Horizontal coordination of sales through collective decision-making may be feasible and sufficient to link farmers with markets that do not require much: investment in lumpy assets to add-value compliance with stringent standards and complex timing requirements bargaining power (owing to the presence of many competing buyers) A large group of farmers may be required to finance lumpy assets, achieve size economies and to gain some measure of control over supply Investment decisions are difficult because the farmers may not agree on how they will share the costs and benefits of the investment However, the costs of making and enforcing collective decisions become prohibitively high in markets that do require lumpy investments, compliance or bargaining power because: Marketing Cooperatives

However, horizontally integrated farmer organisations like marketing cooperatives and farmer-owned companies follow different institutional rules, some of which discourage investment & participation by members This weakness stems from three fundamental cooperative principles: Democratic control Member economic participation Open membership Horizontal integration reduces the costs of collective action by centralising decision-making power in the hands of directors and managers Traditional cooperatives, in particular, do not create strong incentives for members to invest equity capital because their property rights (i.e. their voting and benefit rights) are ill-defined

each member has one vote, no matter how much capital they invest in the cooperative (i.e. one vote per member rather than one vote per share purchased) all members must be patrons and new members must not pay more for their shares than did those members who joined earlier profits are distributed according to levels of patronage rather than levels of investment In practice, most countries have interpreted these principles as cooperative laws requiring that: To fulfil these last two requirements, a limit is set on any dividends earned by shares, and shares are redeemable & non-appreciable [i.e. the co- operative can buy an exiting member’s shares at their par (original) value] A traditional cooperative is therefore controlled and owned by patrons who expect management to reward them with favourable prices for their inputs and products. Individual benefits are thus proportional to patronage and exclude capital gains – these go to the cooperative as ‘unallocated reserves’

A company is therefore controlled and owned by investors who expect management to maximise the sum of dividends and capital gains earned by their shares. Benefits are thus proportional to individual investment and include capital gains The absence of tradable, investment-proportional benefit and voting rights in a traditional cooperative creates a number of institutional problems that discourage its members from investing in the cooperative voting rights are proportional to investment (one share, one vote) Dividends are proportional to investment (individual shareholding) Shares are non-redeemable and can be traded at their market value This is very different from a company where: Low levels of equity capital also constrain the amount of debt capital that a cooperative can borrow because lenders usually require Debt/Equity<1. As a result, traditional cooperatives struggle to finance the lumpy assets needed to access high value markets

The internal free-rider problem arises because benefits are proportional to patronage Members are therefore reluctant to invest equity capital to finance cooperative assets because the benefits accrue largely to patrons rather than investors The external free-rider problem arises when non-members qualify for the same patronage benefits (favourable prices) offered to members Members are therefore reluctant to invest equity capital to finance cooperative assets because the benefits accrue largely to patrons, some of whom have not contributed any capital at all What are these institutional problems that constrain a traditional cooperative’s access to capital?

The horizon problem arises because members of a traditional cooperative cannot trade shares at their market value. Instead, the cooperative is entitled to redeem members’ shares at their par value Members therefore have little incentive to finance assets that generate returns beyond their term of membership because they cannot realise capital gains when they leave the cooperative. New members benefit from these assets yet pay only par value for their shares The portfolio problem arises because members of a traditional cooperative cannot transact equity shares freely Equity investment is therefore sub-optimal because members cannot diversify their own investment portfolios to reflect their personal risk preferences

The control problem arises in any organisation where a manager (the agent) is hired by the owners (the principal) to manage their business This problem can be particularly severe in a traditional cooperative because equity shares are not traded at their market value Members are therefore reluctant to invest equity capital because: (a)they find it difficult to monitor a manager’s performance in the absence of a market price for equity shares (b)they cannot sanction (punish) poor management by disinvesting, and (c) they cannot align a manager’s interests with their own interests by remunerating him or her with tradable shares

The influence problem also discourages Banks from financing cooperative assets because it is difficult for lenders to influence managerial decisions when small, risk-averse investors (who benefit from patronage rather than from the cooperative’s growth) command the voting power Hence, for any given level of equity, a traditional cooperative’s ability to borrow is adversely affected by the influence problem The influence problem arises because members of a traditional cooperative have equal voting power This discourages entrepreneurial members who are willing and able to invest more equity capital in the cooperative from doing so because decisions taken by the cooperative are influenced by majority voters, not majority investors

However, the main reason is that firms which reward farmer-owners for their patronage find it cheaper to negotiate and enforce supply contracts than do firms that reward farmer-owners for their investment. Why? Given these institutional problems, why do we still see farmers establishing cooperatives rather than farmer-owned companies to access markets? In some countries the answer lies in subsidies and tax advantages afforded to cooperatives by governments that have a political bias towards egalitarian and non-capitalist principles Farmers therefore have an incentive to ‘borrow’ some institutional arrangements from traditional cooperatives (in order to benefit from lower transaction costs and any subsidies or tax advantages that might be offered to cooperatives) and from companies (in order to address the institutional problems that limit access to equity and debt capital This explains the emergence of hybrid marketing cooperatives, like the New Generation Cooperatives (NGC’s) that have become so popular in the USA