. Unlike uncertainty, it was possible to calculate risk using probability calculations.

One way of transforming uncertainty into risk is the feature of the relational contract (Williamson 1979) between members and the cooperative'. The final economic result is distributed to the members afterwards, which means that the possible risk is also distributed depending on their use of the cooperative. Cooperatives may also provide a kind of an insurance to members. For instance, if the costs of a spare part service at weekends for a limited number of farmers were charged only to those unlucky enough to have their combine harvester break down during the weekend, it would be too expensive to utilize the service. Despite its availability the farmer would not use the service, and after a while the market would make the service impossible to maintain. However, if some of the cost were to be distributed among all members as part of the cost of the cooperative, the service would be available to all a t a reasonable cost?.

The collective decision of providing a home for all the products of a member of a producers' cooperative also transfers the uncertainty of delivery into a risk of possibly lower prices to all the members in a situation of surplus. Although this might not be a transaction cost economizing solution in transactions with a relatively stable supply of products produced without asset specificity, the cooperative solution clearly improves the coordination of supply and demand in production

7 The relational contract feature with patronage refunds is among the features which differentiate cooperatives from nonprofit organizations analyzed comprehensively earlier in this Annals (Ben-Ner & Van Hoomissen 1991). 8 Of course, such a service could also be arranged in an IOF considering such costa as fixed costs. However, independent of the way of spreading the fixed costs, their contribution would differ significantly from the situation above.


involving features of a fluctuating supply, e.g. of perishable goods. Note that that because a cooperative in this case is not able increase profits by restricting supply, i t is unable to distort the market in the way that economic theory describes as monopoly power.

Cooperatives may also reduce uncertainty by engaging staff to collect information for all the members’ benefit in cases where i t would be too expensive to arrange it individually. When the use of such a service becomes a kind of a semi-public good, it lowers the threshold to utilize such information, which might not be the case in market exchange of such information, especially among small producers.

4.2.3 Frequency

The frequency of a transaction means how often a particular transaction conducted by the same actor occurs. Frequency is dependent on the buyer’s behavior, because otherwise no transaction would occur. High frequency of transactions makes i t possible to divide transaction costs among many subsequent transactions. Thus, frequency means economies of scale in transacting. High frequency in the transactions of specialized goods may lead to an interaction that Williamson (1979) calls 4diosyncraticB business relations. This means a special language and mutual trust develops between the transacting parties, which in turn decreases the transaction costs as long as it does not lead to ignorance of other alternatives. High frequency also makes it more difficult to act opportunistically by using *hit and run* tactics. Frequent buying of a good may also be understood as buying gradual proportions of the total good, which makes ex post competition possible.

The production cycle of many agricultural products requires frequent transactions. For a dairy farmer or vegetable grower to make a bidding round every time products are sold this would require hours of work several times a week. A contract is likely to be drawn up for the purpose of lowering the transaction costs of subsequent transactions. The problem is that contracts can affect the fundamental transformation (Williamson 1985, pp.61-63) of transactions. After a binding contract, many bidders’ ex ante transaction may turn the situation into a monopoly ex post transaction.

Cooperatives can prevent fundamental transformation. The cooperatives’ relational contract feature can reduce transaction costs

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while maintaining the members’ opportunity t o make *inquiry buys. from outside (Ollila 1985). Thus, reducing uncertainty by contracting does not necessarily prevent getting market information by acting in the market (exit option in Hirschman’s terms). This information could be catered by both, the members and the cooperative.

.Uncertainty and the potential for opportunism increase when long-term contracting is needed to facilitate coordination. A partici- pant is disciplined when he depends upon repeated transactions, the dissatisfied customer does not return as long as he has an alternative. In the case of frequent transactions learning takes place and search efforts can be spread over a number of transactions. ... Acritical factor promoting cooperation is the fact that a subsequent transaction is expected. If the current transaction is the last, defection is likely. This suggests that cooperative policy promoting continued patronage by members including barriers to exit would discourage opportunistic behavior and facilitate contingency contracting under uncertainty and that such cooperatives might have an advantage over markets in coordinating requiring future delivery agreements.. (Shaffer 1986)

Loyalty (Hirschman 1970, pp.76-105) towards a cooperative can be expected to be greater than for a &range* or independent firm. This may make cooperatives more resistant to short-term difficulties. The sense of loyalty may make it possible for a cooperative to make suggestions about jointly preferable future behavior, e.g. what to produce and how much. Loyalty, which creates high-frequency transactions, combined with the voice option through patronage, facilitates Standard Operating Procedures (Cyert and March 1963) in lowering transaction costs.

4.2.4 Externalities

In addition to the three dimensions of transactions affecting transaction costs mentioned by Williamson, it seems useful to add a fourth one: externalities (Ollila 1989). Externalities may be understood as technical failures of exchange. In this respect, externalities a re those effects of interaction which are not internalized by the exchanging parties (Schmid 1987, pp. 144-146) They are thus related to incomplete institutional design. Goods having public good features may be very difficult to make marketable. Cooperatives on the other hand, as mentioned in the case of insurance-like goods provided to cooperative members, are capable of


exchanging goods the external features of which cannot be internalized in the market.

One of the most interesting features of cooperatives is their ability to exchange both incompatible use and joint impact (public) goodse. Besides incompatible use goods such as tractors, cooperative members may decide to organize training in maintenance, efficient use, etc., without the fear of an IOF that the objects of this investment may use the knowledge to benefit a competitor.

According to Staatz (1984, p.1951, many of the .competitive yardstick* features of farmers’ cooperatives can be viewed as public goods. Farmers who feel tha t existing firms do not provide satisfactory services may establish a cooperative themselves, which in turn may force the IOFs to improve their services through competition. Non-member farmers are also able to benefit from the improved eficiency of the market.

The cooperative principle of open membership is a powerful tool in preventing the negative effects of certain kinds of externalities. For instance, standardization can lower both transaction and production costs significantly. If standards’ are created through competition, of resources will be wasted before the most powerful winner has established his position’O. In a situation of free entry (open membership) this problem may be avoided with low transaction costs.

The problem of free riders starts if i t is not possible to prevent non-payers from utilizing the good. For instance, suppose that it is advantageous to train dairy farmers to produce the best possible milk for quality cheese. If an IOF invests in training its milk producers, i t may be that after the farmers are trained, there is nothing to prevent them from acting opportunistically and starting to deliver their milk to a competitor firm which can pay as much more as the other had

9 Incompatible use goods here mean goods with no exclusion costs. Joint impact goods (public goods) are goods with exclusion costs leading to free riders problems. 10. This has been the situation in many fields of business. I t happened in the tape and video recorder business; it is still going on in the micro computer business, and will probably happen in the high density TV business. The competition may not always even bring up the best possible system. Using the cooperative in order to prevent such *unnecessary. competition has proved to be a good solution. E.g., in Finland the leading credit card company was a cooperative right from the start. Because of free entry, there has been much less competition concerning the leading credit card than in e.g. Sweden.

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invested in producer training. If a cooperative trains its farmers, this kind of opportunistic behavior is not as likely for a number of reasons.

The profit from the improved quality of cheese comes to the producers collectively.

The paid patronage fee and the expectations of increased patronage refunds because of improved quality increase the exit costs. Loyalty (Hirschman 1970) towards the member's own cooperative is usually greater than towards a regular business partner as well as mutual discipline" in a cooperative.

When a cooperative collectively decides to provide such a service it is less likely that this decision will be canceled because of high exclusion costs than in the case of an IOF operator.

Open membership, in combination with collective action, have probably been the main reasons why cooperatives have performed very well in correcting market failures (Rhodes 1985). Through collective action, small units have gained economies of scale and market power. Scale economies have been realized in joint processing operations, collective buying, information systems, hiring expertise in marketing, etc. Market power has been used t o balance the negotiation power between small farmers and large companies, for lobbying on behalf of the membership, etc. Organizing transactions between farmers and processors has succeeded better through cooperatives than through vertical integration.

One of the causes of market failure in perishable mass products is that the products of the growers tend to lose their identity before reaching the retailer and customer. In the absence of identity, growers have no incentive to improve quality above the minimum at the point of inspection; on the contrary, there is an incentive to ride free with other growers' quality image and, when observed by customers, to cause externality costs in the form of a worsened image to all the growers. Sometimes, when the effects of e.g. careless handling, become visible much later, information about the deterioration may never reach the person who effected it. Avoiding the deterioration of product quality has been an incentive for firms to integrate vertically. Kirkman (1975) reports product deterioration

11 Even one farmer can, under certain circumstances, spoil the others' production, e.g., by delivering spoilt milk to the collection tank. Loyalty and mutual discipline may prevent this from happening.


problems of Californian citrus growers in the early 1900s as the reason for establishing the California Fruit Growers Exchange cooperative, later named Sunkist. In this instance i t was possible to make the brand label Sunkist strong for all the members, which would not have been possible individually.

Cooperatives are able to shape the environment by internalizing of certain factors regarding economic decisions. In some cases the decision-making environment may be much larger than the market exchange. In rural areas, economic vitalization has commonly occurred through the establishment of a subsidiary of a firm in the countryside. The management and some of the workers come from outside, the fixed investments are made by local governments, the raw materials come from somewhere else. The factory provides jobs in the area, people get settled, build new houses (site specific investments), etc. If the economy turns bad, the cost of closing the subsidiary may only involve the cost of moving the management and the machinery out. The cost external to t h e firm such a s unemployment, fixed investments and infrastructure, are paid for by the local government. Workers’ investments in housing either keep them in an area with no employment or force them to sell their homes a t a very low price because of surplus of supply and few or no buyers12. If the factory had been owned by the workers as a cooperative, these external costs to the firm would have been internalized, and the factory would probably have remained in the villageI3.

5 The Question of Property Rights

Property rights define whose costs are taken into account as transaction costs and which are external to the various parties. A major problem in the framework of transaction cost economics applied above is the difficulty in defining whose costs are taken into account as transaction costs.

12 The idea of the example has similarities to *Economics of the Company Town* (Williamson 1985, pp.35-38). 13 Worker cooperatives have created some increasing interest in dealing with unemployment (e.g., GRAIGH & PENCAVEL 1992, STABER 1993). It seems that cooperatives may have useful properties, but that they are not an unified solution.

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North (1991) gives primary importance to property rights in his examination of the costs of transacting in institutional change. His starting point is that the cost of transacting is caused by an incomplete definition of property rights. Property rights, in turn, stem from an institutional framework consisting of formal and informal constraints and enforcement possibilities of the society.

In modem society, property rights are a function of public acceptance, usually implicated through political processes. Markets can only deal with politically solved problems and well-defined property rights, while internal governance is based on internal rules. Cooperatives are able to function according to the existing rules of the market, but simultaneously they reflect the special values of the membership if so decided". E.g. if the membership agrees that the price of products will be kept the same regardless of the distance to the cooperative, they may establish such a rule. A similar rule would be difficult to maintain in the market exchange. Settlement of possible disputes is also easier *within the family circle*. In a situation where special contract terms for individual transactions have to be made, there may be economies of scale in drawing such contracts for a larger membership with similar interests.

Rules defining property rights are a cumulative outcome of culture, traditions, legislative actions, and human interaction. In rural areas, the culture, traditions and values may be considerably different from those in urban areas. The reflection of local culture and values in transactions may significantly lower the transaction costs through a common language and shared values. The possibility of utilizing these relatively unified rural value structures and local subcultures could possibly be examined more closely when initiating new cooperatives, e.g. in the developing countries. Inconsistencies in the existing rule structures of cooperatives may be among the reasons for cooperative failures in developing countries (Delvetere, 1993, Trescott 1993). An interesting study could be made in the U.S. about the effect of cultural background on the existence of cooperatives in certain areas and their non-existence in others.

~ ~~~

14 For decades before Finland gained her independence from Russia in 1918, cooperatives had played a significant part in educating and preparing the Finnish people for democracy.

FARMERS' COOPERATIVES AS MARKET COORDINATING INSTITUTIONS 99

6 Conclusions

The above analysis h a s attempted t o show tha t not just ideological or sociological but also economic reasons may be found for the existence of cooperatives. Despite the prevailing trend towards the market economy, this examination suggests that cooperatives do have potential to perform in certain transactions at lower transaction costs than other coordinating institutions. The increasingly comprehensive rules of society and lower cost of information may allow transactions formerly conducted by cooperatives to be taken care of by the market. However, new challenges in exchange are emerging, where the potential of cooperatives is also recognized as an a1 terna tive .

The above examination does not suggest that cooperatives are an allround solution. But i t does suggest that there are situations in the exchange where cooperatives may function at a lower transaction cost than either of the other pure alternatives, the market or internal exchange. If there is a new market where the existing preferences are unknown, the cooperative may be the most efficient way of combining the market and political preference articulation in order to produce desired products. The cooperative appears to be an especially superior solution in situations having transaction specific investments on both sides of the exchange but with widely different economies of scale.

Cooperatives have special properties for coping with uncertainty by transforming it into a shared risk through the cooperative feature of relational contract. The same feature also lowers the cost of transacting in high frequency transactions requiring long-term commitment in an uncertain environment. Cooperatives also are efficient in preventing the transformation of large number exchange into bilateral exchange in high frequency exchange situations.

Mankind continually produces more sophisticated goods to be exchanged. These multi-dimensional goods inherit dimensions that are difficult to be exchanged in the market. Cooperatives are efficient in dealing with goods that possess the properties of both private and public goods.

In agriculture i t is easy to see many of the situations mentioned above. Independent of technological developments, agriculture will be tied to site, time and purpose specific assets and uncertainty caused by natural conditions. It is very difficult to envisage any form of exchange other than the cooperative which would take care of this

100 P. OLLILA

kind of exchange a t a lower transaction cost. Still, technical developments may change some of the features of exchange affecting the exchange institutions. For instance in dairy production, the relative advantage of the cooperative may decrease after the milk has been pasteurized and cooled but yet be superior up to that point.

Externalities in agriculture show an increasing tendency. The external effects of agricultural production - such as pollution - are more and more strictly controlled by society; animals are granted an imal rightsn, and in addition to producing food, fields are also seen as being part of the scenery etc. The potential of cooperatives in combining these various dimensions of future rural production has not been comprehensively analyzed. The same applies to the process of bringing the tasks of food production back to the rural areas. Attempts to combine the advantages of small-scale and large-scale production in networks (~Toyota Model.) can easily lead to bilateral business relations where the cooperative is an efficient mechanism for preventing the exploitation of either party.

To sum up: the potential of the special features of cooperatives as market coordinating institutions still requires new emphasis in research, primarily at the conceptual level. Transaction cost economics seems to provide new tools for such an analysis.

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