Understanding Retained Patronage Refunds in Agricultural

Comments and Replies
Understanding Retained Patronage Refunds in
Agricultural Cooperatives: Comment
C. Brice Ratchford
Knoeber and Baumer (KB) engage in a heroic posmlaiion
thai all the considerations in a cooperaiive's
management are encapsulated in [he preference
ratio of an "innocent" median member between
investment in his cooperative and in his own farm
ing operations. The assumption is naive, as is gen
erally admitted (p. 331.
The applicability of the model depends upon ihe
validity of the following two assumpiions: (a) the
patronage refund policy is determined by [lie
median member and reflects his preferences, and
ib) the median cooperative member attempts to
equalize risk-adjusted returns on assets invested in
(he farm and cooperative.
The assumption [hat the median farmer member
controls the patronage refund policy is invalid be
cause he/she cannot control how much is paid in
cash. The manager and board which represent the
members must take into consideration the need for
lunds for debt service, retirement of "old" equity,
and cash How as well as replacements and addi
tions. Therefore, the banker may exercise the dom
inant influence on the decision. Also, the account
ing practice followed for handling patronage re
funds received from other cooperatives becomes a
limiting factor on the amount of cash patronage
refund a particular cooperative can pay. Patronage
refunds are considered as income in the year re
ceived, even though part is in paper. In 1978 pa
tronage refunds received by local cooperatives in
Misouri were 7]C-r of all their net income, but only
40% was in cash. Hence, the locals could pay no
more than 57% of their net earnings in cash unless
they borrowed or used cash generated from depre
ciation and similar accounts. Income from other
cooperatives is a significant feature in the operating
statements of many large regional cooperatives.
The assumption that members try to equalize re
turns on cooperaiive and farm investments is highly
questionable.
The member's marginal income tax rate is a con
cern with regard to the share paid in cash. The
Internal Revenue Service requires a member to
consider both the cash and retained pans of the
patronage refund as income in the year received;
C- Brke Raldlford is a profe^or. Depi,rm,1;,u of Agricultural
fcconomics. University of Mi\si>uri.
Contribution from Lhc Mmouri Agricultural Experiment Station
Juumal Scr.c:, No. 9401.
Renew was coordinated by Gene A. Fulrell. associate editor.
farmers are disturbed when they do not receive
sufhcient cash to pay their income tax on the pa
tronage refund.
Farmers do not consider patronage refunds as a
return on equity capital within a portfolio context
From a legal point of view, the patronage refund
represents an adjustment of prices lo bring ihe
cooperative to an "operating at cosi position "
Also, by definition and law. cooperatives pay limited
returns on equity capital—in fact most pay none.
Farmers have responded by investing as little as
possible in the cooperative. Incidentally, the me
dian member likely does not even know how much
he or she has invested in the cooperaiive system
Ihe data explained by the KB model can be ex
plained by other factors. The share of patronage
refunds paid in cash increased during ihe 1970s for
the following reasons: (a) As the probability of
farming increased, so did the marginal tax rate of
farmers. This situation applies pressure for more
cash, (b) The 1970s were profitable years for
cooperatives and they were able to satisfy their
cash needs and give a higher cash patronage refund
(3) Loan capital was cheap, and during the decade
cooperatives increased their levcraee positions bv
about 15%.
The authors attempt lo explain with their model the
reason pure marketing cooperatives and large
cooperatives regardless of type pay higher cash pa
tronage refunds, and diversified cooperatives pay
lower refunds than the average cooperative. The
reason advanced may have some validity, but the
major factors are earnings, capital requirements,
and alternative .sources of capital. As the authors
indicate, the pure marketing cooperatives use re
tained capital as the major source of capital and.
hence, have the flexibility to return most of the
patronage refund in cash. Larger cooperatives gen
erally have higher earnings, as measured by rate of
return on investment or percent of sales, and can
afford higher cash patronage refunds. The diver
sified cooperatives lend to have higher capital re
quirements, as measured by sales per dollar in
vested, and tend to be more responsive than mar
keting cooperatives to members" requests for more
service even at the expense of higher earnings. This
means that payment of high cash patronage refunds
is impossible or impractical.
In addition, the KB note that small cooperatives
pay lower cash patronage refunds. This is due not
only to lower earnings but also to heavy depen-
Copyright 1985 American Agricultural Economics Association
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114 February 1985
dence on patronage refunds from other coopera
tives, ihe majority of which is in paper.
While usefulness of KB's model is limited be
cause of [he restricted assumptions necessary to
apply i[ to cooperatives, it allows one to test several
interesting hypotheses. The decision on retained
patronage refunds is a good place to start looking
al ihe entire decision-making process used by
cooperatives, ll is a critical economic and psycho
logical issue thai has both short- and long-run im
pact on the entire operation.
This comment gives reasons for questioning the
validity of the two basic assumptions in the KB
Amrr. J. Agr. Earn.
model. Also, factors and conditions not included in
the model are identified that can explain the data
used to support the validity of the model.
Reference
[Received July 1983; final revision
received March 1984.]
Knocber, Chirk R.. anil David L, Baumer. "Undemand
ing Retained Patronage Refunds in Agricultural
Cooperatives." Amtr.J.Agr, Econ. 65(19831:30-37.

Understanding Retained Patronage Refunds in
Agricultural Cooperatives: Reply
Charles R. Knoeber and David L. Baumer
In his comment on our paper, Ratchford makes two
broad points. First, our model is "naive" and un-
Sliited to explaining cooperative behavior. Second,
alternative explanations of some of our empirical
findings are presented. We address these in order.
We view an important contribution of our paper
to be the development of a simple (not naive) model
in which maximizing behavior generates testable
hypotheses. In order to do this, cooperative mem
bers are treated as rational maximizers and (by use
of a median voter approach] the ultimate determi
nants of cooperative financial behavior. We are
criticized on both counts. Ratchford asserts that
farmers do not know what they have invested in the
cooperative and do not consider this investment as
a part of their portfolio of assets. More succinctly,
farmers are not rational maximizers. We think this
is a peculiar and counterfactual assertion. More
over, it precludes any economic analysis. Ratch
ford also asserts that laws, bankers' rules, and ac
counting practices, not the desires of members, de
termine the financial behavior of cooperatives.
While we admit that legal rules, tax laws, and other
institutional arrangements limit the range of finan
cial decision making by cooperatives, they do not
eliminate it. Indeed, the share of patronage refunds
retained varies considerably across cooperatives.
Ratchford offers no way to explain this variation.
We do. Our approach, which presumes control by a
median member is admittedly extreme, but it seems
closer to reality than the approach offered by
Ratchford which allows no member influence on
cooperative decision making.1 In sum, our model
Charles R. Knoeber is an associate professor, and David L.
Haunier is an assistant professor. Department of I;conumics and
Business. North Carolina State University.
Review was coordinated by Kichard !-. Just, editor.
1 indeed. Ratchford's initial strong staiemeni [hat "The as
sumption that [he median farmer controls patronage refund policy
is invalid because he cannol control how much is paid in cash" is
contradicted by his later argument thai retention policy is con
strained by members who are "disturbed) when they do not
receive sufficient cash to pay their income lax on the patronage
refund." Member preferences matter, and we have modeled This
in a median voter framework. Alternatively, we could have ap
pealed To The voluntary nature of cooperative membership. Mem
bers "disturbed" by decisions of a cooperative manager may
"vote with their feel" by leaving The cooperative and in this way
influence cooperative decision making.
offers a simple framework for analyzing coopera
tive behavior and provides straightforward hypoth
eses. Webelieve this is clearly preferable to a litany
of institutional constraints which provides neither a
cohesive framework nor testable implications.
We provide two sons of empirical support for our
model. First, we suggest possible explanations (fol
lowing from our model) for some differences across
time and across cooperatives by type in the aggre
gate share of patronage refunds retained. Second,
we estimate cross-section regressions on major
farm supply cooperatives.2 We do not find alterna
tive explanations of the aggregate data surprising.
Our intent was only to suggest a model consistent
with widely known "facts" about retained patron
age refunds. Competing explanations are surely
available. Their existence docs not weaken the em
pirical case for our model. Only if competing mod
els make different predictions can the superiority of
one be established empirically. Indeed, our crosssection
results which Ratchford ignores can be
viewed as just such a test. Our model suggests that
the variance of the rate of return on cooperative
equity capital (a partial measure of the riskiness of
this part of the farmer's portfolio) will be negatively
related to the share of patronage refunds retained.
RatchTord's approach suggests this variable will be
unrelated to cooperative retentions (since the share
of patronage refunds retained is not affected by
members' portfolio desires]. The negative relation
we find provides empirical support for the superior
ity of our model.
[Received August 1984: no revision.]
'■ While we refrain generally from commenting on the ad hoc
reasons offered by Ralchford lor patterns in the aggregate data on
patronage refunds retained, one error in logic should be pointed
out. The increased profitability of farming in the 197ns and its
inleraction with the marginal lax rate will nol create "pressure for
more cash." First, this increased profitability (as we measured it)
is largely due lo appreciation in Ihe value of farm land. This
appreciation is untaieil if i[ is unrealized. Second, to the extcnl
that farmers realized higher incomes in Ihe 19711s and also faced
higher marginal tax rales, ihey found themselves with abnormally
large (not Mnalll amounts of c.ish creating no pressure for higher
cash palronago refunds.
Copyright 1985 American Agricultural Economics Association