This is a text version of a paper submitted to the Postal Commission by Robert Cohen, Postal Rate Commission. The footnotes have not been included in this conversion with the exception of the highlights referencing certain issues . You can Download the PDF and DOC files for all of the footnotes.
THE COST OF UNIVERSAL SERVICE IN THE U.S. AND ITS IMPACT ON COMPETITION*
Postal Rate Commission
Postal Rate Commission
Postal Rate Commission
Postal Rate Commission
Some Highlights of the Report
*An early version of this paper was presented at “The Future of Universal Postal Service in the United States,” The Brookings Institution, June 18, 2002. The views expressed in this paper are those of the authors and do not necessarily represent the opinions of the Postal Rate Commission.
The modern concept of the Universal Service Obligation (USO) was not resent in the early days of the republic. At the beginning of the 19th century the post was simply an intercity carrier that provided no collection or delivery. Service was provided only to towns on post roads designated by Congress. Outlying villages and settlements were not included in the network. City delivery was not introduced until 1863 and then only in 45cities. By 1890, delivery had expanded to 50 cities, about 30 percent of the population. Ubiquity of delivery only became a goal with the introduction of rural free delivery at the end of the 19th century. By 1917, the post office was only delivering to about 80 percent of rural Americans. Thus, the goal of ubiquitous delivery was not realized until well into the 20th century. City delivery meant that farmers did not have to live so near a post office and so began a long and steady decline of rural postal offices throughout the 20th century.
At its core “universal service” means ubiquity of access to the mail (either by delivery or other means) and reasonable access to collection and counter service. Many observers, however, would add one or more of the following: uniform prices, six-day-a-week delivery, current product offerings and current service standards. The non-core aspects of universal service have also changed over time. Multiple daily deliveries in cities were eliminated in the early 1950’s. Postage rates for local and long-distance letters were not equalized until 1885 and they diverged again in 1932 only to be set equal again in 1944.
The eminent regulatory economist John Panzar has stated that the cost of the universal service is the cost of the services that would not be provided in a competitive environment., This is the concept of the cost of the USO that we use in this paper. We examine the aspects of universal service that management might consider changing in response to a financial exigency that could be brought about by a competitive environment. Our purpose is not to propose that management make these changes, but to analyze the possible cost savings that might be achieved and to put these savings in perspective.
In the penultimate section of this paper we discuss the significance of the cost of universal service to the competitive position of the Postal Service in the eventuality that the U.S. letter mail market were liberalized. While these analysesare specific to the U.S. Postal Service, the findings should be broadly applicable to posts in other industrial countries.
It will be useful to keep some gross Postal Service statistics in mind in order to provide an international perspective for the potential cost savings presented below.
The analysis is based on fiscal year 1999 (FY 99) costs. In that year total Postal Service expenses were $62.4 billion. The distribution of expenses by function is shown in Table 1. The U.S. Postal Service has a greater percentage of mail processing costs than every other industrial post because of its large per capita volume.9 Consequently, its delivery costs constitute perhaps the lowest percentage of total costs of any post in an industrial country. The opposite is true for posts with low per capita volume. Thus, cost savings from reductions in the delivery aspect of the USO would be relatively larger in posts with less per capita volume.10 Back to Top
Table 1: USPS Costs by Function
We do not predict that competition would bring about a financial exigency. Quite the contrary, our analysis shows that little competition would emerge if the letter mail monopoly were eliminated. See Cohen, et al., (2000).
This paper first presents the costs of three core universal service elements that conceivably could be candidates for elimination in the face of serve financial exigencies resulting from competition and thereby pass the Panzar test. These are: (1) elimination of unprofitable routes, (2) closure of small post offices; and (3) elimination of Air Parcel Post to the Alaskan bush country. Each of these involves dismantling the ubiquity of service. A core service that we do examine here but reject as not passing the Panzar test is the curtailment of expansion of the delivery function by not adding new delivery points. Lastly, two non-core universal services that might pass the Panazar test are examined, maintenance of six-day delivery on all routes and the right to door delivery on park and loop routes.
We define the profit of a delivery route as the revenue from the mail delivered on the route, minus the total cost of operating the route, minus the attributable upstream cost of the mail delivered on the route. Net profits from delivery routes are a relatively small portion of total costs in a breakeven post. This is intuitive because unprofitable routes offset a large portion of the profit from profitable routes. Table 2 displays the delivery profits and losses by semi decile of the 230 thousand delivery routes of the U.S. Postal Service.
Table 2: Annual Route Profits (Losses) by Semi
It can be seen that approximately 45 percent of routes are loss making and the total losses are $2.6 billion (or 4.2 percent of total cost). Jettisoning the loss making routes would allow the USPS to reduce its costs and hence its rates by this amount., Because the value of the network is positively correlated with the number of points served, few customers would think it worthwhile to trade a rate reduction of this small magnitude for the inability to reach 45 percent of the population.
Rather than abandon service to all unprofitable routes it would be better from a business standpoint to simply abandon uniform prices and charge differential rates to bulk mailers so that all routes are profitable. Another alternative would be to reduce delivery frequency on loss-making routes until they are at least breakeven.
A post that delivers 6 days per week could reduce service on each loss making route just enough so that it was no longer unprofitable. Each route would be reduced to 5, 4, 3, 2 or 1 day per week according to the size of the loss on particular routes. In this way there would be no loss making routes. This would result in about the same $2.6 billion saving. It would, however, probably cause a political problem for a government owned postal service because profits on a route depend for the most part on volume, which in turn is highly correlated with the income of patrons served on the route. Reducing delivery frequency for unprofitable routes would involve relatively poor people getting less frequent delivery than relatively rich people. Nevertheless, this would not be so great a political problem as abandoning these routes altogether. Arguably, reducing service frequency on loss making routes would be an economically rational approach to lowering costs, especially when direct competitors provide no service to those routes. The estimates of savings from reducing delivery frequency are upper bounds because no allowance has been made for additional costs that might be incurred.
It should be emphasized that the issue of unprofitable routes, uniform prices and uniform delivery frequency are closely linked. While ubiquitous delivery and uniform prices are commonly understood to be part of the universal service obligation, it is not so clear that uniform frequency of delivery is also part of the concept of the USO. Many rural routes received delivery only three days per week until the 1950’s.
Unlike France and probably all other European countries, the unprofitable routes in the U.S. are not overwhelmingly in rural areas. Delivery routes serving rural areas as a group are profitable as are the routes serving urban areas. Consequently, there is no cross-subsidy of service to rural areas by urban area delivery. Also, the percentage of unprofitable routes is about the same in rural areas as in urban areas. The major reason for this near balance is the fact that roadside delivery by rural carriers is frequently more efficient than park and loop delivery by city carriers. At any rate, it is to be expected that in a breakeven post roughly half the routes would be unprofitable. Back to Top
Providing reasonable access to postal counters is part of the universal service obligation of all posts in industrial countries. In 1901, the U.S. had 77,000 post offices and the number has been in decline ever since. Today the Postal Service has about 28,000 post offices, 6,000 stations and branches, 3,000 contract stations and branches, and 1,500 community (franchised) post offices. All told the USPS currently has about 38,000 facilities with counters. The Postal Service had been closing some small post offices each year until it imposed a moratorium on closings in 1998. It has recently lifted this moratorium. Many small offices have few transactions and many average less than ten transactions daily.
The authors cannot identify which offices would be eliminated under the hypothesis of this paper, and thus cannot quantify the potential savings exactly. We can, however, put an upper bound on the savings. In FY 99 the 10,127 smallest offices cost the post office $567 million annually including personnel and facility costs. This was nine-tenth of one percent of total postal costs.
The General Accounting Office recommended the closing of 7,000 small offices in a report written in 1982. This was about 70 percent of the small offices at the time. Closing this number would produce annual savings of $397 million or 0.6% of total costs.
Rural carriers in the U.S. provide retail services to patrons on their route. They sell stamps and virtually all other postal services and accept mail. Customers may meet their carrier making their rounds or more typically they leave a request in their roadside mailbox with payment and the carrier will leave what is requested in the box. The carrier will stop at the customer’s roadside box (even if there is no mail to be delivered to that box) if the customer raises a small flag that is attached to rural boxes. Thus, counters are arguably less important in areas served by rural carriers.
Franchising small post offices has been resisted by rural residents, postmasters and Congress. If the U.S. Postal Service were pressured by competitive forces to economize, franchising much of the retail network (not only small post offices) would become more attractive to postal management. About half of all retail transactions are stamp purchases. The USPS has a stamp consignment program with retail stores (primarily grocery stores). If the Postal Service paid commissions for stamp sales, sales by non-postal outlets might become much more prevalent and relieve postal counters from many current transactions. Back to Top
III. ALASKA AIR STUDY
The USPS has two general parcel classifications; Priority Mail, which is entitled to air transportation and parcel post, which is entitled to surface transportation only. Because the bush country of Alaska has no roads, virtually all mail is transported to and from the bush by air. Although it is a ground service, parcel post is available to the Alaskan bush because of the use of air transportation.
It turns out that parcel post is the lowest priced way to transport goods to the bush because its rates don’t reflect the cost of air transportation. This has caused the Postal Service to become the principle means of transporting virtually all merchandise to the bush that is mailable (no more than 70 lbs. and 108 inches in length and girth). Much of the material never enters a post office before being transported. Local airlines maintain industrial size freezers, refrigerators and warehouses where groceries and other goods are brought and stored and then have postage applied before being placed directly on airplanes and flown to the bush as parcel post.
The Postal Rate Commission in its R90-1 decision found that the reason the Postal Service flies parcel post to the bush is because of its universal service obligation. UPS ground service, for example, is not available to the Alaskan bush. Air transportation of parcel post to the Alaskan bush cost the Service $99 million or two-tenth of one percent of total costs in FY 99. This is the upper bound amount that the Postal Service could save if it were to discontinue parcel post service to the Alaska bush., It should be kept in mind that Priority Mail service would still be available to the bush as is UPS Blue Label (air) parcel service. Back to Top
IV. Expansion of the Delivery Network
The cost of serving the ever-expanding number of new delivery points (including the cost of new equipment and local post offices) is an often-cited financial problem for the Postal Service. In order to avoid these expansion costs, the size of the delivery network could be frozen or a charge applied for new access to offset costs due to growth.
The USPS estimated that the cost of new delivery stops in 2003 was $176 million or two-tenth of one percent of total costs. This cost does not take into consideration any new revenue that would offset some or all of the cost increases due to new delivery points. Thus, there may not be any net savings from curtailing expansion and whatever savings are achieved would be small relative to the growth of costs due to inflation. Consequently, the cost savings from denying service to new delivery points would seem not to be worth the potential reduction in value of the network or lost revenue. It is likely that competitors would seek this business and thus it does not fall under the Panzar definition of the USO. Consequently, it is not included in the list of potential savings summarized below. Back to Top
REDUCING the NUMBER OF Delivery Days on all Residential Routes
Reducing delivery frequency might be part of the response of the Postal Service to a financial exigency. The authors have not conducted a detailed study of the cost savings achievable from reducing the number of delivery days. We have calculated the fixed cost of delivery and assumed that a portion could be saved by reducing delivery frequency on all non-business routes. The latest estimates by the Postal Service are that a little more than half of total delivery costs are fixed. If delivery frequency were reduced by half, variable cost would not change but fixed cost would be cut in half. The savings from reducing delivery days on non-business routes are shown in Table 3. For example, cutting delivery frequency from six days per week to three would be $5.7 billion or 9.1 percent of total FY 99 costs. Again, this is, in fact, an upper bound on the savings since the analysis has not taken into account costs that might be incurred in order to accommodate reduced delivery frequency.
Table 3: Cost Savings from Reducing Delivery
Days on Non-Business Routes
The Post Office Department eliminated the second daily delivery in 1952 because the ubiquity of the telephone had made it much less necessary. Overnight services, fax and e-mail now provide alternatives to mail that were not available in 1952. Moreover, phone costs have dropped dramatically since then, making mail even less competitive for personal communications. Today, much of the mail is non-urgent advertising. The average household receives more advertising mail than First-Class. Moreover, about 10 percent of First-Class mail consists of pure advertising. Given sufficient competitive pressure, 3-day-a-week delivery to residences might become attractive to postal management. Such a change would be very inconvenient for weekly magazines and daily newspapers that use the mail for a substantial portion of their circulation. This change might also have adverse effects on advertising mail. Many observers believe that each piece of advertising in a day’s mail competes for the recipient’s attention. Cutting delivery frequency would increase this competition and make mail a somewhat less desirable advertising medium.
While many posts in industrialized countries deliver six days a week, several deliver only five days without apparent problems (Australia, Austria, Canada, Finland, Greece, Ireland, Luxembourg, Portugal, Spain and Sweden). Sweden Post’s competitor, City Mail, delivers every third business day. Thus, six-day-a-week delivery may not be necessary to retain volume. Back to Top
VI. CONVERSION OF PARK & LOOP ROUTES TO CURB ROUTES
The distribution of the various types of delivery for the USPS in FY 99 were:
Foot routes and park and loop routes involve delivery to the door while curb delivery is to a box placed by the street in front of the residence and roadside delivery is to a box placed alongside a road that is traveled by a rural carrier. In the mid-1970’s the Postal Service stopped serving new housing developments with park and loop routes. Since then new housing developments have been served by curb routes. The increasing use of cluster boxes is a continuation of the trend to more efficient delivery.
Table 4 displays the possible savings from converting all park and loop routes to curb routes. The savings of $778 million, is 1.2 percent of total costs. Again, this is an upper bound since we have not factored in the additional vehicle costs and we do not know the number of routes where curb delivery is not practical.
Table 4: Savings from Conversion of All Park
& Loop Routes
Obviously, mail recipients prefer the convenience of delivery to the door versus curb delivery (and they do not have to pay for the extra cost). The disparity of treatment of different mail recipients is clear, however. It would be difficult but not impossible to force change in this area, especially if the Postal Service were to give the recipient the option of being charged for delivery to the door but not to the curb.
Park and loop routes tend to be in the older parts of cities while curb routes tend to be in the newer more outlying parts of cities. Generally, the newer areas are more affluent and would be more likely to attract competitive entry in the face of strong competition. Arguably the U.S. Postal Service might choose to rationalize its costs by converting park and loop routes in response to a financial exigency caused by competition. Back to Top
THE COST OF UNIVERSAL SERVICE
Table 5 presents a summary of the potential savings from modifying the USO in response to a financial exigency caused by competition. This in effect is an application of the Panzar definition of the cost of the USO. We use the GAO recommendation of closing 7,000 small post offices to arrive at the savings for this category. We use three-day a week delivery for reduction in frequency of delivery since. We think further reductions are unlikely.
Table 5: Summary of Potential Savings
Table 5 is divided into core aspects of universal service (those aspects which bare on ubiquity) and non-core aspects. The cost with the core concept of universal service is $3.12 billion or 5 percent of total annual expenditures. The cost with the expanded concept of universal service is $6.48 billion or 10 percent of total cost.
In an absolute sense these are substantial sums. However, in the context of postal inefficiencies they are not large. For example, from the time of postal reorganization in 1970 through 1999 total factor productivity only had a cumulative growth of 9.2 percent despite the automation of mail processing and the growth of curbside delivery. In the middle part of the last decade postal costs began to grow faster than inflation. The R2001-1 rate increase was 7.7 percent while inflation had grown just 2.7 percent since the previous rate increase. Postal management began to take steps to reduce the rate of cost growth in 1999. Since that time, employment has been reduced by nearly 9 percent and this trend shows every sign of continuing.
The Postal Service has employed Dr. Michael Wachter, an economist at the Warton School, the University of Pennsylvania, to study the postal wage premium. His latest study estimates that postal clerks are paid between 21.2 and 35.7 percent more than employees who have similar “human capital” characteristics and who are doing compatible work in the private sector. Assuming all postal bargaining employees enjoy a similar premium, the total would amount to between $7.6 and $12.8 billion in FY 99 or between 12 and 20 percent of total costs. Back to Top
The basic reason for introducing competition into the postal market would be to stimulate efficiency gains. In all probability, these gains would exceed any costs associated with universal service. This can be seen in the efficiency gains in posts that have lost their monopolies or expected to lose them.Back to Top
New Zealand Post began to prepare for liberalization in 1988 and was actually liberalized in 1999. From 1988 to 2001, it reduced employment by about 40 percent. We understand that New Zealand Post has lost almost no market share and it continues its USO.
Sweden liberalized its market in 1993 and City Mail emerged as a competitor, along with many small operators. To date, City Mail has gained about a 30 percent share of its “niche,” but Sweden Post has lost only about five percent of its total market. Sweden Post has reduced its employment by about 30 percent. It continues its universal service obligations, but it has abandoned uniform prices for bulk mail. It now charges different rates for bulk mail according to the area of the country where it is delivered.
Deutsche Post had expected to lose its monopoly by 2001. In contemplation of this, and its pending privatization, Deutsche Post reduced its employment by about 37 percent between 1990 and 1999.
Royal Mail anticipates the first stage of liberalization in 2003. In preparation, it has announced plans to cut employment by 15 percent by 2005.
These figures are summarized in Table 6.
Table 6: Impact of Liberalization on Operators’ Efficiency
United States Postal Service Transformation Plans, Appendix H. April 2002.
Royal Mail Group plc Press Release June 13, 2002 http://www.royalmailgroup.com/news/expandarticle.asp?id=485&brand=consignia
Compared to potential cost savings from reductions in their USO, these posts have achieved, or planned to achieve far greater savings by reducing employment. Back to Top
For more than two centuries posts have been developing their markets and building scale. Because the postal delivery function exhibits large economies of scale, incumbents would have a considerable advantage under liberalization., Consequently, it is unlikely that an entrant would be able to assume the same universal service obligation as the incumbent and compete successfully. An entrant would instead provide limited service. For example, it might be that an entrant would initially provide less frequent service than the incumbent, provide little or no counter service, provide a limited range of products, or provide service only to the most profitable areas.
We believe that the cost of providing universal service to be significant but a modest burden, for the incumbent under potential competitive situations. The advantages of providing universal service is in itself very important. In addition, the incumbent would have the advantage of scale economies in delivery, name recognition, established relationships and incumbency itself. These would more than offset the burden of the USO in a competitive situation. On the other hand, the prospect of reducing the incumbent’s cost by jettisoning the USO would reduce the incumbent’s cost. Since the savings are modest, however, we do not think that these savings would be crucial to the competitive outcome. Back to Top
We have presented the cost of the universal service obligation of the U.S. Postal Service according to the method esposed by John Panzar. It appears that the core concept of the USO (those aspects that imply ubiquity) cost about 5 percent of current expenditures. Other non-core aspects cost another 5 percent. In an absolute sense, these costs are large but they are modest in light of the possible efficiency gains shown above.
We think that the USO burden in of itself is not an excessive handicap in a liberalized market. After all, the incumbent would have considerable offsetting advantages (scale, name recognition, customer loyalty, etc.). Finally, reducing the USO in and of itself would not reduce the cost of the incumbent so much that the mail would become uncontestable for competitors.
38 Dr. Michael Wachter, a consultant to the Postal Service, has estimated that postal clerks are paid between 21.2 and 35.7 percent more that employees who have similar "human capital" characteristics and who are doing comparable work in the private sector. See U.S. Postal Service, et al., (2001). Back to Top
As a group, routes serving rural areas are profitable in the U.S., contrary to common expectations and experiences in many other countries. Consequently there is no cross-subsidy of rural routes by urban routes in the U.S. This is demonstrated by the data in Table 7. The profit for “rural areas” in FY 99 was $175 million. The definition of “rural area” used here is actually a “most rural” subset of rural households as defined by the Census Bureau. The Postal Service has two distinct delivery crafts city delivery carriers and rural carriers. The latter serve both urban and rural areas. In our study we ordered all Rural Carrier routes by the number of boxes per mile on each route. We then selected the 60 percent of routes that serve the fewest boxes per mile and considered that these routes clearly serve rural areas. It turns out that only 13.3 percent of households are included in that group of rural routes. This is far less than the 21 percent of the households classified by the Census Bureau as being in rural areas. Because rural carrier routes become more profitable as boxes per mile increase, and since we have clearly selected the most rural of rural routes, we have understated the profits earned from delivering to all rural areas and correspondingly overstated the profits earned from delivering to urban areas.
Table 7 shows that 47 percent of the routes serving our sample of rural areas of the U.S. are unprofitable and 44 percent of the routes serving remaining (presumably) urban areas are unprofitable. Back to Top
Bernard, Stephane, Robert H. Cohen, Matthew H. Robinson, Bernard Roy, Jöelle Toledano, John D. Waller and Spyros S. Xenakis. 2002. “Delivery Cost Heterogeneity and Vulnerability.” In “Postal and Delivery Services: Delivering on Competition, edited by Michael A. Crew and Paul R. Kleindorfer. Boston, MA: Kluwer Academic Publishers.
Campbell, James. 2002. “An Introduction to the History of Universal Postal Service." Presented at “The Future of Universal Postal Service in the United States.” The Brookings Institution, Washington, D.C. June 18, 2002.
Cohen, Robert H. and Edward H. Chu. 1997. “A Measure of Scale Economies for Postal Systems.” In Managing Change in the Postal and Delivery Industries, edited by Michael A. Crew and Paul R. Kleindorfer. Boston, MA: Kluwer Academic Publishers.
Cohen, Robert H., William W. Ferguson, John D. Waller and Spyros S. Xenakis. 1999. “An Analysis of the Potential for Cream Skimming in the United States Residential Delivery Market.” In Emerging Competition in Postal and Delivery Services, edited by Michael A. Crew and Paul R. Kleindorfer. Boston, MA: Kluwer Academic Publishers.
Cohen, Robert H., William W. Ferguson, John D. Waller, and Spyros S. Xenakis. 2000. “Universal Service without a Monopoly.” In Current Directions in Postal Reform, edited by Michael A. Crew and Paul R. Kleindorfer. Boston, MA: Kluwer Academic Publishers.
Cohen, Robert H., Carla Pace, Antónia Rato, Matthew H.Robinson, Ricardo Santos, Gennaro Scarfiglieri, Vincenzo Visco Comandini, John D. Waller and Spyros S. Xenakis. 2002. “Towards a General Postal Service Cost Function.” Presented at the Tenth Conference on Postal Deregulation and Delivery Economics, Potsdam, Germany. See prc.gov papers for copy.
Cohen, Robert H., Carla Pace, Matthew H. Robinson, Gennaro Scarfiglieri, Vincenzo Visco Comandini, John D. Waller and Spyros S. Xenakis. 2002. “A Comparison of the Burden of Universal Service in Italy and the United States.” In Postal and Delivery Services: Pricing, Productivity, Regulation and Strategy, edited by Michael A. Crew and Paul R. Kleindorfer. Boston, MA: Kluwer Academic Publishers.
General Accounting Office. 1982. “Replacing Post Offices with Alternative Services: A Debated but Unresolved Issue,” September 2, 1982.
Haldi, John and John T. Schmidt. 1999. “Transaction Costs of Alternative Postage Payment and Evidence Systems.” In Emerging Competition in Postal and Delivery Services, edited by Michael A. Crew and Paul R. Kleindorfer. Boston, MA: Kluwer Academic Publishers.
Haldi, John and John T. Schmidt. 2000. “Controlling Postal Retail Transaction Costs and Improving Customer Access to Postal Products.” In Current Directions in Postal Reform, edited by Michael A. Crew and Paul R. Kleindorfer. Boston, MA: Kluwer Academic Publishers.
Kielbowicz, Richard B. 2002. “Universal Postal Service: A Policy History, 1790-1970.” Prepared under contract to the Postal Rate Commission. “An Introduction to the History of Universal Postal Service.”
Panzar, John. 2001. “Funding Universal Service Obligations: The Costs of Liberalization.” In Future Directions in Postal Reform, edited by Michael A. Crew and Paul R. Kleindorfer. Boston, MA: Kluwer Academic Publishers.
Postal Rate Commission. 1991. Docket No. R90-1, Opinion & Recommended Decision, Vol. 1, pp. III-95-237.
Postal Rate Commission. 2002. Docket No. R2001-1, Opinion & Recommended Decision, March 22, 2002.
Tolley, George S. Direct Testimony on behalf of the United States Postal Service before the Postal Rate Commission in Docket No. R2001-1.
U.S. Postal Service and American Postal Workers Union. 2001. Interest Arbitration Panel Award. December 18, 2001, Supplemental Opinion Dealing with Economic Issues.