Competition in postal services

This entry was added to http://www.reckon.co.uk/headlines-franckblog on 4 January 2005.
Full blog table of contents available at Contents | viewpoint: Franck.

Postcomm, the regulator of postal services in the UK, has proposed "a faster route to ending Royal Mail's monopoly", with "full market opening" on 1 January 2006.

At the same time, the regulator proposes to "set a framework for Royal Mail's price and service quality control from April 2006", which rewards growth, operating efficiency and quality of service.

Is it sensible to try to have both competition and price controls ("incentive regulation") over the same services at the same time?

The case for a hybrid approach

The basic case for Postcomm's proposed hybrid approach is simple enough, and rests on two premises:

Competition is good because it places pressures on firms (and more importantly on their managers) to strive to deliver services that customers (who have freedom of choice) want, and to innovate in doing so. Postcomm is proposing an accelerated removal of Royal Mail's monopoly in order to gain these benefits in the letter mail service.

Even with these pro-competitive policies, international experience can be taken to indicate that competition is unlikely to be an effective constraint on Royal Mail's ordinary letters service. Because Postcomm has a duty to ensure that consumers receive an adequate service at an "affordable" price and is committed to geographically uniform pricing for 1st and 2nd class stamped post, regulation of consumer prices is therefore considered necessary.

This article questions whether the hybrid approach mapped out by Postcomm is a good way of gaining the benefits of competition without jeopardising the interests of consumers.

The case against a hybrid approach: economics

There are some theoretical reasons to doubt the wisdom of the case summarised above for a hybrid approach involving both ongoing incentive regulation and the promotion of competition within the same relevant markets for postal services.

A hybrid approach requires the regulator to set prices at different levels of the supply chain: "access" prices which competitors pay to use elements of the incumbent's network which they cannot economically replicate (and for which they therefore face a monopoly), and "retail" prices which the incumbent (presumed dominant in some retail markets) is allowed to charge to end customers. As a result, it could blur the special responsibility of the incumbent not to (ab)use its dominant position by impeding competition, by effectively sharing that duty between the regulator and the dominant firm.

If both the "retail" and "wholesale" price controls are binding on the incumbent (and why have them if there is no expectation that they will be binding?) then the regulator will find itself applying one version or another of the efficient component pricing rule (ECPR) or price squeeze test. As I argued earlier (see Access pricing in water | viewpoint: Franck), there are significant problems with using the ECPR on an ex-ante basis as a rule for setting network access charges. In particular, there are tensions between transparency and accuracy objectives. More importantly perhaps, the rule is based on the static idea of allowing the most efficient operator to provide each element of the service, and as a result does not recognise the innovation and efficiency improvement benefits that arise from competitive pressures, and may act as a barrier to gaining these benefits. At a more practical level, it may also encourage some forms of anti-competitive conduct by incumbents and by potential new entrants.

Another (related) set of issues with the dual regulation of "retail" and "wholesale" prices is that it may fail to exploit the incentive that an unregulated network monopoly would naturally have to promote and exploit downstream competition. In the absence of regulation on retail prices, a network monopolist may well make the commercial choice of encouraging competition in downstream activities, on the basis that this is likely to be the best way of encouraging efficiency in these activities (by placing pressure on both its own downstream management and that of competitors), and that its pricing freedom with respect to wholesale prices would enable it to capture a share of the financial benefits of such efficiency improvements. But if prices are regulated at all levels of the supply chain, then the profits from such a strategy are limited (if they exist at all) and the likelihood must be that the managerial tendency to build and maintain as large an "empire" as possible would act as a serious barrier to competition, with nothing other than regulatory action to counter-balance it.

Underpinning all the points made above is a judgement about the relative merits of regulation (bureaucracy) and market processes to allocate resources in the economy. Insofar as one adopts the view that decentralised competitive markets are likely to provide better mechanisms to transmit information between market participants and reach efficient decisions than a centrally-planned arrangement, then there are advantages in promoting such processes, even at the apparent expense of a short-term static concept of efficiency based on the identification of a "lowest-cost" supplier for each component of the service today.

The case against a hybrid approach: experience

I am not sufficiently familiar with the situation in the postal sector in Sweden or New Zealand to comment on whether the experience of liberalisation in these countries supports the economic case against a hybrid "competition and regulation" approach to postal sector reform. But I have seen little to suggest that these examples are seen as clear successes.

Besides international comparisons, there is also relevant experience from other sectors which share some of the economic features of postal services, and lessons might be drawn (with caution, as indeed should be the case for any lessons derived from international comparisons).

UK approaches to regulatory reform in "network" industries might be characterised as follows:

The telecoms approach: strong ongoing regulatory pressure and price controls on the monopolies, without intrusive regulation of business structure or ownership.
The original water approach: no sector-specific rules, "reliance on competition law" and access codes produced by each network operator (now being replaced by a new licensing and access regime under the Water Act 2003).
The media approach: ex ante enforcement of competition law obligations, without any prescriptive pricing rules or structural requirements.
The energy approach: structural reform (along the lines of the electricity and gas sectors in Great Britain), based on a policy decision that some activities are monopolies and others are competitive; and a robust process of structural separation between monopoly and competitive businesses.

All these models have their successes and problems, and rely on specific features of their industries. I would argue that:

The telecoms approach is vulnerable to the criticism that it has led to slow and patchy development of competition coupled with a high level of regulatory intrusiveness and costs.
The original water approach might be said to have generated litigation at least as much as competition (see water access CAT cases).
The media approach relies on a very high level of product differentiation and innovation, which permits effective competition even in the presence of strong operators such as BSkyB and the BBC. In particular, the drive to spread digital TV may well have provided a much stronger incentive for Sky to promote competition and efficiency in the supply chain for its satellite service than would be available in the case of Royal Mail.
The energy approach is costly in terms of compliance. Also of concern in the case of post is that it requires an ex ante identification of the underlying monopolies by the regulator, i.e. a regulatory "resolution" of debates such as whether there are increasing returns to scale in delivery and/or in sorting. It would be costly to get it wrong, and it seems somehow inappropriate to leave such a decision to a regulator (rather than a market process) when the facts are so far from clear.

So it's horses for courses (of course), and the question must be which of these arrangements (or hybrid thereof) seems most suitable to the particular circumstances of postal services in the UK. Here are my guesses of how the different approaches would fare for UK post:

Telecoms approach, original water approach: both seem doable but not particularly attractive?
Media approach: would not work due to lack of product differentiation?
Energy approach: would give too much power over industry structure to a central planning/regulatory process, with a high cost of error?

No obvious winner there I'm afraid!

Competition in postal services

The case for a hybrid approach

The case against a hybrid approach: economics

The case against a hybrid approach: experience

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