Shaping the Values of a Milk Cooperative: Theoretical and Practical Considerations

Dairy cooperatives bestow upon farmers the virtues of controlling a large supply quantity of a relatively scarce product, that is, milk (e.g., higher bargaining power, fixed cost sharing, etc.). However, the cooperative structure also encourages individual farmers to free‐ride (i.e., provide low‐quality milk in the hope that other farmers provide good‐quality milk). The question arises: How can the benefits of a cooperative be retained, while eliminating free‐riding, especially when individual inspection costs are high? We examine this question from the perspective of a social planner, who wishes to achieve the simultaneous goals of quantity efficiency, quality efficiency, and minimal testing. The basic challenge in this quest is that of countering an endogenous value function associated with a coalition of farmers. This value function emerges from the joint interaction of three forces: (i) an individual farmer’s payment‐maximizing behavior, (ii) the testing policies employed by the cooperative, and (iii) the manner in which the revenue earned by a coalition is shared among the farmers (allocation rule). A novel allocation rule—that exploits individual incentives to guide the collective behavior of the farmers and thereby the value–function endogeneity—is proposed that achieves the planner’s goals in the presence of these forces. A modification to this allocation rule is made to address the goals of practicality, e.g., the presence of low‐income farmers and unintended variation in the quality of a farmer’s output. We examine our interventions in the light of sample data from actual dairy cooperatives to demonstrate the viability of our proposals.