Academic journal article Journal of Agricultural and Resource Economics

Horizon and Free-Rider Problems in Cooperative Organizations

Academic journal article Journal of Agricultural and Resource Economics

Horizon and Free-Rider Problems in Cooperative Organizations

Article excerpt

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Cooperative organizations, including clubs and professional partnerships, play an important role in the economy, often bridging the gap between the purely public and the purely private in the provision of goods (Buchanan, 1965). This has been particularly true in agriculture, where cooperative organizations have emerged to deal primarily with market failures such as oligopsonistic pricing (Sexton and J. Iskow, 1988).

The collective nature of cooperative organizations creates two key property rights issues: the free-rider problem (Olson, 1965) and the horizon problem (Furubotn and Pejovich, 1970). In agricultural cooperatives, free-rider problems emerge in raising investment funds at formation and later for growth and expansion during operation; in both cases, members prefer to let others make the investment but to nevertheless have access to the benefits of the investment (Caves and Petersen, 1986; Knoeber and Baumer, 1983).1

Horizon problems in agricultural cooperatives potentially arise when the period of time over which members have a claim on the benefits of an investment is less than the length of time over which the benefits are generated. The result of this horizon mismatch may be underinvestment in assets or investments in assets that generate short-run benefits but not the long-run benefits necessary to keep the cooperative efficient and viable (Rey and Tirole, 2007; Porter and Scully, 1987; Vitaliano, 1983; Jensen and Meckling, 1979). For instance, in almost all large-scale agricultural cooperatives, members pressure their board or management for a payout of equity, for cash payments instead of the retention of earnings for investment purposes, or for investment in projects that will yield immediate rather than long-term benefits. If this pressure is successful in reducing investment overall or in limiting investment in things like product development/quality or variety improvement, then the lower investment can be attributed, at least in part, to a horizon problem (Cook, 1995; Saitone and Sexton, 2009).

Of course, the lower investment may also be a reflection of the free-rider problem discussed above, making it difficult to identify the precise cause of underinvestment. This is particularly the case because, as this paper will show, the two problems are linked and interact in important ways. For instance, free riding under decreasing returns to size reduces the returns to cooperative investment, further exacerbating the horizon problem. And reducing the horizon of cooperative investments to make them more attractive to individuals with shorter time horizons leads to increased incentives for free riding.

This paper formally examines the horizon and free-rider problems together, examining first the distinct differences between them and then showing how they interact. More specifically, the paper develops a model of differentiated individuals to examine the impact of the two problems on investment and patronage decisions and, in turn, on cooperative membership and member welfare. In undertaking this analysis, the focus is on the establishment of new cooperatives, although insights are obtained into the manner in which existing cooperatives finance on-going operations.

The paper makes a number of contributions to the literature on cooperative organizations. Two of these are highlighted here. First, the paper shows that cooperative formation depends on two things: (1) the presence of a set of members with sufficiently long time horizons to make investment the optimal strategy; and (2) the ability of this set of members to see itself as a distinct group. One of the important insights from the paper is that this social identification dimension is as critical to cooperative formation as the economic dimension. Moreover, if this group of members is able to finance the investment, then it opens itself up to free riding by new members, who benefit from the investment without being required to help finance it. …

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