Article: Wednesday, 22 February 2017
Choosing your route to market can be complicated. Entrepreneurs in agriculture – and in other industries such as banking – can benefit from forming or joining a co-operative (or ‘co-op’) because they make revenues less volatile through risk-spreading and uniform product pricing. On the downside, entrepreneurs offering high-quality products through a co-op can expect to get less for their produce than they would through an investor-owned firm. Research by Xiao Peng of Rotterdam School of Management, Erasmus University (RSM) now offers a model that can help entrepreneurs to decide what type of governance structure would suit them best.
What sets co-ops apart from other governance structures is the prominent role of individual members, says researcher Peng. A co-op is collectively owned and controlled by its members, and the aim is to benefit all members with a pooling price scheme. This is an attractive business model for agricultural entrepreneurs who run high risks because of seasonal effects, market fluctuation and diseases, but also share the need to organise their sales in a very competitive market.
But the co-op also has disadvantages for producers, says Peng. It can invite free-riding behaviour when farmers don’t deliver their best quality produce because the co-op only guarantees a fixed price. Farmers might also start to overproduce, knowing that they always have a buyer.
Peng developed a model to find out when market circumstances are best for joining a co-op. In her model, every producer is characterised by the quality of their produce and their distance from the processor, where famers deliver their produce. This can be a co-operative or an investor-owned firm. In the model, transporting produce to the next step in the chain adds costs. The quality of the produce determines the price it will fetch.
By simulating several market conditions, Peng’s model showed that generally farmers use the smartest economical route and choose to sell to the closest co-operatively run dealer, wholesaler or processor. Farmers with high-quality products are more likely to collaborate with investor-owned firms rather than co-ops.
Peng’s calculations also showed that prices paid by investor-owned firms determine how the market will organise itself. Low prices lead to a market equilibrium in which most farmers decide to deal with a co-op. On the other hand, when the investor-owned firm offers high prices, co-ops will remain relatively small players.
Peng did notice a trend: an increasing number of co-ops are starting to offer higher prices for better quality products. Co-ops that do this will also attract more producers of high-quality goods, Peng predicts.
Interestingly Peng’s model demonstrates that when investor-owned firms choose to maximise profits, most farmers will still choose to produce for the co-op. Co-operatives will then become the dominant market model. This result should inform investor-owned firms that maximising profit is not the best strategy for capturing a large market share. To achieve scale, investor-owned firms must develop a price policy that will not just benefit their own profits, but will also attract farmers by offering reasonable prices, Peng concludes.
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