United States General Accounting Office

GAO Report to the Chairman, Subcommittee

on the Postal Service, Committee on

Government Reform and Oversight

House of Representatives

November 1995 U.S. POSTAL SERVICE

Postal Ratemaking In

Need of Change

GAO/GGD-96-8

GAO United States

General Accounting Office

Washington, D.C. 20548

General Government Division

B-260868 

November 15, 1995

The Honorable John M. McHugh

Chairman, Subcommittee on the Postal Service

Committee on Government Reform and Oversight

House of Representatives

Dear Mr. Chairman:

This report responds to your March 7, 1995, inquiry about matters for

congressional consideration contained in our March 1992 report to

Congress on postal pricing.1

 You asked (1) whether changes in policies

concerning volume discounting and demand pricing should still be

considered by Congress, (2) what are the issues surrounding the current

ratemaking process, and (3) what proposals for modifying the postal

ratemaking process and other changes merit further consideration by

Congress. The Postal Service’s continued viability as a full-service

provider in the current environment depends on several factors, including

controlling costs and improving the quality of service. In this report, we

focus on ratemaking issues.

Background Under the Postal Reorganization Act of 1970 (the 1970 Act), the Postal

Service is an independent establishment in the executive branch that

began operations on July 1, 1971. The Postmaster General, Deputy

Postmaster General, and the nine presidentially appointed members of the

Postal Board of Governors direct the operations of the Postal Service. The

1970 Act set a number of goals, objectives, and restraints for the Postal

Service. The Postal Service is to operate in a businesslike manner and is to

break even in the long term. Unlike its competitors who can select the

markets they serve, the Postal Service by statute must provide universal

service to all urban, suburban, and rural customers at uniform and

reasonable rates.

To regulate the Postal Service’s adherence to ratemaking standards and to

ensure that it does not take advantage of its monopoly—granted through

the Private Express Statutes2

—on the delivery of letter mail, the 1970 Act

established the Postal Rate Commission as an independent establishment

1

U.S. Postal Service: Pricing Postal Services in a Competitive Environment (GAO/GGD-92-49, Mar. 25,

1992).

2

The Private Express Statutes (18 U.S.C. 1693-1699 and 39 U.S.C. 601-606) are a set of federal laws

enacted originally in 1792 to restrict private carriage of letters. Congress enacted these laws primarily

to guarantee a healthy postal system that could afford to deliver letters between any two locations,

however remote.

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of the executive branch. The 1970 Act requires the Postal Service to file

with the Commission a request for changes in rates for all services offered.

As part of its request, the Postal Service provides detailed information and

data explaining revenue requirements, mail-volume estimates, costing,

pricing, and rate design. The Commission must hold public hearings and

allow interested parties, including Postal Service competitors, the

opportunity to make their views on proposed rate changes known. The

Commission is required to provide the Postal Service’s governors with its

recommended decision on new rates within 10 months of the filing. In

making its decision, the Commission is required to take into account the

nine criteria (see app.I) specified in the 1970 Act.

The ratemaking criteria set forth in the 1970 Act were established during a

period when the Postal Service had less competition than it does now. The

Postal Service now operates in a different environment because of

increasing competition from private companies and advances in electronic

communications. In 1992, we reported that Congress should reexamine the

nine criteria set forth in the 1970 Act and consider amending them to state,

among other things, that in allocating institutional costs, demand factors

are to be given a weight that takes into account the need to maintain the

long-term viability of the Postal Service as a nationwide full-service

provider of postal services, and to determine whether these criteria are

still valid in light of changing marketplace realities.

Since the late 1970s, the Postal Service and the Commission have

disagreed over the extent to which the ratemaking criteria allow the use of

demand factors to allocate the Postal Service’s overhead burden among

the various mail classes. The Postal Service believes that demand factors

should play a major role in overhead cost allocation in determining prices

for various mail classes to recognize market realities, whereas the

Commission has in the past placed less weight on demand factors in its

pricing decisions than the Postal Service has. This report focuses on this

issue as well as volume discounting.

Results in Brief Legislative changes to the 1970 Act’s ratemaking provisions may be

necessary to recognize market realities which have contributed to the

reasons why the Postal Service has not been an effective competitor in

some markets. These reasons include such factors as price and regulatory

constraints. In our 1992 report, we said that Congress should reexamine

the 1970 Act to (1) determine if volume discounting by the Postal Service

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would be considered a discriminatory pricing policy and (2) clarify the

extent that demand pricing should be considered in postal ratemaking.

Recently, the Postal Service sent the Commission (1) a petition to initiate

rulemaking that would give it more flexibility in pricing postal products3

and (2) a proposal to establish a market-based mail classification

schedule.4

 Although we still believe that our 1992 matters for

congressional consideration have merit, their consideration by Congress

might be more useful after the outcome of these Postal Service initiatives

is known.

For the reasons discussed in our 1992 report, we believe that if the Postal

Service is to be more competitive, it needs more flexibility in setting postal

rates and that postal rates should be based to a greater extent on

economic principles that consider volume discounting and demand

pricing. This is not meant to exclude other factors addressed in the

ratemaking criteria prescribed in the 1970 Act. These pricing mechanisms,

which recognize market factors, could help minimize mail volume losses

due to competitive forces and help keep rates lower for most mail classes

and subclasses over the long term.

At present, the Postal Service and the Commission disagree, as they have

in the past, on the relative weight to be given to market factors versus

other elements, such as principles of fairness and equity, in setting rates.

Resolving this situation may require that Congress clarify the ratemaking

criteria established in the 1970 Act.

Postal ratemaking is a complex process that usually takes 10 months;

however, this period does not include the time the Postal Service spends

preparing a rate case, nor the time it takes for an appeal when the Board

of Governors and the Commission do not agree. Various study groups

believe that the current process takes too long for the Postal Service to

respond to today’s rapidly changing market conditions.

Over the 25-year period since the 1970 Act, many studies have proposed

changes to the postal ratemaking process. We believe that proposals by

the Institute of Public Administration and the Joint Task Force on Postal

Ratemaking have merit and deserve consideration by Congress. The

Institute of Public Administration examined the process by which prices

3

On April 10, 1995, the Postal Service petitioned the Commission to, among other things, give the

Postal Service the authority to offer volume-based rates.

4

Mail Classification Schedule, 1995, Classification Reform I, Docket No. MC95-1.

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are set for mail services and assessed the process in terms of timeliness,

flexibility, simplicity, and fairness. In its 1991 report to the Board of

Governors, the Institute concluded that the ratemaking process had

adversely affected the Postal Service’s ability to serve the public and

compete in a changing, competitive environment.5

 The Institute

recommended that a joint task force be set up to draft a comprehensive

revision of rules governing ratemaking and classification. The Institute

also proposed a number of legislative changes. In response, the Postal

Service and the Commission established a joint task force to examine

ratemaking problems and make proposals for new procedures. The task

force made several recommendations that seem to have merit.6

 They

include developing accelerated procedures for market testing new

products, establishing rate bands for competitive products, and allowing a

form of volume-based rates for high-volume shippers.

In addition to ratemaking reforms discussed previously, other provisions

of the 1970 Act may require changes if the Postal Service is to be more

competitive. For example, as discussed in our automation and

labor-management reports,7

 Congress may want to reexamine those

aspects of the 1970 Act that affect the Postal Service’s ability to control

labor costs and resolve workforce issues. Without progress in these and

other areas, such as avoiding the frequent use of binding arbitration to

settle labor disputes, it will be difficult for the Postal Service to be

competitive in the marketplace, regardless of ratemaking changes.

Scope and

Methodology

In preparing this report, we reviewed the Commission’s rate decision for

1994 (Docket No. R94-1), the Postal Service’s testimony supporting the

1994 rate case, expert testimony given on demand pricing, technical

papers on postal pricing policies, and our past work. We also discussed

the 1994 rate case with Postal Service and Commission officials. In

addition, we reviewed reports that recommended reforms to the

ratemaking process, in particular, reports by the Institute of Public

Administration and the Joint Task Force on Postal Ratemaking.

5

The Ratemaking Process for the U.S. Postal Service, report of the Institute of Public Administration to

the Board of Governors of the U.S. Postal Service (New York: Institute of Public Administration, Oct.

8, 1991).

6

Postal Ratemaking in a Time of Change, a report by the Joint Task Force on Postal Ratemaking

submitted to the Board of Governors of the United States Postal Service and the Postal Rate

Commission, June 1, 1992.

7

Postal Service: Automation Is Taking Longer and Producing Less Than Expected (GAO/GGD-95-89BR,

Feb. 22, 1995), and U.S. Postal Service: Labor-Management Problems Persist on the Workroom Floor

(GAO/GGD-94-201A & 201B, Sept. 29, 1994).

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We received written comments on a draft of this report from the Postal

Service and the Postal Rate Commission. We discuss these comments at

the end of this report. Copies of the comments are located in appendixes II

and III.

We did our work in Washington, D.C., between March and May 1995 in

accordance with generally accepted government auditing standards.

Our 1992 Analysis In our March 1992 report, we said that to better compete in the current

market, the Postal Service needs more flexibility in setting postal rates and

that these rates should be based to a greater extent on economic

principles. Therefore, we suggested that Congress should reexamine the

1970 Act to (1) determine if volume discounting by the Postal Service

would be considered a discriminatory pricing policy and (2) clarify the

extent that demand pricing should be considered in postal ratemaking.

These pricing mechanisms could help minimize mail volume losses due to

competitive forces and help keep rates lower for most mail classes over

the long run. The reasons underlying our position follow.

Volume Discounting Three mail categories are subject to significant direct competition where

Postal Service competitors provide discounts to large volume customers:

parcel post, Express Mail, and Priority Mail. These three categories

accounted for $4.7 billion or 10 percent of total Postal Service 1994

revenues. As we reported in March 1992, the Postal Service lost major

market share in the multi-billion dollar parcel post and Express Mail

markets.8

 Although other factors contributed, such as the operating costs

faced by the Postal Service and quality of service, a key element in this

loss was that the Postal Service could not offer competitive prices to large

users.

The Postal Service’s Priority Mail (second-day) service is its fastest

growing service and has a mix of statutorily protected and unprotected

material. According to the Postal Service’s Origin-Destination Information

System database, about 53 percent of Priority-Mail volume consists of

small parcels and packages not subject to the Private Express Statutes or

urgent letter regulation. This market is being pursued by competitors of

8

The Postal Service’s fourth-class parcel mail services do not include letters, as defined by Postal

Service regulation, and thus are not protected by the Private Express Statutes. In 1979, the Postal

Service issued a regulation (39 C.F.R. 320.6) that suspended operation of the Private Express Statutes

for private carriage of “extremely urgent” letters, and overnight delivery of such letter mail has been

opened to competition.

Page 5 GAO/GGD-96-8 Postal Ratemaking
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the Postal Service through aggressive pricing strategies and service

offerings.9

In our March 1992 report, we said that if the Postal Service is to be more

competitive, it will need greater pricing flexibility in markets exposed to

direct and growing competition, including its second-day market, as well

as its overnight and parcel post markets. The Postal Service lacks

authority to revise rates quickly or grant volume discounts to users of its

competitive services. It has proposed volume discounts for Express Mail

and certain international services.10 The Commission did not accept the

Express Mail proposals. However, after a federal district court ruled that

the Postal Service’s proposed volume discounts for international mail

service unreasonably discriminated among mail users and could not be

implemented, the United States Court of Appeals for the Third Circuit

reversed the District Court’s ruling and upheld the authority of the Postal

Service to implement volume discounts.

Demand Pricing The Postal Service is a multiproduct, regulated enterprise subject to

varying degrees of competition in its product lines. Since the late 1970s,

there has been a basic disagreement between the Commission and the

Postal Service on the extent that the principles of economically efficient

pricing or Ramsey pricing can be applied to postal ratemaking. Ramsey

pricing has been used in varying degrees as a basis for ratesetting in

regulated industries, and its advantages have been analyzed at length in

the economic literature. Under Ramsey pricing, an agency that regulates a

natural monopoly would set prices so that in each market segment, the

percentage markup would be inversely proportional to the elasticity of

demand11 in that segment. For example, available evidence from Postal

Service econometric models shows that First-Class Mail is more inelastic

than third-class mail. In this situation, use of Ramsey pricing or the inverse

elasticity rule would result in allocating a higher-than-average percentage

of the institutional costs to First-Class Mail and a lower-than-average

percentage to third-class mail.

9

See our report U.S. Postal Service: Priority Mail at Risk to Competition If Double Postage Rule Is

Suspended (GAO/GGD-92-68, May 7, 1992).

10The Postal Service proposed volume discounts for Express Mail in its R87-1 and R90-1 rate cases. The

Postal Service’s proposed volume discounts for its International Customized Mail Service were

contested before the United States District Court for the District of Delaware. The ruling of the Federal

District Court against the Postal Service was reversed by the United States Court of Appeals for the

Third Circuit; UPS Worldwide Forwarding, Inc. v. United States Postal Service, 853 F. Supp. 800 (D.

Del. 1994), rev’d, No. 94-7423 (3rd Cir. Sep. 15, 1995).

11Elasticity of demand measures the sensitivity of customer demand to historic changes in prices.

Elasticities are estimated using econometric models.

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It should be noted that Postal Service estimates included with R94-1 show

that demand for 15 selected mail categories is inelastic. In one category,

Express Mail, demand is elastic. Under Ramsey pricing, the markups

depend on relative elasticities, not whether demand for a particular postal

service is elastic or inelastic. As illustrated in R94-1, on the basis of Postal

Service elasticity estimates, a 10-percent increase in the First-Class letter

rate would result in about a 2-percent loss in volume.

Although the Postal Service and the Commission both agree that market

factors should play a role in ratemaking, our March 1992 report described

the different views and strategies they have in applying these factors in the

ratemaking process. Since our report, another omnibus ratemaking

proceeding has been completed (Docket No. R94-1). In the 1994 rate case,

the Postal Service’s strategy was to keep the rate change process relatively

simple and provide enough revenue until it could propose a major rate

reclassification. It requested a 10.3-percent increase for most major

subclasses, which the Postal Service said was less than the economywide

rate of inflation since its March 1990 filing. The Commission did not accept

the proposed uniform rate increase, stating that the resulting rates for

some classes would not be in accordance with the 1970 Act’s requirement

that the Commission recommend rates that are fair and equitable.

As in previous rate cases, one disagreement in R94-1 centered on the

Postal Service’s proposed allocation of a large portion of the $19.7 billion

in total institutional costs to First-Class letters and third-class bulk mail,

which together account for 83 percent of postal mail volume and 78

percent of postal mail revenue.12 These allocations are made as “markups”

to the costs that can be attributed to each mail class. The Postal Service

proposed to mark up by 81.5 percent the costs attributed to First-Class

letters. According to the Commission, this markup would result in

First-Class Mail absorbing 77 percent of total institutional costs—an

increase of 5 percentage points over the contribution approved in the 1990

rate case. The Commission considered this an excessive burden for

First-Class mailers, considering that the costs attributed to First-Class had

declined from 60 percent to 58 percent since the 1990 case.

In support of its uniform rate proposal, the Postal Service said that the

cost allocations proposed in R94-1 for First-Class letters and third-class

12A similar disagreement between the Postal Service and the Commission concerning the role of

economic variables has arisen in the last two rate cases over the proper method for attributing city

delivery carrier access and coverage related load costs totaling about $3 billion. In addition, the Postal

Service and Commission disagreed on the need for and quality of certain data for setting rates in the

1994 case.

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bulk mail were more in accord with Ramsey pricing principles than were

the allocations in recent Commission-recommended decisions. In addition,

the Postal Service said that its emphasis on demand factors is consistent

with the criteria in 39 U.S.C. 3622(b), in particular, section

3622(b)(2) dealing with the value of the mail service to both the sender

and the recipient.

The Commission believed that the Postal Service’s proposed allocation of

institutional costs to these two major mail categories would be a

significant departure from previous rate-case decisions. The Commission’s

stated objective in previous rate cases was to have First-Class markups

slightly above the systemwide average and third-class markups slightly

below the systemwide average. The Commission allows a lower markup

for third-class bulk regular mail to reflect its “higher elasticity of demand,

the potential for volume diversion to alternative delivery, and the need to

set rates which are responsive to the market,” as well as to recognize “the

low intrinsic value of its service standards and service performance.”

The Commission calculated rate changes necessary to return to the

relative markup relationships that were recommended in the 1990 rate

case. On the basis of this analysis, the Commission found that the

third-class bulk regular rate would require a 17-percent increase rather

than the uniform 10.3-percent increase proposed by the Postal Service. In

its recommendation to the Board of Governors, however, the Commission

limited the third-class bulk regular rate increase to 14 percent. The

Commission tempered the rate increase to reflect its concern with the

impact a larger rate increase would have on users of this service. As finally

recommended, the First-Class letter markup was 131 percent of the

systemwide average, and the third-class bulk mail markup was 90 percent

of the systemwide average. While the Commission accepted the Postal

Service’s proposed 32-cent rate for the First-Class stamp, it recommended

a smaller increase than the Postal Service’s proposed rate for postcards

and no increase in the extra ounce rate for letters weighing more than 1

ounce.

The Postal Service and the Commission also disagreed on the resulting

rate increases among the competitive mail categories. For example, the

Commission recommended a lower-average rate increase (4.8 percent) for

Priority Mail, overall, than the uniform rate increase (approximately

10.3 percent) proposed by the Postal Service, because it believed the rate

proposed would place an unfair institutional cost burden on this mail

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component.13 Similarly, the Commission recommended a lower rate

increase for Express Mail (8.0 percent compared to 10.2 percent) because

it had the highest elasticity of any mail class. While it recommended lower

rates in two competitive categories, the Commission recommended a

higher rate increase (18 percent) for fourth-class parcel post, another

highly competitive market, instead of the Postal Service’s proposed

13 percent. The Commission believed that this small mail component

should make a higher contribution to institutional costs than that

proposed by the Postal Service.

As we noted in our March 1992 report, the Postal Service and the

Commission do not agree on the extent to which demand factors can be

used to price postal products. There appear to be two principal sources of

disagreement. First, section 3622 (b) of the 1970 Act specifies nine criteria

to be used in setting postal rates. (See app. I.) These criteria set a number

of potentially conflicting objectives, and the Postal Service and the

Commission disagree on the relative emphasis to be placed on each of

them.

Second, the implementation of a pricing scheme that includes demand

factors crucially depends on the availability and quality of data on

economic variables and on the econometric methodology that is used to

analyze the data and derive estimates of relative demand elasticities.14 The

Commission has generally been more pessimistic than the Postal Service

about whether the current state of the art is sufficiently advanced to

permit heavy reliance on demand-based pricing.

With regard to these disagreements, we made the following observations

in our 1992 report, which we believe are still germane. First, we recognize

that existing law requires the Commission to balance multiple objectives

in setting the rate structure. For that reason, we do not advocate the

application of Ramsey pricing principles to the exclusion of other

considerations. However, the pursuit of diverse objectives comes at a

price in terms of loss of consumer welfare, as well as possible erosion of

the Postal Service’s competitive position in the long run. Further, there is

every reason to believe that changes in the economy that have taken place

since 1970 have increased the potential cost to the Postal Service and the

economy of pursuing diverse objectives. Resolving this situation may

13While the Commission recommended an average rate increase of 4.8 percent, the recommended rate

increases for heavier-weight Priority Mail (6 to 70 pounds) ranged from 12 percent to 34 percent in

zones 1 through 5.

14See GAO/GGD-92-49, appendixes II and III.

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require that Congress clarify the ratemaking criteria set forth in the 1970

Act.

Second, we are aware of ongoing disagreements among econometricians

who have studied technical issues related to demand-based pricing.

However, we continue to believe that decisions should be made on the

basis of the best information available, and that policymakers should not

wait for such controversies to subside before taking action.

The Current Postal

Ratemaking Process

Postal ratemaking is a complex process that usually takes 10 months—the

statutory deadline established by Congress in 1976. This period does not

include the time the Postal Service spends preparing a rate case, nor the

time it takes for an appeal when the Board of Governors and the

Commission do not agree. In the last rate case (R94-1), the Commission

issued its recommended decision in less than 9 months. While we do not

know how long the process should take, various study groups believe that

the current process takes too long for the Postal Service to respond to

today’s rapidly changing market conditions.

The ratemaking process begins when the Postal Service files a formal

request with the Commission for rate changes. The Postal Service provides

detailed information and data explaining (1) revenue requirements,

(2) mail volume estimates, (3) costing, (4) pricing, and (5) rate design. As

required by the 1970 Act, the Commission holds public hearings and

allows interested parties the opportunity to make their views known. A

typical rate case can involve up to 100 parties, 150 witnesses, and several

rounds of hearings lasting many days or weeks. In addition to the Postal

Service and an officer of the Commission representing the interests of the

general public, the parties and witnesses represent an array of interest

groups, including (1) commercial mailers, (2) publishers and publishers’

associations, (3) Postal Service competitors, and (4) Postal Service unions.

The most important and time-consuming parts of the proceedings center

on the Postal Service data explaining the attribution and assignment of

costs to specific services or classes of mail and the rate design based on

those data. As long as the core letter mail business—represented largely

by First-Class and third-class mail and accounting for about 80 percent of

revenues—is protected by the Private Express Statutes, some type of

regulatory oversight will be necessary. The President’s Commission on

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Postal Reorganization (“Kappel Commission”) whose 1968 report15

persuaded Congress to pass the 1970 Act said that “were we to

recommend a privately-owned Post Office,” which it did not, “rate

regulation by an independent Federal commission would be a necessary

and appropriate corollary.” Instead, the Kappel Commission recommended

that Congress establish an independent government-owned postal

corporation. The Kappel Commission said that it saw no advantages to,

and had serious problems in, proposing the regulation of a government

corporation by another government body.

Proposals for

Modifying the Postal

Ratemaking Process

Over the 25-year period since the 1970 Act, many studies, including four by

us,16 have proposed changes to the postal ratemaking process. The

remaining section of this report focuses on proposals for modifying the

postal ratemaking process contained in two recent and important studies

that were completed in fiscal year 1992. These studies, like our pricing

report, focused on ratemaking changes to reflect the competitive

environment in which the Postal Service operates. The findings and

recommendations in earlier studies are generally revisited in these more

recent reports.17

Institute of Public

Administration

Because of the contention between Postal Service management and the

Commission over the 1990 rate case, the Board of Governors contracted

with the Institute of Public Administration18 in May 1991 to study the

ratemaking process. The study examined the process by which prices are

set for mail services and assessed the process in terms of timeliness,

flexibility, simplicity, and fairness. The Institute’s report to the Board of

Governors in October 1991 concluded that the ratemaking process had

adversely affected the Postal Service’s ability to serve the public and

compete in a changing competitive environment.

15Toward Postal Excellence: The Report of the President’s Commission on Postal Organization,

President’s Commission on Postal Organization (Washington, D.C.: Government Printing Office,

June 1968). Most of the commissioners were chief executive officers of major corporations.

16In addition to our 1992 pricing report, see The Role of the Postal Rate Commission Should Be

Clarified (GAO/GGD-77-20, Apr. 1977), A Case Study of Why Some Postal Rate Commission Decisions

Took As Long As They Did (GAO/GGD-81-96, Sept. 1981), and Opportunities to Improve the Postal

Ratemaking Process (GAO/GGD-84-10, Apr. 1984).

17A chronology, listing, and summary of the other studies are discussed in Part IV of the report issued

by the Institute of Public Administration. (See footnote 5.)

18The Institute of Public Administration is a private, nonprofit organization whose staff members

include specialists in public and business administration, finance, political science, and economics.

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The study found that the process had become too cumbersome, rigid, and

narrow to best serve the overall financial interests of the Postal Service

and its customers. The Institute made a number of recommendations that

would, among other things, allow the Postal Service more flexibility to

compete, as well as an increased ability to protect the system from

financial loss. It did not make any specific recommendations for changing

the rate criteria. However, it stated that (1) “the full range of factors listed

in the Postal Reorganization Act should be used in redefining rate criteria”

and (2) the Commission’s use of “historical average” markups to guide

ratemaking “is an inappropriate criterion, and not on the list in the Act.”

This latter point was consistent with our view in the 1992 report on pricing

postal services in a competitive environment.19

The Institute recommended that the Board of Governors and the

Commission establish a joint task force to draft a comprehensive revision

of rules governing ratemaking and classification and propose a strategy for

reform of the process. Among many other ideas, it also offered several that

we believe merit further consideration: (1) base an omnibus rate case on a

4-year financial plan, rather than on a 1-year test period; (2) have the

Postal Service and the Commission agree on categories of information to

be submitted with the plan, which should become regular products of

budgeting and information systems, thus reducing the need for special

statistical studies for ratemaking; and (3) permit the Postal Service to

compete on “level playing fields” in its competitive markets, while also

constantly improving its existing core services by controlling costs and

improving efficiency.

The Institute also proposed legislative changes that we believe merit

consideration as follows:

• require the Commission to determine which segments of Postal Service

proposals are competitive and use expedited review processes for rate

changes on these segments,

• give the Postal Service experimental authority to market-test new

products and service enhancements without being subjected to the

standard rate and classification procedures of the Commission,

• change the requirement that unanimous consent of the Board of

Governors is needed to reject or modify a Commission-recommended

decision to a two-thirds majority requirement, and

• eliminate the second round of rate-case reconsideration.

19As part of that review, we analyzed the Commission’s rate decisions from 1971 to 1990.

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Joint Task Force on Postal

Ratemaking

In response to the Institute’s report, the Postal Service and the

Commission established a joint task force to examine the problems of

ratemaking and to provide proposals for new procedures that would

eliminate some of the structural rigidities. The Commission and the

Governors each appointed four members to the task force. The

eight-member task force started its work in January 1992 and issued its

unanimous report on June 1, 1992. The task force found “a need for more

flexibility in pricing by the Postal Service, a need for greater predictability

of prices, and a continuing need for greater accountability in postal

financial performance.” The task force proposed a number of

recommendations, none of which has been implemented. Based on past

work on postal ratemaking, our observations on some of the key

recommendations follow.

First, the task force recommended that postal ratemaking be based on a

4-year, 2-step rate cycle. Under the 4-year cycle, the Commission would

recommend rates for the first 2 years of the cycle and project but not

recommend rates for the remaining 2 years. A midcycle case proceeding

would be held to validate or adjust the earlier proposed rates, but the

scope would be limited in that the Commission would not revisit cost

attribution methods, volume estimating methods, and pricing policies or

other factors affecting assignment of institutional costs. According to the

task force, the proposed 4-year process would (1) provide better rate

matching to marketplace realities, (2) provide more predictable rate

increases in smaller increments, (3) reduce the costs of the ratemaking

process, and (4) improve accountability in financial performance. Looking

at the Postal Service’s financial and operating needs over a 4-year period,

rather than a single year as is currently practiced, was similar to the

proposal suggested by the Institute.

Among the issues that need further study would be (1) whether the Postal

Service can accurately project revenues and expenses for 4 years; (2) how

the specific proposal would be implemented; (3) what rules and

procedures would need to be changed in the two-stage process; and

(4) what would be the views of the Postal Service, mailers, and other

interested parties to the proposed rate-case cycle.

To address these issues, the Commission issued a Notice of Proposed

Rulemaking in August 1992 containing proposed rules on implementing

the 2-phase, 4-year rate cycle for omnibus rate proceedings.20 In its

October 13, 1992, comments, the Postal Service disagreed with the

20See Federal Register, Vol. 57, pp. 39160-73, Aug. 28, 1992.

Page 13 GAO/GGD-96-8 Postal Ratemaking
B-260868 

proposed rules believing there were more disadvantages than advantages.

Basically, the Postal Service wanted a more flexible approach to general

rate proceedings and did not want to be locked into a rigid 2-phase, 4-year

rate cycle. While the Postal Service did not support the proposed general

rate cycle, it encouraged the Commission to formulate procedures to

address other recommendations made by the joint task force (see below),

which the Postal Service believed would be more responsive to its needs

in a competitive environment.

Second, the task force suggested changes in how rates are set for mail that

directly competes with products offered by the private sector. The three

service areas it identified as competitive classes were Express Mail, parcel

post, and heavy-weight Priority Mail. The task force recommended that the

Commission adopt a “rate band” approach to introduce more flexibility in

setting rates for these products. Under this proposal, upper and lower

bands for each rate element within the rate category’s rate structure would

be recommended by the Commission. Within these bands, the Postal

Service would be free to select specific prices after giving appropriate

notice to its customers. In establishing the rate bands, the Postal Service

and the Commission would ensure that the lower rate band covered

attributed costs and made a minimum acceptable contribution to

institutional costs to “protect against the possibility of cross-subsidy” from

another mail class.

Third, a proposal that would recognize market pricing strategies dealt with

developing a system of “declining block rates” to create incentives to

postal customers to increase usage. This recommendation, if adopted,

would allow the Postal Service to offer discounts to large-volume users in

its competitive markets. When the Postal Service proposed discounting

schemes in past rate cases, a major issue was rate discrimination, as

discussed in our March 1992 report.

In addition, the task force made a series of recommendations to help the

Postal Service experiment with new product lines and changes in service,

which currently are subject to lengthy reviews by the Commission and the

public. These recommendations include accelerated review procedures for

marketing new products and services and multi-year cost recovery for new

service introductions.

As we previously mentioned, the Postal Service filed a petition with the

Commission on April 10, 1995, to obtain more flexibility in ratemaking. In

this petition, the Postal Service asked the Commission to consider the

Page 14 GAO/GGD-96-8 Postal Ratemaking
B-260868 

recommendations of the task force that the Postal Service had not rejected

in October 1992. In addition, the Postal Service has filed a proposal with

the Commission to establish a market-based classification schedule that,

among other things, restructures First-Class and bulk regular third-class

mail.

Although we still believe that Congress should consider changes in

policies concerning volume discounting and demand pricing, such

consideration might be more useful after the outcome of these Postal

Service initiatives is known. Furthermore, other changes to the 1970 Act

may be required if the Postal Service is to be competitive as discussed in

our September 1994 labor-management report.

Conclusions Today, the Postal Service is competing with communication technologies

and private carriers for the delivery of services in markets that in 1970

were the sole domain of the Postal Service. Many observers believe the

current ratemaking process takes too long for the Postal Service to

respond to today’s rapidly changing market conditions. The proposals that

we and others have offered—to improve the effectiveness of the postal

ratemaking process, ensure financial accountability, and give the Postal

Service more flexibility to price and compete in the marketplace—provide

the Postal Service, the Postal Rate Commission, and the Subcommittee

with a variety of ideas to consider in reforming the ratemaking process.

Agency Comments

and Our Evaluation

The Postal Service and the Postal Rate Commission provided written

comments on a draft of this report. They are located in appendixes II and

III. The Postal Service said that Congress should not defer consideration of

the issues raised in our 1992 report while the Postal Service initiatives are

pending before the Commission.21 The Postal Service believes that the

ratesetting criteria should be clarified by an explicit congressional

determination that market demand factors be given substantial weight in

pricing postal products. In addition, it believes that Congress should make

clear through an amendment to the 1970 Act that appropriate economic

factors, such as marginal costs, should be given a relatively large role in

establishing an attributable cost threshold for rates.

21The Postal Service states that we “support” the proposal that the Postal Service has submitted to the

Postal Rate Commission for changes in the ratemaking process. To set the record straight, although we

believe that changes to the ratemaking process are needed, we have not endorsed any specific

proposal.

Page 15 GAO/GGD-96-8 Postal Ratemaking
B-260868 

The Commission said that it would welcome a review of the ratesetting

criteria in the 1970 Act, and it agreed with our suggestion that Congress

should defer this review until the two pending Service initiatives are

concluded. The Commission said it would not comment on the merits of

volume discounting because this issue is pending before it.

Regarding market-based pricing, the Commission said it disagreed with

our conclusion in this report and our 1992 report that postal rates should

be based to a greater extent on demand-pricing principles. The

Commission had several overall criticisms of our report, saying that we

produced a report that was not within our proper institutional role, that

we failed to address key issues, and that we did not sufficiently

understand the economic theory underlying postal ratemaking.

We do not believe that these criticisms are warranted. It is important to

understand that our objective was to report to Congress on the

implications of a greater or lesser reliance on demand pricing for setting

postal rates, recognizing the need for balance with the pursuit of other

goals. It was not our role or goal to reduce the postal ratesetting process,

which is inherently complex, to a single formula or set of formulas that

specifies the exact weight to be given to demand factors vis-a-vis other

considerations. We have made several changes to this report to clarify this

point. Because this was not our objective, we did not present an

exhaustive discussion of all the technical aspects of the economics of

postal ratemaking. In our 1992 report, we analyzed some of the more

important issues as they relate to the application of criteria prescribed in

the 1970 Act for ratemaking. The basis for our conclusions that these

criteria are matters that require consideration by Congress is spelled out in

the objectives, scope, and methodology section of our 1992 report and the

scope and methodology section of this report.

The Commission (1) summarized what it considered to be the conclusions

and recommendations of our 1992 report and this update of that report,

(2) stated that our report had a “major error” because it believes the

effects of Ramsey pricing on the Postal Service’s rates and long-run

finances will be different than we reported, and (3) argued that the effects

of demand pricing on the Postal Service’s competitiveness will be different

than we reported. The Commission also said that (4) the conditions

necessary for Ramsey pricing to achieve efficient consumption patterns

are not met, (5) Ramsey pricing would not have a substantial effect on

consumption patterns, and (6) disagreements between the Commission

and the Postal Service do not necessarily imply that the ratesetting

Page 16 GAO/GGD-96-8 Postal Ratemaking
B-260868 

process is intrinsically defective. Below, we respond to each of these

positions.

The Commission’s

Summary of Our Work

The Commission’s summation of our work is inaccurate in certain crucial

respects.22 We never predicted that Ramsey pricing would ultimately lower

rates for all classes of mail, as the Commission asserts.23 Rather, both of

our reports said that demand pricing, along with volume discounting,

could help keep rates lower for most mail classes over the long term.

Further, we do not agree that our conclusions would apply only in

“extreme and improbable conditions,” for the reasons given in the

following sections.

The Commission’s Concern

About a “Major Error”

We do not concur with the basis for the Commission’s second point, which

deals with an alleged “major error” in this report. The Commission argues

that, because the demand for most postal services is relatively inelastic,

the effects of demand pricing on the Postal Service’s rates and long-run

finances will be different than we reported.

The Commission argues that the total institutional-cost contribution from

competitive postal services could decrease if their markups were reduced.

We agree that this could happen under certain conditions. In particular, it

might happen where demand is very inelastic. While the precise

magnitudes of future elasticities of demand are unknown, we do not

believe that the situation described by the Commission applies to the

Postal Service in the long run. Rather, we believe that, if mailers are

increasingly offered alternatives and postal rates continue to increase as in

the past, the Postal Service will face considerably more competition in

some markets. This would likely lead to elasticities of demand that are

higher (in absolute terms) than those reported for the Commission’s most

recently recommended postage rates (Docket No. R94-1).

Further, we question the relevance of the hypothetical example provided

in footnote 5 of the Commission’s letter regarding the impact of adjusting

22See appendix III for the Commission’s comments.

23The critique of Ramsey pricing that runs throughout the Commission’s letter might suggest to some

that we recommended total reliance on Ramsey pricing, which is not the case. We stated our

conclusions and matters for congressional consideration in terms of demand pricing in general, rather

than the more specific Ramsey pricing, along with other factors. We used the term “Ramsey pricing” to

refer specifically to prices that are set according to a formula from the literature on the economics of

regulation, as we explained in our 1992 report. The term “demand pricing” refers more generically to

pricing schemes that take demand factors into account.

Page 17 GAO/GGD-96-8 Postal Ratemaking
B-260868 

the rates on a single mail class. Not only might the demand for various

mail classes change significantly in future years, but also it is the relative

elasticities that are relevant, not absolute elasticities. The Postal Service is

required to operate subject to a break-even constraint. Thus, the task is

one of determining the relative markup on different classes in order to

achieve a systemwide average markup that just covers institutional costs.

This means that the markups on all classes of mail, taken together, should

cover institutional cost. When the markup on one class of mail is

increased, the markup on one or more other classes of mail must be

lowered to maintain a break-even operation overall, all other factors being

equal.

We continue to believe that demand pricing, along with volume

discounting, could help keep rates lower for most mail classes over the

long term. Such pricing mechanisms could help minimize mail volume

losses due to increasing competition in some postal markets. The extent of

the curtailment of volume losses will depend in part on the future demand

for the various classes of mail.

We do not believe that over the long term, the outcomes that we have

indicated are at all improbable in light of past mail volume trends. Our

1992 report discusses how the Postal Service has already lost major

market share in parcel post and Express Mail due to competition. One

reason for this loss was the application of the current pricing criteria and

the resulting limited ability to (1) price postal services with sufficient

weight given to market factors, i.e., the relative demands for the various

services, and (2) use pricing schemes that are routinely used by the Postal

Service’s competitors, e.g., volume discounts.

Impact of Ramsey Pricing

on Competitiveness

In its third point, the Commission argues that the Postal Service’s

competitive position would not be improved by a shift toward Ramsey

pricing. The Commission’s arguments emphasize second-class mail, parcel

post, Priority Mail, and Express Mail. As we noted in our 1992 report, the

principal issue we discuss has been and remains the allocation of

institutional cost between First-Class and third-class mail, which together

accounted for 93 percent of total mail volume and 84 percent of revenue in

fiscal year 1994. We believe that this is where the potential benefits of

demand-based pricing will primarily be found.

Further, the Commission argues that the Postal Service will be incapable

of realizing any contribution to overhead, or what the Commission calls

Page 18 GAO/GGD-96-8 Postal Ratemaking
B-260868 

“profit,” in competitive markets over the long term. The Commission’s

logic is that competition will drive the rates toward the level of marginal

costs, and thus drive the “profit margins” toward zero. We find this

argument unpersuasive. If this logic were applied to private carriers, who

are subject to similar market forces and presumably also have cost

structures involving overhead or fixed costs, it would imply that their

“profit margins” would also be driven to zero. However, this is implausible,

at least for viable competitors over the long term, because the firms would

be operating at a loss.

We agree that the Postal Service’s experience in the parcel post delivery

market is important, but we disagree with the Commission about the exact

nature of the lesson to be learned. As we discussed in our 1992 report and

in this report, at the time it was losing parcel delivery business to its

competitors, the Service was limited in its ability to use pricing techniques

similar to theirs. We recognize, nonetheless, that the use of different

pricing techniques alone will not guarantee financial stability. As we have

pointed out in this report, unless significant progress is also made in, for

example, controlling labor costs and improving labor relations, the Service

may still be unable to compete effectively, regardless of ratemaking

changes.

Finally, the Commission said that our report noted “with approval” the

Postal Service proposal for a rate increase. In fact, we merely cited the

Service’s view that its proposal regarding cost allocations for First-Class

letters and third-class bulk mail were more in line with Ramsey pricing. It

was not our purpose to approve or disapprove of any specific proposal.

Also, as previously indicated, the debate surrounding cost allocations in

prior rate cases has focused primarily on First-Class and third-class mail

and not on Priority Mail and Express Mail, which the Commission has

chosen to emphasize.

Conditions Necessary for

Ramsey Pricing to Achieve

Efficient Consumption

Patterns

In its fourth point, the Commission argues that the conditions necessary

for Ramsey pricing to achieve economically efficient consumption

patterns are not present. Regarding the Commission’s arguments in this

area, we have several observations. First, although monopoly ratepayers

may perceive that they are paying a disproportionate share of fixed costs

under demand-based pricing schemes, we believe that over the longer

term their rates would likely increase less under a demand-based pricing

scheme than under other schemes, for the reasons we stated in our 1992

Page 19 GAO/GGD-96-8 Postal Ratemaking
B-260868 

report. This view has been supported by others who have studied postal

economics.24

With regard to the Commission’s argument that Ramsey pricing is viewed

by many as unfair to competitors, we repeat that we do not advocate the

use of demand-based pricing, and certainly not Ramsey pricing, to the

exclusion of all other considerations. To respond to concerns about

fairness to competitors, the Commission would be free to use this factor in

its deliberations, since it is included in the criteria specified in the 1970

Act. Further, the issue of fairness to competitors involves considerations

that go far beyond ratesetting, into such areas as the existence and

magnitude of the postal monopoly, and hence are beyond the scope of

either our 1992 report or this report. As noted in this report, we are

reviewing aspects of the postal monopoly and plan to report on that

review later.

We agree with the Commission about the importance of measuring costs

properly. However, if the inability to measure both stand-alone costs and

incremental costs is a problem for Ramsey pricing or other demand-based

pricing schemes, it would seem to be equally problematic for other types

of pricing schemes. In our 1992 report, we noted the need for better cost

and demand data. However, as we noted both in that report and this one,

we continue to believe that decisions should be based on the best

information available, and that decisions on the continued appropriateness

of the rate criteria in the 1970 Act should not be postponed pending

improvements in the data. Further, with regard to the Commission’s

statement that the Postal Service’s underlying direct costs (e.g., labor

costs) are not at a technically efficient level, we note that its operating

costs, whether efficient or not, must be taken as a given for ratesetting

purposes. Again, to the extent that this is a problem, it is equally

problematic for both demand-based pricing and other forms of pricing. We

did not address Postal Service workforce issues in this report; however, as

noted in the text, we have done so in other recently issued reports on

automation and labor-management relations.

As a final comment on the Commission’s fourth point regarding the

conditions necessary for Ramsey pricing, we note that the assertion that

no regulatory body requires rates to conform strictly to Ramsey pricing

principles is not relevant to our report. Again, we did not state that

demand pricing in general, or Ramsey pricing in particular, should be used

for setting postal rates to the exclusion of all other factors. As we noted

24See, for example, the testimony of John Panzar in the R94-1 rate case.

Page 20 GAO/GGD-96-8 Postal Ratemaking
B-260868 

earlier, Ramsey pricing has received considerable attention in the

academic literature, and it has been applied to varying degrees in

ratesetting proceedings in regulated industries.

Impact of Ramsey Pricing

on Consumption Patterns

The Commission’s fifth point is that a rate structure that is derived from

Ramsey pricing formulas would not affect consumption patterns in a way

that differs substantially from the impact of the rate structure that the

Commission actually adopted in Docket No. R94-1. In fact, we made no

estimate of the impact of Ramsey pricing on consumption patterns. We are

aware of the estimates that are cited by the Commission. We note that

these estimates are based on short-run estimates of demand elasticities

and that the long-run scenario may be quite different. Further, the

Commission asserts that our draft report criticizes the Commission for its

actions. In fact, our purpose was merely to describe the differences in

reasoning expressed by the Postal Service and the Commission in their

respective applications of the postal ratemaking criteria set forth in the

1970 Act.

Disagreements Between

the Commission and the

Postal Service

Regarding the Commission’s observation on the differing views of the

Commission and the Postal Service, we agree that regulators often

disagree with regulated entities over the prices to be set in a particular

case. However, our report addressed the more fundamental issue of

whether the criteria established by Congress in 1970 for setting postal

rates are still valid today. Critical to addressing this issue is the question of

the weight to be assigned to demand factors, relative to other criteria

prescribed in the 1970 Act. It is the difference in Postal Service and

Commission perspectives regarding this relative weight that is of concern

to us and that we believe requires consideration by Congress.

We are sending copies of this report to the Board of Governors and

Postmaster General of the U.S. Postal Service, the Commissioners of the

Postal Rate Commission, and other interested parties.

Page 21 GAO/GGD-96-8 Postal Ratemaking
B-260868 

The major contributors to this report are listed in appendix IV. If there are

any further questions or if assistance is needed, please call me on

(202) 512-8387.

Sincerely yours,

J. William Gadsby

Director, Government Business

 Operations Issues

Page 22 GAO/GGD-96-8 Postal Ratemaking
Page 23 GAO/GGD-96-8 Postal Ratemaking
Contents

Letter 1

Appendix I 

Rate Criteria

26

Appendix II 

Comments From the

U.S. Postal Service

27

Appendix III 

Comments From the

Postal Rate

Commission

29

Appendix IV 

Major Contributors to

This Report

35

Page 24 GAO/GGD-96-8 Postal Ratemaking
Page 25 GAO/GGD-96-8 Postal Ratemaking
Appendix I 

Rate Criteria

The Postal Reorganization Act sets forth, in 39 U.S.C. 3622(b), the

following nine criteria for determining postal rates and fee levels:

1. The establishment and maintenance of a fair and equitable schedule.

2. The value of the mail service actually provided each class or type of mail

service to both the sender and the recipient, including but not limited to

the collection, mode of transportation, and priority of delivery.

3. The requirement that each class of mail or type of mail service bear the

direct and indirect costs attributable to that class or type plus that portion

of all other costs of the Postal Service reasonably assignable to such class

or type.

4. The effect of rate increases upon the general public, business mail users,

and enterprises in the private sector of the economy engaged in the

delivery of mail matter other than letters.

5. The available alternative means of sending and receiving letters and

other mail matter at reasonable costs.

6. The degree of preparation of mail for delivery into the postal system

performed by the mailer and its effect upon reducing costs to the Postal

Service.

7. Simplicity of structure for the entire schedule and simple, identifiable

relationships between the rates or fees charged the various classes of mail

for postal services.

8. The educational, cultural, scientific, and informational value to the

recipient of mail matter.

9. Such other factors as the Commission deems appropriate.

Page 26 GAO/GGD-96-8 Postal Ratemaking
Appendix II 

Comments From the U.S. Postal Service

Page 27 GAO/GGD-96-8 Postal Ratemaking
Appendix II 

Comments From the U.S. Postal Service

Page 28 GAO/GGD-96-8 Postal Ratemaking
Appendix III 

Comments From the Postal Rate

Commission

Page 29 GAO/GGD-96-8 Postal Ratemaking
Appendix III 

Comments From the Postal Rate

Commission

Page 30 GAO/GGD-96-8 Postal Ratemaking
Appendix III 

Comments From the Postal Rate

Commission

Page 31 GAO/GGD-96-8 Postal Ratemaking
Appendix III 

Comments From the Postal Rate

Commission

Page 32 GAO/GGD-96-8 Postal Ratemaking
Appendix III 

Comments From the Postal Rate

Commission

Page 33 GAO/GGD-96-8 Postal Ratemaking
Appendix III 

Comments From the Postal Rate

Commission

Page 34 GAO/GGD-96-8 Postal Ratemaking
Appendix IV 

Major Contributors to This Report

General Government

Division, Washington,

D.C.

Michael E. Motley, Associate Director, Government Business Operations

 Issues

James T. Campbell, Assistant Director

Barry P. Griffiths, Senior Evaluator

Office of the Chief

Economist,

Washington, D.C.

James R. White, Acting Chief Economist

Timothy J. Carr, Senior Economist

(240179) Page 35 GAO/GGD-96-8 Postal Ratemaking
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