View of Coordination of supply and demand in the dairy marketing system – with special emphasis on the potential role of farmer cooperatives as coordinating institutions

Journal of Agricultural Science in Finland Maataloustieteellinen Aikakauskirja Vol 61:135—321

COORDINATION OF SUPPLY AND DEMAND

IN THE DAIRY MARKETING SYSTEM

with special emphasis on the potential role of farmer cooperatives as coordinating

institutions

Selostus: Kysyntä ja tarjonta

maidon

PETRI OLLILA

The ^Academy of Finland

Hämeentie ^68,SF-00550 ^{Helsinki, Finland}

Academic Dissertation

ToBEPRESENTED WITH THE PERMISSIONOFTHE

FacultuofAgriculture_and ^Forestry_{of the} UniversityofFlelsinki, for public criticism in theLittle ^AssemblyHall in theMain Building_{of the}University

onOctober ^sih, 1989at 12 o’clock.

SUOMEN MAATALOUSTIETEELLINEN ^{SEURA • HELSINKI}

137 ACKNOWLEDGEMENTS

This study is a joint effort of numerous people. The project has really shown me how smallaperson can feel when faced with a large, complex problem.

The initial idea for this research camefrom Professors James D. Shaffer and John Staatz of Michigan State University, USA. They were willing _to assign _{me to} the project examining the coordination problems of marketingsystems,and the Finnish Academy was willing to finance the work. I am deeply indebtedto both organiza- tions.

Many people atMichigan State University provided guidance and good ideas for my study. JamesShaffer, A. Allan Schmid and Larry Hamm gaveme crucialcom- ments. Without John Staatz’s patient help this study wouldneverhave been finished.

Pellervo Society, Central Organization of Farmers’ Cooperatives in Finland provided working facilities for two years, which was a great help. Juhani Tauriai- nen, thanks for believing in me even during the times I myself didn’t! AimoKöy- lijärvi of the Market Research Institute of Pellervo Society has ^put a lot of effort in providing the dairy data for me.

Also I want to thank all the helpful people at Valio who were willing to devote a lot of their limited timeto meand my questions. Special thankstoDirector Ensio Hytönen, who patiently time and time again pulled meback down_to the grownd again.

Several people in the faculty of Agriculture and Forestry have helpedmethrough.

The comments of professors Hahtola and Prihti were very valuable. Thank You, Vice Rector Risto Ihamuotila for your assistance in the project and in guiding me through the formal procedures.

Marja Oravainen from Autora Oy has carefully and without sparing her efforts inspected myEnglish.

Thanks to my wife Päivi and daugher Suvi. You have hadto tolerate all kinds ofstrangebehavior when I have hadtoo manythoughts in my head,^{being athome} but at the same time somewhere else...

139

COORDINATION OF SUPPLY AND DEMAND

IN THE DAIRY MARKETING SYSTEM

with

I INTRODUCTION 145

1.1 COORDINATION AS A PROBLEM OF MARKETING ECONOMICS 145

1.2 WHAT DO WE MEAN BY COORDINATION? 146

1.2.1 Exchange economyand transactions ¹⁴⁶

1.2.2 Towards the definition of coordination 147

1.3 RESEARCH ISSUE ALTERNATIVEINSTITUTIONAL/POLICYMEASURES TO

DEAL WITH COORDINATION 149

1.3.1 What research can offer todeal with theproblem 149

1.3.2 A new way of economic analysis ^is needed 150

1.3.3 Prices and institutions in economic analysis 152

1.4 ^{APPROACHANDOBJECTIVESOF THISSTUDY} 153

1.4.1 Approach application of transactioncost ^economics 153

1.4.2 Objectives 154

1.5 PLAN OF DISSERTATION 154

2 APPLICATION OF THE TRANSACTION COST APPROACH TO ANALYZING ECO-

NOMIC COORDINATION 155

2.1 BASIC SETTING 155

2.2 MODES OF PREFERENCE ARTICULATION 155

2.2.1 Voice and exit 155

2.2.2 Cooperativeswith respectto preferencearticulation 156

2.3 PROPERTIES OF TRANSACTIONS IN ECONOMIC COORDINATION 157

2.3.1 Behavioral assumptions 157

2.3.2 Basic ways of arrangingthemarketing system 158

2.3.3 The market as acoordination mechanism 159

2.3.4 Reliance solelyon markets as a coordination mechanism 160

2.3.5 Bureaucraciesas coordination mechanisms 162

2.3.6 Conclusions regardingbasic coordination mechanisms 164 2.3.7 Cooperativeswith respect to markets and hierarchies 165

2.4 THE TRANSACTION COST APPROACH(TRC) 167

2.4.1 The concept of the transactioncost approach 167

2.4.2 Dimensions of transactions 169

2.4.3 Principles of organizational design 172

2.4.4 Cooperativesin the light of transaction cost economics 176 3 BEYOND TRC: FRAMEWORK FOR ANALYZING ECONOMIC COORDINATION ^.. 177

3.1 LIMITS OF THETRANSACTION COST APPROACH 177

3.1.1 The issue of propertyrights 177

3.1.2 Evolution of institutions 179

3.2 THE MARKETING SYSTEMS ANALYSIS FRAMEWORK 180

3,3 OPERATIONALIZATION OF RESEARCH ANDEXPERIMENTAL DESIGN ^.... 181

140

4 THE FINNISH DAIRYSUBSECTOR^ASVIEWEDIN THETRANSACTION COST AP-

PROACH 183

4.1 AGRICULTURE AND DAIRY PRODUCTIONIN THE FINNISH ECONOMY ^... 183

4.2 POLICY AIMS AND CONSIDERATIONS 185

4.3 CHARACTERISTICSAND COORDINATION ISSUES 186

4.3.1 Dimensions of transactions 186

4.3.2 Structure 191

4.3.3 Conduct 201

4.3.4 Performance 207

4.4 KEY TRANSACTIONS WITH RESPECT TO EACH COORDINATION ISSUE ... 209

5 SYNCHRONIZATION COORDINATION 213

5.1 OVERALL BALANCING 213

5.1.1 The issue 213

5.1.2 How the problem arose 215

5.1.3 Alternative policy measures:price, quantitativecontrol,cooperative adjustment^fund 218

5.1.4 Conclusions 230

5.2 COMPONENT BALANCING 231

5.2.1 The issue 231

5.2.2 How the problem arose 232

5.2.3 Alternative policy ^measures 234

5.2.4 Conclusions 238

5,3 SEASONAL BALANCING 239

5.3.1 The issue 239

5.3.2 How the problem arose 240

5.3.3 Alternative policy measures 242

5.3.4 Conclusions 244

6 ADAPTATION COORDINATION MFTiTINGNEW CONSUMER DEMANDS 246

6.1 THE ISSUE 246

6.1.1 The changingconsumer 246

6.1,2 The changing food system 248

6.1.3 Reflections on dairy product markets 250

6.2 HOWTHEPROBLEM AROSE 253

6.2.1 Key transactions 253

6.2.2 Current policy asexplained by TRC 257

6.3 ALTERNATIVE POLICY MEASURES 259

6.3.1 Producer-members and adaptation coordination 259

6.3.2 Developmentof newproducts 260

6.3.3 Governmental agricultural and food policies 260

6.3.4 Scenario projected by ^TRC 260

6.4 CONCLUSIONS 261

7 COMPARISON OF THE DAIRY MARKETING SYSTEMS IN UNI^ANI)AND IN MIC 111

GAN, USA 263

7.1 DAIRY PRODUCTIONIN MICHIGAN 263

7.2 TECHNICAL SEPARABLE INTERFACES OF THEMICHIGANDAIRY MARKET-

ING SYSTEM 263

7.3 MAJOR DIFFERENCES IN CHARACTERISTICS AND THEIR EFFECT ON COOR-

DINATION ISSUES IN FINLAND AND MICHIGAN 264

7.3.1 Dimensions of transactions 264

7.3.2 Structure 266

7.3.3 Conduct 270

7.3.4 Performance 274

7.4 ROLE OF COOPERATIVESIN THE U.S. DAIRY MARKETING SYSTEM 277

7.5 CONCLUSIONS 278

8 CONCLUDING REMARKS AND FUTURE RESEARCH NEEDS 280

8.1 WHAT WAS DONE 280

141

8.2 CONCLUSIONS ABOUT COORDINATION IN THE FINNISH DAIRY SUBSECTOR 282

8.3 CONCLUSIONS ABOUT THE PROBLEMS CONSIDERED 283

8.3.1 Overall balancing 283

8.3.2 Component balancing 285

8.3.3 Seasonal balancing 286

8.3.4 Adaptation coordination 286

8.4 DAIRY MARKETING SYSTEMS IN FINLAND AND MICHIGAN 288

8.5 COOPERATIVES AS COORDINATING INSTITUTIONS 289

8.6 APPLICABILITY OF THE FRAMEWORK 290

8.7 FUTURE RESEARCH NEEDS 290

EXHIBITS I—s 292

REFERENCES 313

SELOSTUS: KYSYNTÄ JA TARJONTA MAIDON MARKKINAJÄRJESTELMÄSSÄ^.... 318

List of abbreviations used

CAF Cooperative AdjustmentFund.

FMMO Federal Milk Marketing Orderused inthe United States.

IOF Investor OwnedFirm. A firmowned by investorsas adifference fore.g. cooperativewhich areowned by customer-members.

M—W- Minnesota—Wisconsin Price for B Grade milk.

price

NBDG New Product Development Group.

NFNPS NonFat Non Protein Solids. The solids inmilk exceptfat and protein.

PSM Pellervo-sociely’s MarketingResearch Institute. Pellervo-Society is the Central Organization of Farmer’s Cooperatives.

SOP Standard OperatingProcedures TRC Transaction Cost Economics

USDA United States Department of Agriculture Valio Finnish Cooperative Dairie’s Association

JOURNAL OF AGRICULTURAL SCIENCEIN FINLAND Maataloustieteellinen Aikakauskirja

Vol. 61: ^143—321, 1989

Coordination of supply and demand in ^(he dairy marketing system withspecial emphasis on the potential role of farmer

cooperatives as coordinating institutions

Abstract.The study^attemptsto gainabetter understanding of matching the ultimatesup- plyand demand for milk atvarious stepsof the production-distribution^sequence.The^pur- poseis toassess the suitability of priceorregulationsinsolvingvarious coordination prob- lems. Special emphasis is given to the cooperativesascoordinatinginstitutions.

The theory inthe study draws from Transaction ^CostEconomics,Economics of Public Choice,^andIndustrial Organization approach. The application used is termed Marketing Sys- tems Analysis. ^Itis applied to the dairy marketingsystemproviding explanations to the surrent structure andanalyzing four problems: (1) coordination of total supply and demand if milk, (2) coordination ofmilk components,(3) seasonal balancing, and (4) adaptation of new con- sumer preferences.

Index words: Agricultural marketing, marketingeconomics,cooperatives,transaction costeconomics,dairymarket- ing, agricultural policy design, market coordination

143

I INTRODUCTION

1.1 COORDINATION AS A PROBLEM

OF MARKETING ECONOMICS

Marketing economics isaratherundefined field of study with differing perceptions about itscontents.Thetermitself describes its close relation to economics. However, marketing economics^isnotmerely asubcategory ofeco- nomics.

When economics focuses its attention on production, alternative production costsand economic efficiency, the core of marketing economics is exchange and its implicationson production. How are various preferences taken into ^account in economic activities?

Whose preferencesaretaken intoaccountand in what order? How is the production system

ableto convert the preferences into products and services offered? Howare costs,benefits and risk distributed? In otherwords, how is supply and demand coordinated? The prob- lems of marketing economics ^aremostly re- lated_to inefficiencies in the systems of ex- change. A basic problem often isapoorun- derstanding of the mechanisms in the process of exchange.Thus, understanding thesystem is the first step.

Thesystem of exchange is alwaysa mixture of society-made rules and somekind of bar- gaining, i.e., the market. In every so-called free market therearerules defining the differ- ence betweena good buy and theft. Even in the most strict ^planning economies ^{there is} some type of bargaining ifnot involving money, ^at least mutual promises. Thus, the economics of exchange, not just marketing economics, ^{could be} a more comprehensive name for this field ^{of study.}

Likeeconomics,micro andmacrolevelsare

found in marketing economics ^aswell. What ismeantby marketing is mostoften the Kot- lerian-type of business marketing (Kotler

1986).Thiscanbe definedas“micro ^market- ing” which attempts to correct exchange in- efficiencies to match the consumers’ and producer’s preferences in production. Evena field of “micro-micro marketing” can be found, called internal marketing (Klemi

1985, Grönroos 1987,^Rope 1988).

Macro marketing economics is interested in howanexchangesystemconsisting of several economic units is able to convert the prefer- ences over a number of steps. Various ex- change institutions, rules of exchange, have

differing capabilities toperform the exchange which affect human behavior, ^giving as an outcome differing distributions of costs, benefits and risk. They in turn have implica- tionson the production circumstances. Mac- ro marketing economics is interested in the varioussetsof rules for correcting exchange inefficiencies.

The tools of marketing economics draw also from other disciplines besides economics: be- havioral sciences in order to understand the behavior of actors and actor groups, politi- cal sciences to understand the collectively made rules, legal science to understand the construction ofrules, humanistic sciences to understand the cultures, values and prefer- encesinvolved, etc. Thus, ^marketingeconom- ics is a multi-disciplinary science.

This study belongs tothecategoryof“mac- ro marketing economics». Itattempts to un- derstand the process of converting the prefer- encesof variousactorsinto products andserv- ices desired in food production. The empiri- cal environment is the dairy subsector.

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1.2 WHAT DO WE MEAN BY COORDINATION?

1.2.1 Exchange ^economy and transactions If aperson owns something that another person needsmore orsomething heowns, the former person needsless, shifting theowner- ship of thesetwo items_canbe said tobenefit both. This is a basic example of exchange.

The development of exchange has been per- haps oneof the main issues affecting the de- velopment of human culture. Instead of mak- ing all the needed commoditiesthemselves, ex- changing themallowed individuals_tospecial- ize. Exchange also provided incentives forso- cial interaction and a sense of community.

Exchange seemsto be an essential require- mentfor the division oflabor, which in turn isconsidered basic for prevailing humancul-

ture. Smith (1961) begins his pathbreaking work,“The Wealth ofNations”, as follows:

“Thegreatestimprovement in the produc- tive powers oflabor, and thegreatestpart of theskill,dexterity, and judgement with which it is anywhere directed, orapplied, seem to have been the effects of the divi- sion of labor.”

Smith presentsthe famous example of pin making and concludes:

“... ten persons, therefore, could make among them^upwards of fifty-eight thou- sand pins ina day. Each person,therefore, making a tenthpart of forty-eight thou- sand pins, might be consideredas making four thousand eight hundred pins inaday.

But if they had all wrought separately and independently, and without any of them having been educatedto this peculiar busi- ness,they certainly could^noteach of them have madetwenty, perhapsnot onepin in a day ^...” (Smith 1961, pp: ^B—9).8—9).

The main interest of this study is in finding possible arrangements for transferring inter- mediate products from onephase tothe other as smoothlyas possible.

Exchange seems to be closely related to ownership and achange of ownership. In ju- ridical economics thecorrect term for this is

“propertyrights”.

“Property rights describe the relationship of one person to another withrespect to a resource orany line of action. ^... Rights arethe instrumentality by which any soci-

etycontrols and orders human interdepen- dence and resolves the question who gets what.^... Theterm ’property right’ includes both real and personal property.”

(Schmid 1978, pp. 10—19)

Property rights define socially accepted rules regarding thecommand of particular property in the environment of human inter- dependence. Schmid emphasizes that aprop- ertyright to somethingcannotexist without the acceptance of the surrounding society.

Thus, ^theproperty right is a function ofso- cialacceptance. This is important in thesense that without rules of the game defined byso- ciety, people would havetodefend their prop- ertyrights by fighting, as wasthecasebefore the creation of the modern juridical society.

Still in some cases in which the opinions of

propertyrightsdiffer, the acquisition ofsome- thingcan mean“taking my ownback” tothe actor but a theft to the object.

Exchangecan,thus, be definedasthe shift- ing property rights of an item in human in- terchange according torules accepted by so- ciety. In economic literature this kind ofex- change is more often called a transaction.

Even when transactions take place under defined rules accepted by the parties, they may occur under different circumstances. Schmid divides transactions accordingtothe rights of the parties into three categories: bargained transactions, administrativetransactions, ^and

status and granttransactions.

1

The reason for examining transactions is that transactions, the shift ofpropertyrights, occurwithin the rules _setfor thetransaction, but by changing therules, the distribution of property rightscan be affected. It isa matter of public choice, which oneof the transaction modes is chosenas a form of transferring the

' He also presents other categorizations such as managerial and rationing transactions by ^Commons (1950, ch. 3) and 1.tradition, 2.command and3. mar- ket by Heiibroner (1962, ch. ^I).

146

propertyrights. Property rights inturndefine

“whogetswhat and whopays”. Thus,by af- fecting transactions the performance of the

system can also be affected.

1.2.2 Towards the definition of coordination The problem

of

Whenevernumerousactions havetobe tak- en in order toreach an outcome, coordina- tion between these actions is required. A rowing team needsa mate to coordinate the timing, a choir needs adirector and a musi- cal score, and abusiness organization needs amanager andplanning. The efforts of vari- ousindividuals havetobe integrated and syn- chronized.

As the number of parties involved intrans- actions increases, the transactions become muchmorecomplex. Actually, the initial buy- erand seller very seldom see each other for direct negotiations. The goods are often manufactured before the buyingdecision, ^and the price is setbefore the buyer even knows about the existence of the product.

What provides the coordination of these thousands of people workingtocomplete their contribution perhaps years before the final outcome the product is consumed? How do they know whatto do? How theycan be surethat theyare doing the right thing? Let us think abouta loaf of bread. Beforea con- sumer seesthe loaf in a store,somebody has delivered it into the shop, madeit,ordered the flour fromsomewhere, ^{which inturnhas been} milled by somebody and for which somebody has grown the grain. If the investments are considered, it would be easyto find hundreds of individual decisions _some made many years beforetoproduce that particular loaf of bread.

How is it possible that all these individual decisions will produce aloaf of bread? How do these decision makers know about some- body’s willingness tobuy that particular loaf?

That is the problem of (vertical) coordination of the exchange system.

All the parties involved in the decisionex-

amine thesystem as a part of theirown, ^in- dividual opportunity sets.^2. That is why the parties have different needs andwants regard- ing the system.These needscansometimes be in conflict with each other.

When all have different preferences, the rules of the system, i.e. the institutions, ^de- cide what preferences are taken into account and in what order. As a matter offact, ^the particular exchangesystemis themeansofar- ticulating preferences. “The effectiveness of the food system as a mechanism for prefer- encearticulation is the key question about the

system performance.” (Shaffer 1980) Market andgovernment canbe understood asalternativesystems of preference articula- tion.³ Public discussion has many value- based _arguments about the ability of either

markets or government toarticulate certain preferences. This discussion is often basedon entirely differentconceptsconcerning human beings.

Coordination isa specialcase of the prob- lem of preference articulation. Itcan be de- fined _asmatching eachstepof the production- distribution sequence of _agood with existing demand. This broadens the question ofcoor- dination also to the adjustment problems on the supply side.

Marion (1976) defines coordination as a process by which various functions ofa ver- tical value-adding_{system are}brought into har- mony. Hepresents the following questions as important for the coordinationprocess:

(1) What is produced and marketed(quan- tity and quality)?

2 Anopportunity set can be definedasthe available lines of action^opentoanindividual.^Theopportunity set of one person is shaped by the opportunities of others (Samuels 1972)andrestricted by theresources tousethe opportunities.

3 “Government and marketsarejointmechanisms for articulating preferences. Government producesthe regula- tory system shapingthe opportunity set of firms and households. This determines what is to be taken intoac- count by participants. The regulatorysystem sanctions a patternof private powerincluding facilitatingand limit- ingcollective action. Inthissensemarkets deal only with solved political problems, and the market isaninstrument of the regulatory system.” (Shaffer 1980)

147

(2) When is it produced and marketed?

(3) Where is it produced and marketed?

(4) How it is produced and marketed?

(What is the efficientuse ofresources for completing the vertical value- adding task? Unnecessaryorinefficient stepsand cross-purpose work is elimi- nated or combined.)

(5) What adjustments and adaptations are neededtorespond promptlytochanges in demand, ^new technology, or other shifts in profit incentives?

Marion includes two dimensions into the coordination process: asynchronizing dimen- sion andanadapting dimension. The former considers coordination in the sense of fine- tuning thesystemby systemizing, routinizing and stabilizing various actors’ activities and relationships. The aim is for all thesteps in the production-distribution sequence^tofit in smoothly with each other in_anefficient way.

Marion says this leads towards streamlined, efficient systems to satisfy short- and inter- mediate-period market demands. Such sys- tems, however,accordingtohim,maybecome relatively rigid and inflexible in alonger time horizon.

Marion further^statesthat coordination in anadaptationsensemay involvequite differ- ent forces. It leads towards disrupting and remodeling an existing system so that it will be relevant in the longrun. Thus, some out- comes of synchronizing decisions may be in conflict with the adapting dimension ofcoor- dination. Mechanisms that improve syn- chronization may stifle adaptation.

The first three points presented above re- fer mainly to the synchronization dimension of coordination, while the latter two refer more to the adapting dimension. Marion feels that this distinction can lead to two different partsof _acontinuum called coordi- nation. He fears that concentration ^{on fine-} tuning the system so that the parts mesh smoothly together may encourageonetofor- getthat we arealso supposedto ask whether wemight be able_{to create}a new and superior

system.

Marion further emphasizes the distinction

between coordination as a process and the mechanisms which influence that process, and

presents four categories of decisions affecting subsector coordination. He adds that besides these decisions there _are factors beyond the control of subsector participants such as weather and foreign supply. The categories presented by Marion are:

(1) Incentives (economic incentives as reflected in prices, social incentives such as the relationship between the members of thesystem,security incen- tives which encourage conventional be- havior, etc.)

(2) Flow of information (which affects the level of knowledge, the level ofuncer- tainty and the communication of incen- tives).

(3) Adequacy of necessary inputs _to be abletorespond to incentives (i.e., the extent to which decisions _are severely restrained).

(4) Management alertness and ability.

As coordination mechanisms Marionmen- tions such arrangements and institutions as markets of all kinds, private treaties, vertical ownership, bargaining associations, ^market orders, informationsystems(including grades and standards), transportationservices, ^credit services, governmental programs, trade as- sociations and cooperatives. Different coor- dination mechanismscan affect all the four

aspects of decisions presented above, but in adifferent _manner.

Levels and modes

of

Shaffer and Staatz (1985) define four levels of the coordination problem:

(1) Coordination within firms (micro-mi- cro coordination).

(2) Coordination between individual firms (micro coordination).

(3) Coordination of total supply withto- tal demand for commodities_orindus- tries in each stepof the production-dis- tribution process (macro coordina- tion).

(4) Coordination of aggregate demand with aggregate supply for the economy as a whole (macro-macro coordina- tion).

148

A theory of coordinationmust include all these levels. The problems and mechanisms of coordination _are interrelated between these levelsand, thus, the governancestructuresof all the levels should be addressed in the ex- amination of coordination problems. Theem- phasis in this study is on levels 2 and 3.

Coordination and integration

Integration of separable tasks into the_same organization has beenoneway ofcoping with market imperfections. The coordination of certain activitiescanbe assumed to improve through integration. Galbraith (1967)states that integration has been more important in modern corporations than before, e.g., be- cause of the increased complexity and time span of production processes.

Vertical integration is defined by Shaffer (1986) as the coordination of technically separable activities in the vertical sequence of production and distribution of products un- der the control ofan organization byowner- ship. Among incentives for vertical integration are: (1) the reduction of production costsand cost of acquiringinformation; (2) solutionsto problems involved in transactionsacross mar- kets, problems of uncertainty, impacted infor- mation, opportunism, and externalities; ^and

(3)economies of scale in allocating lumpy in- puts over a set of activities. Shaffer also in- cludes in the list the growth goals of manage- ment. As anvexample of economies involved in vertical integration, Scherer (1980, p. 78) mentions the integration of blast furnaces,

converters and primary reduction mills in the steel industry in order toreduce handling and reheating.

Horizontal integration involves combining withinone organization a number of techni- cally separable production-distribution sys- tems of the same product. Incentives of horizontal integration includeapotential im-

provement in the match of supply with de- mand(macro coordination), potential market power, andgenerally improved abilitytocon- trol the environment associated with the econ-

omies of scale (Shaffer 1980 and Ollila 1984).

Scopeintegration involves combining with- in oneorganization the production-distribu- tion ofanumber of productsorservices which aretechnically separable. An example of this is the Finnish conglomerate, Tampella which manufactures textiles, locomotives and lum- ber. Incentives for scope integration include potential for economic power, possibleecon- omies ofscale,especially in selling, and reduc- tion of the uncertainty of changing market conditions. Shaffer⁴_states that few coordi- nation benefits are apparent from scope in- tegration per se. However, very large con- glomerate firms may have the capacityto in- fluence thesystem through the exercise of po- litical and economic power.

1.3 RESEARCH ISSUE —ALTERNATIVE INSTITUTIONAL/POLICY

MEASURES TO DEAL WITH COORDINATION

1.3.1 Whal research can offerto deal wilh the problem

Probably themostcommon topic of polit- ical discussion has been transactions managed either through market orthroughadministra- tive decisions. When demand and supply are observed, the market between them has often developed by itself. If exchange through the market hasnot succeeded, the mostcommon way ofimproving the situation has been pub- lic involvement. If the public administrative

system has_not performed well, more market has again been demanded. Schmid (1978, pp.

xii—xiii) describes the situation_as follows:

“It is ironical that we seemto goin cycles on many issues ofpublic policy. Ifwedo not like the results in agivenarea andmar- kets_are being used, ^{it is}common to hear recommendations thatweturn togovern- ment enterprisesorregulation. If govern- ment is already involved, reformers will

4 Shaffer, ^J. 1986,Thinkingabout Farmers’ Cooper- atives, Contracts and Economic Coordination, unpub- lished.

149

suggest that markets be tried... With re- spect toinstitutionalchoice, we seemtobe acting in ignorance. Wego through cycles of reform withgreatpromise of_newresults only to find failure and some newround of reformers advocatingreturn towherewe started. ...They can choose any rule they want but theyarenot sure what the result will be. How many times havewewatched a grouplspend their political capital, obtain a newrule, and then receive no change in performance?”

The food system has always been anespe- cially important exchangesystemin all socie- ties. The same kinds of cycles as those described by Schmid are easily seen in all modern societies. As a result, the poor per- formance of markets has been “corrected”

with regulations, and the poor performance of administrative exchange with more mar- kets. It can be supposed that there is a lack of sufficient understanding of _asometimes

very complex exchangesystem.

In the real world, theactorsin the economic environment make decisionsatdifferent times without perfect knowledge about each others’

decisions and about the development of the decision-making environment. The uncer- tainty that prevails at every single decision causesuncertainty of the future supply and de- mand of that particular commodity. This results in anuncertain allocation ofresources, which inturncauses the sub-optimal coordi- nation of supply and demand.

The uncertaintyateach level of the produc- tion-distribution chain makes the problem of coordination complex and difficult. Accord- ing toShaffer and Staatz (1985), the failure in coordination mayoccurat anystep in the sequence but ismostobvious whennotmatch- ing the ultimateconsumer demand at prices consistent with ^cost.

A researchercan contribute_toabetterun- derstanding of the system. Each person be- haves accordingtohisorherownpersonal op- portunityset and, thus, ^{seesonly one part of} the complexsystem. A researchermayseethe

system in_{a more}holistic way, which will help to spot themost critical parts of the system

when tryingtochange its performance. What- ever prioritiesare given to the system, a bet- terunderstanding will help topredict the pos- sible ^outcomes.

1.3.2 A new way

of

During thepast 40 years, economic analy- sis has been mainly basedonthe neoclassical tradition. _However, alternative views have continuously been presented.

Along with the steady growth of the_econ-

omyand with the help of the development of mathematical methods andcomputertechnol- ogy, it becamepossible toformalize compre- hensive models to explain economic events with great accuracy. As the complexity of models increased,^some economists started to question the basic assumptions of the neoclas- sical economic model. In the opinion of the heterogenous group of so-called institutional economists, traditional economics searched foraccurate answersbut sometimesnot tothe most relevant questions. In their view there were many problem _areas where norelevant questions even existed, yet.

This study makes no ^attempt to deny the relevancy and operationality of traditional economic research based on the neoclassical model, ^butacceptsits limitations in questions suchasthe appraisal of the multigoal perfor- mance of the Finnish dairy subsector.

The theory of X-efficiency presented by Liebenstein (1979) criticizes the basic as- sumptions of neoclassical economic models suchas the maximizing behavior ofeconom- ic actors including implicit assumptions of complete information and purely rational be- havior. Liebenstein statesthat in anenviron- mentof uncertainty, the continuous maximiz- ing behavior of all the _actors involved is un- realistic. It^can always be stated that theac- torsmaximizesomeunderlying factors in their behavior. Liebenstein states that in anoper- ationalsensethis kind of maximizing behavior doesnot tell anything else than that people be- have like theydo. He concludes that the en- 150

tire concept of efficiency should be sup- plemented by the concept of X-efficiency, which differs from theformer in the follow- ing features:

The cost of a commodity is not in- dependent of the price of the commodi-

iy-

Firms⁵ do not minimizecostsexcept in extreme circumstances.

Thecost of production hasatendency to rise toward the price level.

There is _no production function in- dependent of the environment of the firm and the history of the firm.

In mostof the studies examining industrial subsectors,efficiency has been takenas agiv- en measureof the performance of thesystem.

Researchers interested in relations among groups of firms adopted a much wider view of performance including aspects such as equity, progressiveness and full employment in additiontotechnical and allocative efficien- What may also have relevance in the problem considered in this research is pricing efficiency.

Neoclassical theory had basically two models of interaction: the perfectly competi- tive market and,to some extent, the monop- oly market. Many economists started to de- velop the oligopolistic theory, because they observed mostof the real-world economic in- teraction_to be closest _to oligopoly. Among these is the socalled Industrial Organization School,⁷ which sees as a basic problem of neoclassical economics the_concept of the hu- manbeing and the difficultiestofit it in with the models in a world of uncertainty.

Some neoclassical economists argue that the criticized questions have already been an- swered by extensions of neoclassical econom- ics. A counter argument could be thatifthe complexity of _a theory grows more rapidly

5 In this study, the terms “firm”, “organization”,

“bureaucracy”and “hierarchy”willbe used somewhat interchangeably.

6 Various categories of performance dimensions have been provided,e.g., by Sosnick (1964),^Bain(1968) and Scherer (1980).

7 ^{See Bain (1968), Scherer (1980), Marion et al.}

(1986).

than its explanatory power, would thisnot be the right moment to return to basics again?

There is_an increasing number of economists who doubt the possibilities to model human behavior mathematically. One of thestrongest arguments has been given by ^Boulding (1981, p. ⁷⁹⁴⁾ as follows:

“The social sciences of the twentiethcen- tury have been captured by essentiallysev- enteenth-centurymathematics, witha lit- tle dash of nineteenth-century probability and statistics, much of which is quite in- appropriatetothetypeof real world which is being investigated.”

Peach and Webb (1983) made an experi- ment comparing theory-based econometric models with others having independent vari- ables chosenatrandom. Their conclusionwas that ^“... a large proportion of models gener- ated randomly are indistinguishable from models based on accepted theoretical frame- works and estimated by respected investiga- tors if the usual tests of goodness of fit and statistical significance are the only criteria used.” The experiment shows the realtrapof using this kind of methodology without hav- ingaclear understanding of the underlyingas- sumptions.

The meaning of human behavior in the the- ories _canbe consideredan initial foundation of criticism of neoclassical economics. Al- though someeconomists referto “humanna- ture as we know it” (Knight 1965, p. 270), itplaysarather insignificant role in their anal- ysis. Friedman (1953) has considered the realistic assumptions ofatheory unimportant but rather _sees the fruitfulness of _a theory turning on its implications.

The central starting point of institutional economic analysisis, then, toinclude the hu-

manbeing into economic behavioras well as we know it, although this causes many difficulties in theory construction.“Modern institutional economics should study man as heis,acting with the constraints imposed by real institutions. Modern institutional eco- nomics is economics as it ought to be.”

(Coase 1984)

1.3.3 Price and institutions in economic analysis⁸

Economic behavior depends on the incen- tivestructure(opportunity set) of human be- ings and organizations, which consists of in- dividuals with interconnecting rules. Among the fundamental elements of economic be- havior, after the basic needs of human beings, are the available technology affecting the in- put/output -ratio,and the values and ideolo- gies affecting what is desirable,preferable and acceptable.

In order_toalter the economic performance in prevailing technological and ideological conditions, ^{two issues}can be modified. We can change the price structure, and we can change the rules. The neoclassical economic theory focuses onprices, keeping the existing rules institutions constant. Institution- al economics attempts to examine the effect of changing the ruleson the performance of thesystem. In suchanexamination, it is usual- ly appropriate _tokeep prices constant.

In the conditions of pure neoclassical eco- nomics,coordination is conducted by prices, i.e. markets. Prices will allocate theresources, and changes in prices will carry information about changes in circumstances. Institution- al economists argue that thereare no markets independent of the rules of exchange. The rules, e.g., define the difference between a good buy and fraud. Asamatteroffact,there are notable differences in these matters in different cultures.

When a neoclassical economist makes an analysis of how price changes affect perfor- mance, the institutional economist considers possible changes in performance when rules are changed. When both affect the perfor- mance of the economic system, the two ap- proaches havetobeconsidered ^ascomplemen-

8 Before going on, twoconcepts havetobe defined:

“Transaction” is the shift of the^propertyrightsofa re- sourcefor anotherparty. Itincludes both exchanges and contracts.“Institution” is the set of rules under which atransactionoccurs.Institutions includelaws,operating procedures,habits and cultural traditions associated with transactions.

tary, not exclusive perspectives. Neoclassical economists have also startedtoemphasize the role of institutions. The well-known agricul- tural economist, professor Glenn Johnson (1988), writes:

“The agricultural institutions in the Devel- oped Countries, Newly Developed Coun- tries and Less Developed Countries arein such_anarray thatinstitutional deficiencies impose more important constraints on agricultural production and adjustment than lack of available technologies and bi- ological and physical resources.”

The still rather heterogenous group of the- ories ^of institutional economics has many roots. The origin of the so-called “old institu- tional economics” is rooted in the work of Commons (1934) and even in the so-called German School. Transaction^costeconomics, as oneintersection of thisroot, owes a great deal to the work of Coase (1937). The school of old institutional economics examines the ef- fect of different deviations ofpropertyrights on what is countedascosts. E.g.,the produc- tion cost ofpigs vary depending on whether any damage caused by the operation to a close-flowing river is includedorexcluded as a ^cost for theoperator. The literature of old institutional economics examines the alloca- tion ofpropertyrights defining whatcostsare taken into account in anefficient market so- lution. As a result, many efficient solutions are possible, and the society has to decide which one is preferable.

Another root of institutional economics is known as “new: institutional economics”.

This group of work has been influenced by the works of ^Hayami and Ruttan (1988), Wil- liamson,⁹and so-called agency theorists such asFama (1983), Jensen and ^Meckling(1974).

This body of literature argues that institutions arise along with theeconomic process of al- locating scarce resources to meet human preferences.

Williamson explains the rise of institutions as afunction of transactioncosts.^{Hayami &}

9 The work of Williamson is presentedindetailin ^the following chapters.

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Ruttan explain the changes in instituntions and technologyasendogenous tothesystem.

This_meansthat acertainsituation is likelyto induce_a certain kindofachange. Usingtheir

“theory of induced institutionalinnovations”, explanations can be found, ^e.g., for the rise of the paper machine industry, paper process- ing computerprogramming and state-of-the- art ice breaker industry in Finland.

The agency theory, in^turn, understandsan institutionas a nexusofcontractsmade by the participants (agents),each having varying ob-

jectives for participating in the system.

Among other things, the agency theory looks for stable coalitionsassolutionstocoopera- tion problems.

As “new institutional economists” under- stand it, institutions minimize transaction costs in asimilarway astechnologyattempts to minimize production ^costs. The connection between institutions and economic perfor- mance isnot a new idea. Staatz¹⁰pointsout that the Marx had the same idea, but more on a macro level. He also defines the differ- ence between “old” and “new” institution- alismso that new institutionalism sees insti- tutionsas parts of factors affecting econom- ic efficiency, while old institutionalism under- stands efficiencyas afunction of existing in- stitutions.

Among the behavioral economists coming mainly from business schools ^are Simon,

Cyert and March. They have also in- fluenced institutional economics by challeng- ing the behavioral assumptions of neoclassi- cal economics suchasperfect rationality and perfect knowledge. Simon’s “bounded ra- tionality” (1972), which creates uncertainty, and^Cyert& March’s “Standard Operating Procedures” (1963), which aimsatdecreasing the transactioncosts, have been important in the work towardsa better understanding of the behavior of institutions in real-world cir- cumstances. Still another group of theories called the “Industrial Organization Ap-

1(1 Staat/’s presentationon “NewAgricultural^Eco- nomics” at^theScientific Agricultural Societyof Finland on April 14. 1988.

proach” has hadan influenceonthe develop- ment of institutional economics. This ap- proachisdiscussed inmoredetail in chapter2.

Institutional economic analysis is stillatan earlystageof development. The results of this kind of analysisare not yetat a level of for- mal presentation comparableto, e.g.,econo- metrics. There is still agap between the con- ceptsandtheirempirical application. Even at itspresent stage,institutional economic anal- ysis is useful in constructing institutionalar- rangements in which price can then be ana- lyzed in more traditional ways.

1.4 APPROACH AND OBJECTIVES OF THIS STUDY

1.4.1 ^Approach applicationof transaction cost economics

As mentioned^above, the problem of coordi- nation involves both prices and rules, i.e.,in- stitutions. The approach used hastobe capa- ble of deal with both elements. The transac- tion cost approachseemstoprovidea bridge between thetwoelements,and is also well ap- plicabletothe problem of organizing the tasks to be coordinated.

in this studyone application of transaction cost economics is used. “Transaction cost”

canbe defined_as the cost of all the activities of gathering and processing information, negotiating contracts,administering, monitor- ing the exchange, and solving possible dis-

putes. In the transactioncost approach, the totalcostsof production include both produc- tion and transaction costs. The institutional setting, or “governance structure”, ^affects transaction costs to a ^great extent, although the costs and organizations are also inter- related.

Ai.chian and Woodward (1988) present twodifferent dimensions of transaction costs.

One emphasizes the administering, directing, negotiating and monitoring of joint produc- tive teamwork inafirm. The other emphasizes the quality of performance of contractual agreements. Where thesecosts arehigh,mar-

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ket transactions tendto be replaced by inter- nal transactions. Thus, ^{there havetobecosts} involved in the reliance on markets as well;

these are transaction ^costs.

The characteristics and circumstances of transactions affect the transaction costs.

When different institutions have different properties inrespectof transactioncosts, some will be more suitable for certain kinds of transactions.

1.4.2 Objectives

This studyattempts to deal with the prob- lem of coordination in real-world conditions.

In a marketing system such as the Finnish multi-goal dairysubsector, coordination ^can-

notsimply be consideredas aprofit maximi- zation problem. The paradigm to be devel- oped hastotake into accountfactors such as political processes, non-market values, ^etc.

The objective is to develop _a tool to help to interpret the problem of coordination, ^to helpto structurethe relevant questions to be examined, ^andtolook for evidencetosupport the conclusions. An ^attempt will be made to apply the transactioncostapproach tothe fol-

lowing:

(1) To explain the current structure:

The transactioncost approach argues that the prevailing organizations are not accidentally born,^but are anout- come of minimizing the transaction costs.By using thisframework, anat- temptwill_memadetoexplain the cur- rent dairy marketingsystem in Finland.

(2) To suggest hypotheses regarding ad- justment processes and constraints to improved coordination:

After understanding the current or- ganization of the dairy marketing sys- tem, reasons for coordination prob- lems in transactions will be examined.

The most important bottlenecks for each coordination problem will be identified.

(3) To make suggestions for institutional redesign:

After identifying themost significant bottlenecks hindering improved coor-

dination, suggestions for correcting the problem will be made. The ability of the market, of regulative policies and/or of cooperatives to solve each problem will be appraised using the theory developed in this study.

1.5 PLAN OF DISSERTATION

The emphasis in this study is on finding a method capable of dealing with the problem of coordinationatmacrolevel. Empirical evi- dence will be drawn from the dairysubsector, which is among the mostdifficult agricultur- al subsectors from the point of view ofcoor- dination in mostWestern countries.The prob- lems of surplus production, ^component balancing, seasonal variation and adjustment to new consumerdemandsare causing prob- lems in many countries, ^not least in Finland.

The aim istocomeup withevidencesupport- ing the conclusions suggested by the theory.

The study of the dairy marketing systemin Finland will be mainly concerned with the cooperative dairy industry, whichcovers a ma-

jorpart of the processing industry. The dairy producer cooperativesareorganized into the Finnish Cooperative Dairies’ Association calledValio, which is often takentorepresent

the entire industry.

This reportis divided into eight chapters.

Chapter2presentsthe application of the the- ory in analyzing the problem in question. In chapter 3 the framework is developed by mak-

ing additions to the theory. Chapter 4 ex- amines the properties of the Finnish dairy sub- sectorasproposed by the framework. Chap- ters5 and 6 examine each of the main coordi- nation problems in the Finnish dairy subsec- torand give suggestions for how to improve coordination withrespect to these problems.

The effect of the suggestions will not be em- pirically identified. In chapter 7, the dairy marketingsystems in Finland and in Michi- gan, USA, arecompared. Conclusionsas well

asfuture research needsarepresented in chap- ter8.

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2 APPLICATION «I THE TRANS- ACTION COST APPROACH TO ANALYZING ECONOMIC COORDINATION

2.1 BASIC SETTING

One of the objectives of economics is to coordinate between what is in demand and what can be supplied. Scarce _resources prevailing, the demanded goods have to be placed into an order of preference.

Different parties have different demands and wishes froman institution, which will here be called “preferences”. Preferences com- bined by the incomeconstraint make up the demand. The problem of coordination boils down to two important questions: (1) how preferences arearticulatedtothe (marketing)

system

1

get counted by the system.

In this chapter, ways of articulating prefer- ences with regard to their effect on the sys- tem will first be examined²The properties of transactions able to react to the preferences will be considerednext, usingtransaction^cost economics. To be able to apply transaction cost economics _to the research problem un- der consideration,additionstothe basic the- ory will be made in Chapter 3.

1 ^The term “marketing system” is used inthis study inter changeably with “exchange system”, including also other institutions than just the ^market.

2 In traditional economic theory, prices ^{and their} changeswereconsideredassufficientmeansof articulating preferences.AdamSmiths’s“invisible hand” took care of both preference articulation and economic coordina- tion.

2.2 MODES OF PREFERENCE ARTICULATION

2.2.1 Voice and exit

When examining the process of recupera- tion (to be able to better coordinate supply and demand), Hirschman (1970) presents the concept oftwo alternative ways of articulat- ing preferences: “exit” and “voice”. Exit refers to the typical market behavior of a buyerchoosingonegood butnotchoosingan- other. If the buyer chooses a competitor’s product, the manufacturer shouldget infor- mation about the relative dissonance³ be- tweenhis product and the buyer’s preference.

This information should, ^after a certain threshold, facilitate recuperation. “Voice”

referstobehavior in which the buyer (citizen, administrator, etc.) seeks to bring about favorable changes in the goods offered byex- pressing his/her opinion to the servicing or- ganization. According _{to Hirschman,} voice

although it is usually _morecostly pro- vides morecomprehensive information about preferences than exit.

Voice and exit affect the recuperation proc- essina different way. Changes will always be more or less resisted. Hirschman discusses the “management reaction function” as the thresholdamount of informationandpressure toalert themanagement of the need for read- justment. Voice may be richer in information but the representativeness of the voiced dis- satisfactioncannotbe determined and its op- portunisticuse mayalways be suspected. Ex- it provides “exact” information about real be- havior but does not tell anything about pos-

J Relative dissonance refers to the best available good, not necessarily^thebest good.

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