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 Statutes—on the delivery of letter mail, the 1970 Act established the Postal Rate Commission as an independent establishment 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. 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. 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. 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. 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. 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 the Postal Service through aggressive pricing strategies and service offerings. 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. 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. 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 demand 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. 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. 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 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 component. 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. 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 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. 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 Postal Reorganization (“Kappel Commission”) whose 1968 reportpersuaded 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. Over the 25-year period since the 1970 Act, many studies, including four by us, 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. 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 Administration 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. 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. 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. 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. In its October 13, 1992, comments, the Postal Service disagreed with the 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 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. 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. 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. 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. 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 process is intrinsically defective. Below, we respond to each of these positions. The Commission’s summation of our work is inaccurate in certain crucial respects. We never predicted that Ramsey pricing would ultimately lower rates for all classes of mail, as the Commission asserts. 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. 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 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. 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 “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. 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 report. This view has been supported by others who have studied postal economics. 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 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. 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. 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. 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.

Summary: GAO examined the U.S. Postal Service's proposals for modifying the postal ratemaking process, focusing on: (1) how the current ratemaking process could be improved; and (2) the effects of the 1970 Postal Reorganization Act on postal rates. GAO found that: (1) the Postal Service has petitioned the Postal Rate Commission to give it more flexibility in pricing postal products and establish a market-based mail classification schedule; (2) new Postal Service pricing mechanisms could minimize mail volume losses and keep rates lower for most mail classes; (3) Congress may have to clarify the 1970 ratemaking criteria because the Postal Service and Commission disagree on the extent that market forces impact postal rates; (4) postal ratemaking usually takes 10 months to complete and it does not include the time the Postal Service spends preparing rate cases and appeals; (5) proposed postal ratemaking reforms include developing accelerated procedures for market testing new products, establishing rate bands for competitive products, and allowing volume-based rates for high volume shippers; and (6) the Postal Service needs to be able to control labor costs and resolve workforce issues to remain competitive in the postal marketplace.