BEFORE THE

POSTAL RATE COMMISSION

WASHINGTON, D.C. 20268-0001

Postal Rate and Fee Changes, 1997 ) Docket No. R97-1

ANSWERS OF THE OFFICE OF THE CONSUMER ADVOCATE

TO INTERROGATORIES OF UNITED STATES POSTAL SERVICE

WITNESS: J. EDWARD SMITH, JR. (USPS/OCA-T600-1-8)

(JANUARY 30, 1998)

The Office of the Consumer Advocate hereby submits the answers of J.
Edward Smith, Jr. to interrogatories USPS/OCA-T600-1-8, dated January
16, 1996. Each interrogatory is stated verbatim and is followed by the
response.

Respectfully submitted,

KENNETH E. RICHARDSON

Attorney

Office of the Consumer Advocate

ANSWERS OF OCA WITNESS J. EDWARD SMITH, JR.

TO INTERROGATORIES USPS/OCA-T600-1-8

USPS/OCA-T600-1. Please refer to page 1 of your testimony.

a\. Please provide a list of all published econometric studies that you
have

> performed.

b\. Please provide a list of all completed but not published econometric

> studies that you have performed.

A. a. [The DOD-Contractor Relationship,]{.underline} Study 71-4,
Logistics Management Institute, 1974, with Dr. Harold Asher. The study
was summarized in the press. The study modeled the cost structures of
sixteen airframe facilities, encompassing all military and commercial
aircraft production in the United States. Publicly available information
was restricted due to commercial, competitive, and national security
reasons. Accordingly, the methodology of the econometric part of the
study will be detailed.

**Data Collection:** Data on costs, inputs, technologies, and equipment
were gathered from 16 fixed-wing aircraft manufacturers. Costs were
measured in labor hours as a function of output; a similar limitation
occurs in witness Bradley's study. Panel data were collected for a time
span of approximately 9 to 15 years from each of the sixteen sites for a
variety of activities; the major activity which was econometrically
modeled was airframe assembly.

**Data Scrubbing:** Data scrubbing included the review of data outliers.
Extensive data review was conducted through actual contact with the
accounting and management personnel at each of the sites. It was
determined that statistical data scrubbing would

ANSWERS OF OCA WITNESS J. EDWARD SMITH, JR.

TO INTERROGATORIES USPS/OCA-T600-1-8

be highly unreliable, for the outliers usually were indicative not of
human error in reporting but, rather, were indicative of changes in
operations. The elimination of the data via statistical data scrubbing
would have deleted important information. Inadequate data scrubbing has
been an issue raised by at least one witness in reviewing witness
Bradley's work.

**Analysis:** The underlying data relationships were examined by
plotting the data for each of the sixteen locations. It was found that a
simple plotting of hours vs. output provided visually compelling insight
on the underlying structure of the data. First, it became clear that
each of the 16 regressions would have a different alpha intercept (which
is what one would expect---given the differences between sites). Second,
it became clear on the basis of a plotting of the data that when a
regression equation would be performed beta sub i would not equal beta
sub j. Similarly, a plotting of individual site data for witness
Bradley's study suggests that the beta sub i do not equal the beta sub
j, an assumption made by witness Bradley. Sixteen equations---one for
each site---were developed based on the relationship of hours =
f(output).

**Economic Interpretation:** Discussions with industry experts confirmed
that both the alpha sub i and beta sub i were highly dependent on the
underlying capital, product, and operating procedures at the sites, and
that an analysis of labor hours and output was essentially a short term
analysis---inappropriate for planning or longer-term costing purposes.

**Econometric Conclusions:** The equations were generated for each site,
involving an estimation of the alphas and betas. The equations were
subsequently used to estimate

short-term changes in labor requirements based on plant loads.

b\. **Work while at General Electric:** Participation in studies on the
residential, commercial, and industrial demands for electricity. The
models were based on regional data and were based on approaches from the
published literature. The modeling of commercial demand required the
explicit modeling of technologies rather than a simple extrapolation of
trends. The projections, subsequently proven to be accurate, confirmed
that the demand for electricity had significantly declined. The sales
and profit implications to the \$6 billion Power Systems Business were
substantial.

**Work while at Washington Gas:** I managed a variety of demand analysis
efforts using standard econometric approaches. The efforts were useful
in establishing a basis for improved business planning.

ANSWERS OF OCA WITNESS J. EDWARD SMITH, JR.

TO INTERROGATORIES USPS/OCA-T600-1-8

USPS/OCA-T600-2. Please refer to page 2 of your testimony.

a\. Please provide the number of years that you have studied United

> States Postal Service mail processing costs and operations prior to
> reviewing witness Bradley\'s testimony.

b\. Please provide complete copies of all studies of United States
Postal

> Service mail processing costs and operations that you have authored or
> participated in.

A. a. Although I have not studied USPS mail processing costs prior to
reviewing witness Bradley's testimony, my experience is immediately
applicable to the evaluation of his testimony, which focuses on cost
analysis in a factory environment. I have addressed a very similar
econometric problem in the fixed-wing airframe industry, involving the
estimation of labor hours as a function of output when associated with
the Logistics Management Institute.

As a manager in General Electric's Power Transformer Division as well as
other GE planning and analysis positions I gained in plant experience
with job shop, automated, and mechanized factory processes---the types
of processes which predominate in mail processing. During a tour of the
Merrifield, Virginia, facility I confirmed the similarity between job
shop factory operations and postal processing.

b\. None.

ANSWERS OF OCA WITNESS J. EDWARD SMITH, JR.

TO INTERROGATORIES USPS/OCA-T600-1-8

USPS/OCA-T600-3. Please refer to page 11, line 17 of you testimony where
you state:

> He \[witness Bradley\] quotes Dr. William Greene, a noted
>
> econometrician, as stating that technological change can be measured
> with an autonomous time trend. However, I believe that witness
>
> Bradley\'s interpretation of Dr. Greene\'s comment is incorrect.

And page 12 line 4 where you state:

> Witness Bradley is not addressing a macroeconomic problem. Instead, on
> the microeconomic issue of technological change, witness Bradley needs
> to address the fundamental driver of technological change impacting
> the mail handling process.

And page 12 line 13 where you state:

> An explicit modeling of capital related variables is required in order
> to explain technological change and other important microeconomic
> factors driving costs.

a\. Please confirm that on page 465 of [Econometric
Analysis]{.underline} (2nd

> edition) the same Dr. Greene states:
>
> A study by Greene (1983) examines the cost of electric power
> generation for a large number of firms, each observed in each of
> several years. The basic model, for the ith firm in year t,
>
> Costit = C(Yit, Pit, t),
>
> where Y is output and p is vector of factor prices, provides estimates
> of the rate of technological change,
>
> δt = -[dlnC]{.underline}
>
> dt

b\. Please confirm that the referred to study is a microeconomic study.

c\. Please confirm that the above equation does not include \"an
explicit

> modeling of capital related variables.\"

d\. Please confirm that Dr. Greene\'s model includes a time trend to
capture

> the effect of technological change.

A. a. Confirmed. A review of Dr. Greene's article, "Economies of Scale
in U.S. Electric Power Generation,\" [Journal of Political
Economy]{.underline}, 1976, vol. 84, no. 4, pages 655-75, indicates at
page 657 that he determined to:

ANSWERS OF OCA WITNESS J. EDWARD SMITH, JR.

TO INTERROGATORIES USPS/OCA-T600-1-8

> limit our attention to conventional steam powered generators by
> analyzing only the costs of steam generation for each firm examined.

This treatment of technological change highlights a problem of the
relevance of the approach. Within a few years of the publication of the
article a new form of steam powered generation known as the "combined
cycle" (combined gas and steam generator) was substitutable for
essentially all base load steam generation, and was in fact more
economical. The technological change has had a major impact on the
economics of electric generation. Econometric modeling could not have
captured this development, being based on existing rather than projected
data. Accordingly, for the specific industry at hand, the approach to
technical change appears to have been inappropriate.

b\. Confirmed. The modeling of technological change in this fashion is
also a macroeconomic approach. Although I did not indicate that this
approach was not used, the potential limitations of the approach were
highlighted in the above discussion on power generation. In the case of
the postal business it should be noted that the Postal Service has an
elaborate, extensive investment and technological innovation program
underway. It is unlikely that the past will represent the future in
terms of technological change. Accordingly, other approaches to the
modeling of technological change may be appropriate.

ANSWERS OF OCA WITNESS J. EDWARD SMITH, JR.

TO INTERROGATORIES USPS/OCA-T600-1-8

c\. Not Confirmed. Equipment configuration is essentially determined by
fuel type. Turning to page 663 in Dr. Greene's article, \"Economies of
Scale in U.S. Electric Power Generation,\" [Journal of Political
Economy]{.underline}, 1976, one finds the statement:

> Since fuel accounts for a very large share (approximately 65 percent)
> of the cost of electricity generated by steam power, it is essential
> to include fuel in the model as a factor of production.

It is well known in the electric business that the choice of equipment
type (e.g., nuclear, hydro, or fossil) coupled with equipment
specifications are the major determinants of the cost of fuel. For
example, among fossil steam plants, the cost of fuel is closely tied to
the type of equipment (for example, certain types of coals are suitable
for specific plant configurations). Accordingly, a consideration of fuel
price is essentially a modeling of equipment selection.

d\. I confirm that Dr. Greene has a time trend and that he intends to
capture the effect of technological change.

ANSWERS OF OCA WITNESS J. EDWARD SMITH, JR.

TO INTERROGATORIES USPS/OCA-T600-1-8

USPS/OCA-T600-4. Please refer to your testimony on page 20 at line 15
where you state:

> I conclude that each of the \"alpha sub i\" in witness
>
> Bradley\'s method relates to a short-run, \"monthly\" facility
>
> specific cost relationship.

Please confirm that this comment is based upon the accounting period
(monthly) frequency of the data. If you do not confirm, please provide
all bases for asserting that the ai are \"monthly\" facility specific
cost relationships.

A. Not confirmed. The monthly facility specific cost relationship is the
regression equation. The alpha sub i, according to witness Bradley,
account for all differences between facilities, leaving only monthly
data relating hours and output for explanation. I confirm that witness
Bradley uses data based on thirteen accounting periods per year, that
the alpha sub i are part of a cost relationship based on a fixed effects
model, and that the alpha sub i capture facility specific effects. I
conclude that witness Bradley has measured short-run labor/output
relationships and that a longer-run analysis, as I have advocated, would
be appropriate.

ANSWERS OF OCA WITNESS J. EDWARD SMITH, JR.

TO INTERROGATORIES USPS/OCA-T600-1-8

USPS/OCA-T600-5. Please consider the following equation:

> Y = X\*Z, where X, Y and Z are all variables.

a\. Please confirm that InY = In X + In Z where \"In\" stands for
natural

> log. If you do not agree, please provide the formula for In Y.

b\. Please confirm that d InY = d In X + d In Z. If you do not agree,

> please provide the formula for d In Y.

A. a. Confirmed. Having not directly testified to this, I examined the
programs in the Library References which I filed to determine any
possible source of misunderstanding. Certain parts of the computer
programs presented in my Library References contain logarithmic
expressions. A review of the SAS code will show that the logarithmic
expressions are inoperative---either because of an asterisk or because
of code order. My testimony inadvertently states that the results are in
log form. They are not, but none of my conclusions are changed. For
clarity, an errata to my testimony is being filed.

b\. Confirmed.

ANSWERS OF OCA WITNESS J. EDWARD SMITH, JR.

TO INTERROGATORIES USPS/OCA-T600-1-8

USPS/OCA-T600-6. Please refer to page 6, line 23 of your testimony.

> Assume that the cost function for a firm facing fixed factor prices w
> \>\> 0 is defined as:
>
> **c(w,y)** ≡ **minx w\*x s.t. x** ∈ **V(y)**
>
> where x is the input into production, y is the output of production
> and
>
> V(y) is the input requirement set, and X(w,y) solves the firm\'s cost
>
> minimization problem.

a\. Please confirm that for this cost function:

c(w,y) ≡ minx w\*x(w,y)

> If you do not confirm, please provide what you think is the correct
> expression.

b\. Please confirm that x(w,y) is known as the conditional factor input

> demand equation. If you do not confirm, please provide what you think
> to be the correct interpretation of X(w,y).

A. a. Confirmed. I examined whether the equation is in the form of a
cost estimation relationship as found in operations research (for
example, labor hours as a function of output, price not being present),
or a cost equation (meeting the theoretical requirements of economics).
In order to determine the correctness of the expression, I have reviewed
the equation using two sources: [Microeconomic Theory]{.underline} (C.
E. Ferguson, R. D. Irwin, 1969), and [Econometric Analysis]{.underline}
(W.H. Greene, Second Edition, Prentice Hall, 1993). The relevant pages
in Professor Ferguson's exposition are pages 202-205. The relevant page
in Professor Greene's exposition is page 465. Professor Greene
(consistent with Professor Ferguson) defines a cost function as follows:

ANSWERS OF OCA WITNESS J. EDWARD SMITH, JR.

TO INTERROGATORIES USPS/OCA-T600-1-8

Cost sub (i,t) = C(Y sub i,t, P sub i,t, t).

The equation presented by Dr. Greene contains Y, the output; P, a vector
of prices; and t, denoting time. The equation presented in the
interrogatory would also appear to contain the variables and a
minimization process. Assuming that the notation, minimization process,
and specification in the interrogatory are consistent with Dr. Greene's
presentation, I confirm.

b\. Confirmed.

ANSWERS OF OCA WITNESS J. EDWARD SMITH, JR.

TO INTERROGATORIES USPS/OCA-T600-1-8

USPS/OCA-T600-7. Please refer to page 15 line 15 where you state: \"I am
unable to confirm that the signs are consistent with a correct
methodology.\"

a\. Please define the term \"correct methodology.\"

b\. Please provide the exact criteria by which it can be determined

> whether a methodology is correct or incorrect.

c\. Please confirm that in a panel data regression, a time trend
variable

> will capture the effects of all factors which vary over time,
> including but not necessarily limited to, technological change. If you
> do not confirm, please explain.

A. a. A correct methodology would include the following:

> 1\. An adequate data base, appropriately verified and complete.
>
> 2\. A discussion of the modeling approach and how it is consistent
> with the underlying data.
>
> 3\. An adequate model and analysis of functional properties.
>
> 4\. A correct estimation procedure which is suitable to the estimation
> needs at hand.
>
> 5\. A discussion of results in which the values, signs, and other
> outputs are fully explained.
>
> 6\. Additional criteria as presented in Dr. Bonbright\'s evaluation
> factors, are presented in my testimony.

b\. Whether the methodology meets the above criteria.

ANSWERS OF OCA WITNESS J. EDWARD SMITH, JR.

TO INTERROGATORIES USPS/OCA-T600-1-8

c\. Assuming that a panel data regression is the appropriate estimating
technique, the time trend variable captures the effects of all factors
which have varied over time, including but not necessarily limited to
technological change. However, I believe that the choice of a fixed
effects approach is incorrect and that the time variable does not solely
estimate technological change.

ANSWERS OF OCA WITNESS J. EDWARD SMITH, JR.

TO INTERROGATORIES USPS/OCA-T600-1-8

USPS/OCA-T600-8. As an econometrician, is it your testimony that in
general

(without reference to witness Bradley\'s testimony) the methodology of
estimation constrains the \"correct\" signs for estimated parameters?

A. My comments must be taken in the context that I am only testifying on
witness Bradley's testimony.

No. I believe that the methodology of estimation is secondary to the
underlying economics problem. In addressing an economic issue, the first
requirement is the specification of a model and theory. Such a
specification should yield testable hypotheses. The quantification and
estimation would then follow. Some theories yield hypotheses that put
some constraints on the reasonableness or veracity of conclusions. For
example, based on various assumptions one would expect demand, supply,
and cost curves to take on the forms presented in textbooks. Associated
with these forms are predicted signs. Accordingly, one would be
suspicious of unexpected signs, absent an explanation.

One is then faced with the problem of estimation. In arriving at a
conclusion, the quantities and signs should be understandable. In some
cases in witness Bradley's testimony they are not. Dr. Bonbright cited
\"understandability\" as one of the requirements generally met by
regulatory standards. On the sign issue witness Bradley's work appears
to lack understandability. Accordingly, the issue becomes one of whether
the modeling effort is correct.

DECLARATION

I, J. Edward Smith, Jr., declare under penalty of perjury that the
answer**s** to interrogatories USPS/OCA-T600-1-8 of the United States
Postal Service are true and correct, to the best of my knowledge,
information and belief.

Executed \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_

[\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_]{.underline}

CERTIFICATE OF SERVICE

I hereby certify that I have this date served the foregoing document
upon all participants of record in this proceeding in accordance with
section 12 of the rules of practice.

KENNETH E. RICHARDSON

Attorney

Washington, DC 20268-0001

January 30, 1998