Wednesday, October 28, 2009

Irrational Pricing at the Postal Service

The Postal Service may be on the verge of having an irrational price structure. The irrationally of the Postal Service's price structure is driven by the regulatory constraints within which it must price its products. Until the Postal Service is free from those constraints, irrational pricing will have detrimental effects on the Postal Service, its customers and its competitors.

How is the price structure made irrational?

The Postal Service had only two choices in setting prices for its regulated products. 1) It could not raise prices and adhere to the requirements of the legislated price cap. 2) It could file an exigent rate case and open up its entire price structure for review by the Postal Regulatory Commission. The first option freezes rates that should rise due to price changes of competitors and changing cost structure affecting particular products. The second option opens up the entire rate structure to regulatory review and would force prices to confirm to nearly 40 years of PRC precedent on pricing and relationships between the prices of various postal products. In particular, this precedent would have likely required that the Postal Service institute a major rate increase on nearly all products at a time when customers are most sensitive to postal prices. Furthermore, an exigent rate case would have the effect of protecting preferred classes of postal customers from rational price changes that violate PRC interpretation of postal pricing law and would most likely cause the most economically and price sensitive mail to see price increases that market-based pricing would not justify.

The choice the Postal Service had is known as Morton's Fork, a choice between two bad options. In choosing to adhere to the price cap, the Postal Service held prices constant at a time that competitive pressures, rising operating costs and substantial operating losses would justify some increases. Opening up its entire pricing structure to regulatory review would reinforce decisions on price relationships made in market environments unlike what now exists and could raise rates far beyond what the Postal Service would want in the depressed economy. Given the difficulty of over tuning PRC precedent, and especially precedent on rate relationships, the Postal Service would have little confidence going into an exigent rate case that the new rate structure would have the rate structure changes that it needs to get back on the path to financial self-sufficiency. Given its options, sticking to the price cap appears to be marginally better for the future of the Postal Service, but it was still not a "good option."

To understand why both options are bad, one only has to look at the pricing decisions of Postal Service competitors, UPS and FedEx and foreign postal operators. All of these firms are expected to raise rates in 2010 and none of these firms are expected to raise rates uniformly across their product lines, delivery locations, or type of customers.

UPS and FedEx are raising rates, after taking into account the decline in the fuel surcharge by around 4%. FedEx's published rates are rising the most for envelopes and parcels under 2 pounds, parcels delivered to residential addresses, and parcels traveling the greatest distance over the FedEx network. (A full price comparison was produced by Parcel Magazine.) The price increases are changing rate relationships across FedEx's range of services.

The published rate changes only affect the rates that parcel customers pay when they tender a single parcel or single envelope at a FedEx Office location or at an independent franchisee, or purchase the service on line and drop the single parcel in one of FedEx's drop boxes. FedEx's largest customers expect that their rate increase will be less due to negotiated discounts that vary based on the volume the customer tenders and the distribution patterns of the parcels shipped.

By not raising its single-piece parcel rates, the Postal Service is likely to gain market share over UPS and FedEx in parcel markets that it already dominates. It will do so at a cost to its financial well being as it will bear rising costs without additional revenue. Without the legal constraints, the Postal Service could raise its First Class parcel, Standard parcel, and single-piece Parcel Post rates as a price follower without affecting the market share of competitors.

Not raising single-piece parcel rates also creates problems for the Postal Service's competitive parcel products. By holding its single piece rates constant, the Postal Service reduces its negotiating room with large scale parcel shippers. The difference in rate between the heaviest First Class parcel and the lightest Priority Mail shipment will grow, possibly encouraging shippers to split parcels to take advantage of lower single-piece rates. It is possible that a profitable contract with a large-scale shipper would be at prices above what single-piece rates are and the Postal Service would be forced to sell services at a loss to customers who can use the capped single-piece rate.

Foreign postal operators have expanded the difference between single-piece rates and rates charged to large volume mailers well beyond the cost differences. A recent strategic review of Canada Post examined the impact of a price cap on single piece rates at Canada Post and recommended that higher rates are required for the financial well-being of Canada Post and the continuation of universal service within a financially self-sufficient entity. (Recommendation 30(iv)) In response, Canada Post has announced a five year pricing plan for the 30 gram (approximately 1 ounce) single-piece First Class letter. Single-piece letter rates are rising 3 cents in January, 2010 and 2 cents each year from 2011 through 2014. To offset the impact on small business, Canada Post is offering a rebate on the first $1,000 of postage equal to the January, 2010, 3 cent increase. Rates for large volume mailers are set within contracts so the actual increases for these customers are unknown.

The Postal Service's single piece First Class rates are still set under two assumptions. First, there should only be a current-cost based relationship between single-piece and volume-tendered mail. Second, the only differences between First Class single-piece mail and volume tendered mail should be the cost differences in handling the two types of mail.

These assumptions worked as long as single-piece First Class volumes were rising or steady. The decade long decline in single-piece First Class mail have shattered both assumptions.

The decline in First Class single-piece mail creates significant transition costs to handle the costs of reducing the workforce, equipment, and facilities that handle this mail that are no longer needed. The decline in First Class single-piece mail also requires that current users of this product bear the future cost of debt (including debt for current losses), retiree benefits, and workers compensation claims. Otherwise rate increases in the future will have to be even greater to cover the annual cash outlays to cover debt payments, retiree benefits, and workers compensation claims in the future.

Limiting price differences between single-piece and volume tendered First Class mail to just cost differences ignores real market differences between postal customers. The two types of customers differ in terms of sensitivity to both price and economic cycles. These differences logically support removing links in price setting for single-piece and volume tendered mail.

The two examples are similar in that the rational solution would require a major change in precedent and conventional thinking, and mostly changes in legislation. Instead it was left at Morton's fork, a place with two directions neither one offering a path to self-sufficiency.

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