Later reforms of postal regulation - Liberalisation of postal services in Sweden

2. Liberalisation of postal services in Sweden

2.4 Later reforms of postal regulation

The first Postal Act was revised three times since 1994. In the first revision of 1 January 1997, the scope of the universal service was extended and new operators were required a licence instead of a notification to the regulator. In the second revision of 1 July 1998, price regulation was reformed and legislation adjusted to the new EU Directive. The third revision of 1 July 1999 concerned only the access to the postal infrastructure (see section 4.2). The contract between the State of Sweden and Sweden Post has been renewed twice and since 2001, the requirements on Sweden Post concerning among other things the universal service obligation are included in its licence conditions. The legislation reforms will be described in more detail in chapter 4.

7 It is unclear whether it is as a share of volume or revenues, but as prices were quite uniform at this time, there will not be a significant difference.

3. Theoretical background to the liberalisation of postal services

3.1 Why regulate or deregulate postal services?

Market, allocative and regulatory failures

The justification from economic theory for regulation in general is what is summarised in the term market imperfections. This includes the existence of public goods, economies of scale, asymmetric information and external effects, which all results in inefficient performance of an unregulated market. For the postal sector, the dominant market failure is the strong economies of scale and scope in postal production. Earlier, it has been argued that postal production as a whole or at least parts of it is even a natural monopoly. One solution in this situation is to limit the market power of a private firm by some kind of regulation at least in the markets where the firm is dominant, most commonly rate-of-return or price regulation. Another solution would be to put the parts that are seen as monopolistic to a public tendering. One more solution is to have a state monopolist, and determine other objectives than profit maximisation, such as a certain return on capital to the state budget and/or average cost pricing, for example. In the postal sector, state production has been the most common solution until the 1990s, even in the otherwise most market-oriented countries like the USA. Only since then, countries have started liberalising parts of the former state monopolies – or they have abolished the monopoly completely, such as Sweden, Finland, and New Zealand.

Recently, deregulation has taken place also in Estonia and the United Kingdom and a few more countries have announced that they will precede the EU timetable with full market opening in 2009.

A second justification for regulation is a purely political one and is not derived from economic theory. For some products, like postal services, the outcome in a pure market economy does not represent the political goals for distribution in society; an allocative failure occurs. Thus, postal services could be regulated in order to reach the desired availability. In practice, this leads to the universal service obligation (USO). It has to be defined in different dimensions: what postal products to be included in the USO, the geographical area, the price and service level. Usually, the geographical area is the whole country, prices are wished to be uniform and affordable, whereas the range of products and the service level vary across countries.

The allocation argument is sometimes used as a justification for state production, because it could be easier to finance universal services that an unregulated firm would not provide through cross-subsidies from products that generate surpluses. Moreover, state production facilitates more indirect reallocations: either to other activities carried out by the postal firm (e.g. providing financial services or free distribution of newspapers) or generating revenues to the state budget that can be used in other sectors of the economy.

When regulation is implemented in order to adjust for market imperfections or policy goals, new imperfections can occur, called regulatory failures. Such failures can take different forms. One is that the state monopolist becomes inefficient in the absence of competition.

Such inefficiency can show up in too high employment and/or overcapitalisation and low

productivity. It is not uncommon in the postal sector that the Post Office mitigates

unemployment problems, becomes an “employer of last resort”. Another result can be that the organisation is suboptimal or that there is a slack in the existing organisation. New regulatory failures can of course emerge as a result of the regulatory framework that replaces the legal monopoly.

A second form of regulatory failure is that the state firm makes monopoly gains, even if it does not reach as far as profit maximisation. Such gains can benefit different stakeholders.

There can be a wage premium for employees with salaries exceeding the competitive level;

there can be excessive benefits for management; they can benefit consumers with too high quality (at high cost); it can generate surpluses, which are used to finance diversification into sectors beyond the postal sector; it can be a source of revenue for the state.

Other results of regulatory failures can be dynamic inefficiencies, with too little innovation, which in the long run harms the sector, that quality is not adjusted to consumers’ shifting demand (i.e. some customers might desire lower quality at cheap prices, but not receive it from the monopolist) and that prices are too uniform and not adjusted to costs.

An important drawback of many of these regulatory failures (“too uniform prices”, “wage premia”, “surpluses that are used to diversify”) is that they create distortions that are both internal and that spill over to the rest of the economy. Too uniform prices mean that some customers do not receive the rebates that they would deserve from an efficiency perspective.

When wage premia exist, some people work in the postal sector that would be more productive in other sectors of the economy. And when an incumbent uses monopoly rents to diversify into other markets – in many countries into financial services and retailing - and the incumbent maybe even cross-subsidizes this diversification, then firms of other sectors are harmed. Resources are transferred from more efficient firms to a less efficient firm. Hence, resources that could be more productive in other markets are wasted and the economy is harmed as a whole. If this problem of allocative efficiency can be solved with liberalisation, there could be a one-off growth potential for the economy.

If the starting point is a postal sector with legal monopoly because of the market and allocative failures that might otherwise occur, it is important to identify the regulatory failures that are to be solved with liberalisation. What are the problems to solve? How are they better solved with new regulation and which new regulatory failures may occur? Problems may differ substantially between countries because of different basic conditions as well as conduct and performance of the postal operator. This incumbent may initially be inefficient,

overemployed and alternatively or simultaneously making monopoly profits.

Theoretical foundation for the issue of natural monopoly

According to Baumol (1977)⁸, a natural monopoly is defined by subadditivity of the total cost function in the relevant area of demand. Subadditivity leads to the result that a single firm can produce the demanded output at a lower cost than two or more competing suppliers. This is typically the case when very large fixed costs exist in a specific market, which leads to economies of scale and constantly decreasing average cost. Although high fixed costs are common for natural monopolies, other factors such as strong economies of scope and economies of density are important for the existence of natural monopolies as well.

8 William J. Baumol, "On the Proper Cost Tests for Natural Monopoly in a Multiproduct Industry," American Economic Review, Vol. 67, No. 5 (December 1977), pp. 809-822.

The existence of a natural monopoly is not yet sufficient to require state regulation.

According to the theory of contestable markets, potential competition is sufficient to force the natural monopolist not to set the price higher than average cost and to behave dynamically efficient (Baumol, Panzar, Willig 1982)⁹. Markets are perfectly contestable if

x the monopolist and the potential competitor have the same cost function;

x there are no significant entry barriers and exit cost;

x the time required for market entry is short;

x consumers are willing to switch to cheaper alternative suppliers.

If a natural monopolist makes economic profits in a market and this market is perfectly contestable, competitors would be able to enter profitably. Thus, a perfectly contestable natural monopolist will be under pressure by potential competitors that will force him to produce productively and dynamically efficient.

In practice, the issue of entry and exist cost is overwhelmingly important. High fixed costs and the derived decreasing average costs are not sufficient to form an entry barrier as long as the fixed investments are economically reversible. If the capital markets are working perfectly and financial institutions can correctly evaluate the future profitability of a new entrant, these investments must be sunk costs in order to form an entry barrier. However, unless the financial institutions can correctly evaluate the future profitability of a new entrant, it can be a problem for a possibly efficient operator to finance large investments¹⁰. Apart from sunk costs, extensive regulations form often entry barriers as well. The legal monopoly in the postal sector is an ultimate example of such a barrier, whereas lower barriers that hinder but not deter entry are more common.

Whenever a natural monopoly exists and this monopoly is not contestable (for example due to high sunk costs or entry-hindering regulation), a monopolistic bottleneck exists: a company with a bottleneck facility could be inclined to refuse access to the facility to other company in order to prevent competition. Network infrastructures such as electricity distribution networks are typical monopolistic bottlenecks. In the past, sectors with natural monopoly segments were often monopolized in vertically integrated, state-owned firms. However, according to regulatory theory, regulation of the monopolistic bottleneck is sufficient to reach economic efficiency.

Sunk costs in the postal market are not nearly as important as in other network sectors. In the wider postal market, there are several undoubtedly competitive segments such as express delivery and parcel services. In the letter market, a disaggregated approach is needed to analyse the existence of natural monopoly.

Evidence of natural monopoly in the postal sector

The postal sector as a natural monopoly builds on the idea that there would be a waste of resources to duplicate delivery, where the marginal cost for a postman to carry more letters approaches zero. Panzar (1991) concludes that because delivery costs typically represent more than half of total costs, postal services is a natural monopoly that ought not to be split into

9 Baumol, W.J., J.C. Panzar, and R.D. Willig. Contestable Markets and The Theory of Industrial Structure, New York: Harcourt Brace Jovanovich, Inc., 1982.

10 In this context, it is notable that the financing costs of state-owned incumbents are often lower than the competitors’ financing cost.

different companies but where contracting out of delivery is a possibility to introduce competition. In Sweden, the report from the Ministry of Communications (1991) is the only source ever to argue that postal services are a natural monopoly as a whole.

Since then, the more disaggregated approach has gained support in postal research. Postal services consist of four different production stages: collection, sorting, transportation and delivery. There are different products, i.e. first and second class as well as local, regional and national mail. Falling average costs in the relevant range of demand is a sufficient condition for natural monopoly, but each stage and product must be analysed separately and joint costs examined. Whether postal services are a natural monopoly becomes a complex question. Only if there are strong benefits from vertical integration, postal services would be a natural monopoly as a whole.

Postal production is characterised by significant economies of scale.¹¹ They exist in the sorting stage since automatic sorting was introduced in the mid-1990s. Sorting machines represent a very large fixed cost, but the marginal cost for each letter is small since the machines can sort up to nine letters per second. However, the level of the scale economies depends on demographic factors. To utilise the capacity, large volumes of mail have to be gathered to one place and if the region is large or volumes insufficient, manual sorting may be a more efficient alternative, see figure 3.1. Then, the cost function may not be subadditive:

there can exist large, capital-intensive sorting facilities as well as small manual sorting in remote places with insufficient volumes to pay for transportation to the large sorting centres.

A second important scale factor exists in delivery. In this case large fixed costs are not the source; instead, the total cost curve is degressive.¹² About half of the postman’s worktime is spent before the delivery round when mail is sorted according to order of delivery. This part’s costs are almost proportional to volume. Delivery along the street consists of two cost components: the cost to travel along the route of delivery points and the cost for each stop when mail is delivered into mailboxes. The costs for travelling around the delivery points increase disproportionally to volume up to the level when there is around a letter to every twentieth household. When smaller volumes exist, the postman works like a courier and improvises a route every day. When volumes are large enough, it is more efficient to follow a fixed route each day.¹³ As long as there is mail to an additional number of delivery points, it requires more stops. When the postman stops at every delivery point, more mail does not increase costs and marginal cost becomes zero. However, the in-house sorting by the postman increases proportionally. Thus, with more mail, each route has to be shorter. More postmen must be hired so the marginal cost for the whole delivery stage including in-house work is positive.

A third factor that contributes to economies of scale in the system is explained by the law of large numbers. There are unforeseeable fluctuations in demand, as well as a risk for disturbances in the system, which requires that some overcapacity be held. The need for such

11 Early studies of sorting costs were carried out when manual sorting was dominant. Cazals et al (1999) found significantly falling average costs for sorting in France. Economies of scale in the delivery stage are shown by e.g. Rogerson and Takis (1993), Bradley, Colvin and Smith (1993), Cazals et al (1997) and Cohen (2002).

12 A comprehensive model of delivery costs is presented in Cazals et al (1997).

13 Based on the findings in a survey of small local operators in Sweden (Andersson 2000).

excess capacity is reduced when volumes increase. On average, a large operator can utilise capacity better than a small one.¹⁴

In the interregional transportation stage, there are also economies of scale, but they are often already exhausted. The mail fills lorries, train cars and aeroplanes and with larger volumes, more capacity is needed. In collection, however, which is also a kind of transportation on a smaller scale, economies of scale exist. However, because collection represents such small part of total costs those scale economies are relatively unimportant.

Figure 3.1: Illustration of total cost curves for sorting and delivery

A+T

TC M TC

A C+D

Q Q

SORTING DELIVERY

For sorting, M is the total cost for manual sorting, proportional with volume. A is the cost for automatic sorting in machines. A+T is the cost for automatic sorting including the transportation cost for bringing the mail from the surrounding region to the sorting centre. For small volumes, manual sorting has lower costs, particularly if the transportation cost is large. Not all items can be sorted in machines, so the total cost is a mix of automatic and manual sorting. When the maximum capacity of the machines in the peak period is reached, manual sorting is also required. Thus, in some instances, the marginal cost for sorting becomes the cost for manually sorting letters.

For delivery, the C-curve is the cost for in-house work and D the cost for delivery along the route. D increases degressively and at a certain point, (C+D) becomes parallel to C, which means that the marginal cost for street delivery is zero.

In addition to economies of scale, there are also important economies of scope. They exist in the delivery stage between different classes of mail. If the postman travels the route to deliver first class mail every weekday, the additional cost for delivering second and third class mail and unaddressed items is much lower than if each category of mail was delivered separately.

The reason why in Sweden City Mail can compete with Sweden Post’s strong scope economies is that because it delivers only second class mail. The postman travels each route every third day, covers three routes and (stand alone) delivery costs are reduced to one third.

Delivery of unaddressed items is also carried out by firms who hire low cost labour and gather the items and deliver once a week. Similar economies of scope exist between local, regional and national mail. The local operators deliver only the former. Their opportunity to beat the economies of scope of Sweden Post is to have lower labour costs if they cannot offer innovative services.

14 As an example, the small local operators in Sweden often have to refuse to take large mailing from local firms or authorities because in can more than double volumes in a single day. Such unpredictable fluctuations for a company of Sweden Post’s size remain within a few per cent.

Are there monopolistic bottlenecks in the postal sector?

Recall that a natural monopoly alone may not require strong regulation if monopolistic bottlenecks do not exist. Such bottlenecks exist to a much lesser extent in postal services than in other network industries like telecommunications or electricity. Postal services have no infrastructure of its own, like cables or wires. Sorting facilities have such features, but they not are part of the infrastructure, instead they must be regarded as production plants (like switching centres or power plants). It may, as in the telecommunications sector, require access regulation to break the monopoly in the sorting stage. Sorting machines may be large sunk costs as the alternative use is very limited. Other sunk costs in the sector are small. For a new, local operator, sunk costs consist in the building up of knowledge: planning a route network, learning of addresses, getting access to door codes and address files etc. The survey of local operators in Sweden shows that these costs exist, but they are small and entry on a small scale is fairly easy.

There is little evidence in the world concerning entry on a large scale. Several factors may be decisive. One crucial factor is the capital market and whether any financial institutions would be willing to lend money to a new postal operator that would challenge a state incumbent monopolist on a nationwide scale. Moreover, it depends on the willingness of large customers

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