Cooperatives and the Free Rider Problem
Phil Kenkel
Bill Fitzwater Cooperative Chair
What features of the cooperative business form make it successful in some situations and less
successful in other environments? Recent research on cooperatives has focused on the
advantages and disadvantages of this unique business structure. This research attempts to define
situations (problems) in which the member interest is not perfectly aligned with the firm’s
interest. Examining these issues helps to explain why cooperatives merge, dissolve or convert to
other business forms. More importantly it provides another dimension to understand what
practices and structures cooperatives should pursue to maximize their success.
One issue with the cooperative business form has been described as “The Free Rider Problem”.
Non-members who receive benefits of the cooperative, such as favorable prices, without
contributing equity are external free riders. A member who temporarily stops patronizing the
cooperative to pursue a better deal benefits by the existence of the infrastructure that they are not
currently supporting. Another internal free rider problem exists because new members are
typically entitled to the same patronage payment and access to services as existing members.
Members using only one aspect of a multi-service cooperative with a single patronage pool may
also be free riding on the profitability of other business areas. Given the choice, everyone enjoys
a free ride. This helps explain why members seldom push their cooperative to retain more funds
or increase their up-front equity investment.
The new generation cooperative model addresses the free rider problem through closed
membership, up-front equity investment and delivery commitments. By eliminating nonmember business and requiring large initial investment all of the users have “skin in the game”
and are on equal footing. Farm supply and commodity marketing organizations are less able to
avoid the free rider problem but can take actions to limit it. Disciplined pricing helps to channel
benefits to members and creates the mechanism for retained equity. A good example is pricing
fertilizer at replacement value even when the manager guessed right on timing the purchase.
Separate patronage pools can also address free rider issues. With separate pools, members using
only the less profitable fertilizer service are not being subsidized by the grain department profits.
A final strategy is to readdress your initial membership fee, considering the amount, in real
dollars, the founding members contributed.
Next week I will discuss the “Horizon” problem.