U.S. Postal Service: Postal Ratemaking in Need of Change (Letter Report,
11/15/95, GAO/GGD-96-8).

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.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  GGD-96-8
     TITLE:  U.S. Postal Service: Postal Ratemaking in Need of Change
      DATE:  11/15/95
   SUBJECT:  Postal law
             Postal rates
             Postal service
             Competition
             Cost control
             Labor costs
             Operations analysis
             Government sponsored enterprises
             Labor-management relations

             
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Cover
================================================================ COVER


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

Postal Ratemaking

(240179)


Abbreviations
=============================================================== ABBREV


Letter
=============================================================== LETTER


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. 


--------------------
\1 U.S.  Postal Service:  Pricing Postal Services in a Competitive
Environment (GAO/GGD-92-49, Mar.  25, 1992). 


   BACKGROUND
------------------------------------------------------------ Letter :1

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\2 --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. 


--------------------
\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. 


   RESULTS IN BRIEF
------------------------------------------------------------ Letter :2

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 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 products\3 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 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. 


--------------------
\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. 

\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). 


   SCOPE AND METHODOLOGY
------------------------------------------------------------ Letter :3

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. 


   OUR 1992 ANALYSIS
------------------------------------------------------------ Letter :4

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
---------------------------------------------------------- Letter :4.1

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 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. 


--------------------
\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. 

\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). 

\10 The 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). 


      DEMAND PRICING
---------------------------------------------------------- Letter :4.2

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\11 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.\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 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.\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
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. 


--------------------
\11 Elasticity of demand measures the sensitivity of customer demand
to historic changes in prices.  Elasticities are estimated using
econometric models. 

\12 A 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. 

\13 While 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. 

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


   THE CURRENT POSTAL RATEMAKING
   PROCESS
------------------------------------------------------------ Letter :5

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 report\15 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. 


--------------------
\15 Toward 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. 


   PROPOSALS FOR MODIFYING THE
   POSTAL RATEMAKING PROCESS
------------------------------------------------------------ Letter :6

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


--------------------
\16 In 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). 

\17 A 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.)


      INSTITUTE OF PUBLIC
      ADMINISTRATION
---------------------------------------------------------- Letter :6.1

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\18 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.\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. 


--------------------
\18 The Institute of Public Administration is a private, nonprofit
organization whose staff members include specialists in public and
business administration, finance, political science, and economics. 

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


      JOINT TASK FORCE ON POSTAL
      RATEMAKING
---------------------------------------------------------- Letter :6.2

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
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. 


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


   CONCLUSIONS
------------------------------------------------------------ Letter :7

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
------------------------------------------------------------ Letter :8

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. 

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. 


--------------------
\21 The 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. 


      THE COMMISSION'S SUMMARY OF
      OUR WORK
---------------------------------------------------------- Letter :8.1

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. 


--------------------
\22 See appendix III for the Commission's comments. 

\23 The 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. 


      THE COMMISSION'S CONCERN
      ABOUT A "MAJOR ERROR"
---------------------------------------------------------- Letter :8.2

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. 


      IMPACT OF RAMSEY PRICING ON
      COMPETITIVENESS
---------------------------------------------------------- Letter :8.3

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. 


      CONDITIONS NECESSARY FOR
      RAMSEY PRICING TO ACHIEVE
      EFFICIENT CONSUMPTION
      PATTERNS
---------------------------------------------------------- Letter :8.4

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.\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 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. 


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


      IMPACT OF RAMSEY PRICING ON
      CONSUMPTION PATTERNS
---------------------------------------------------------- Letter :8.5

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
---------------------------------------------------------- Letter :8.6

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. 


---------------------------------------------------------- Letter :8.7

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. 

Sincerely yours,

J.  William Gadsby
Director, Government Business
 Operations Issues


RATE CRITERIA
=========================================================== Appendix I

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. 




(See figure in printed edition.)Appendix II
COMMENTS FROM THE U.S.  POSTAL
SERVICE
=========================================================== Appendix I



(See figure in printed edition.)




(See figure in printed edition.)Appendix III
COMMENTS FROM THE POSTAL RATE
COMMISSION
=========================================================== Appendix I



(See figure in printed edition.)



(See figure in printed edition.)



(See figure in printed edition.)



(See figure in printed edition.)



(See figure in printed edition.)


MAJOR CONTRIBUTORS TO THIS REPORT
========================================================== Appendix IV

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


*** End of document. ***