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27 October 1995
Competition and Communications:
Some notes on reform options for Australia Post
Department of Economics
James Cook University
Competition and Communications:
Some notes on reform options for Australia Post
The determination of pricing and competition policy for communications services, and for postal services in particular, raises a number of complex issues that can be resolved only be careful empirical study of the industry. The application of a naive competive framework, in which a priori dogmatism takes the place of careful factual enquiry has already caused considerable damage in telecommunications policy and is likely to cause far more in the next few years. It is important that these errors should be avoided in formulating policy for postal services.
The object of these notes is to set out some of the issues that must be resolved before an adequate postal services policy can be formulated, issues of economies of scale and scope and of the potential for cross-subsidisation and 'cream-skimming'. I have not undertaken empirical research in this area, and do not claim to be able to resolve these issues. However, we already have considerable experience of the dangers of adopting competitive models on the basis of little more than wishful thinking concerning their performance.
The naive competitive framework
Recent communications and infrastructure policy has been dominated by what may be called the naive competitive framework. In this framework, it is taken as given that two firms are better than one, and that three firms are better than two. No account is taken of the possibility that a given service may be more effectively provided by a single firm. Among the consequences we have already seen are:
(i) The failure of the digital mobile phone system (GSM) to make significant inroads into the market dominance of analog systems, largely because of the existence of competing networks; and
(ii) The likely provision of duplicate cable television and telephony systems involving an excess cost to telecommunications consumers of billions of dollars, as well as implicit subsidies arising from the granting to cable suppliers of rebroadcast rights for free-to-air television
A mroe surprising result has been the likely provision of duplicate rugby league competitions. In place of a competition pitting the best sides against each other, we will have (assuming Super League is successful in court) two competitions each pitting some of the best sides against much weaker sides. The failure to resolve the deadlock over rugby league may be traced directly to the demands of the competing cable networks.
I will turn in a moment to economic analysis of the issues regarding competition in communications. But the example of rugby league is a telling one. In the naive understanding of competition that seems to drive public policy in Australia, it is simply assumed that two firms (in this case, two football leagues) must be better than one. But it is obvious to any follower of sport that this is not the case. There is room for debate over whether it would be better to retain a 20-team competition or to merge clubs in order to produce 10 top-class teams (the original Super League proposal), but two 10-team competitions represents the worst of both worlds.
Local natural monopolies in communications
A local monopoly arises when a service is most efficiently provided to a given area by a single enterprise. Almost all home-delivered services from telephones to newspaper delivery fall into this category. In some circumstances local monopolies may be subject to challenge. First, an entrant may provide duplicate services in the hope of ultimately gaining monopoly control. This is currently happening with newspaper delivery in Canberra and with the provision of cable TV and telephony. Although this kind of competition may yield short-run benefits to consumers, these will normally be recouped in the long run by the successful contestant. The resources dissipated in needless duplication will be lost forever.
In the case of newspaper delivery, the issue is not one of great moment. However, the misallocation of resources associated with open competition in the provision of cable services is of much more concern. We are likely to see a pattern where some areas are served by duplicate services and others not at all. In addition, the service capabilities provided will be determined primarily by considerations of short-term competitive advantage rather than of long-term social benefit. In particular, a rush to provide a pay-TV service as rapidly as possible is unlikely to be the best way of preparing for a future in which all Australians have access to the Internet.
Another type of competition arises when technologies without local monopoly characteristics compete with local monopolies, or when technological or social change creates convergence between previously unrelated services. The competition between broadcast TV and cable TV and between cable TV and local telephony are examples. For postal services, the most currently important example of convergence is the development of fax machines. For a relatively modest initial cost, the fax machine provides a high-speed substitute for physical delivery of documents. In the medium term, it is likely that fax machines will be supplanted by electronic mail services, which are cheaper and more versatile, but require a more complex initial setup.
It seems reasonable to conclude that the basic postal delivery service currently provided to most Australians is a local natural monopoly. This does not necessarily imply that the same organisation should provide the service in all areas, or that mail delivery should be integrated with mail collection and sorting. Indeed, Australia Post already contracts out mail delivery in many rural areas. Nevertheless, it does suggest that there are limits to the desirable scope of competition.
Network connections and economies of scope
Suppose we consider the outcome of a conscious policy aimed at maximising the number of firms in the postal services sector, subject to the requirement that only one firm offer mail delivery services in a given residential area. This might be achieved through a situation where one or more firms collected and sorted mail with addressed to households, and assigned the mail for a given district to the local delivery firm. At the same time we might suppose that business mail services would be subject to open competition.
Several questions arise here:
(i) Are there 'economies of scope' that would make it advantageous to integrate several of these activities within a single enterprise ?
(ii) What is the minimum efficient scale for these enterprises ? For example, in local mail delivery, it might be possible for individuals to contract to service a single route, or for a single firm to offer service to a few suburbs (the typical situation with milk and newspapers). It might however, be more efficient for all deliveries in a given city or in the entire country to be handled by a single enterprise
(iii) Where an item is handled by two or more enterprises, what are the appropriate pricing rules ?
(iv) Would the outcome of open competition approximate the socially desirable outcome ?
These are empirical questions that cannot be answered on a basis of a priori dogmatism. Unfortunately such dogmatism plays a dominant role in Australian policy formulation today.
Sustainability of natural monopoly
Economists formally define a natural monopoly as a situation where a given service, or set of services, is delivered at least cost by a single enterprise. It is often argued that the existence or otherwise of natural monopolies is not a matter of great moment, since if an enterprise is a natural monopoly, it will be able to resist any attempts at competitive entry.
This claim is unfounded. In fact, it is easy to give examples of unsustainable natural monopoly, that is of situations where a natural monopoly is unable to charge prices which enable it to cover costs and deter competitive entry. The fundamental problem is that, for any set of prices the natural monopoly charges, it may be possible for entrants to engage in 'cream-skimming'. That is, the entrants may serve the most profitable markets, leaving the natural monopolist with the remainder, which do not generate sufficient profits to cover overheads and fixed costs.
Not every alleged case of cream-skimming involves unsustainable natural monopoly. In many cases, the potential for cream-skimming arises because of cross-subsidy policies that are unrelated to considerations of natural monopoly. It is likely that at least some of the potential for competitive entry into postal markets arises from the current policy of a uniform letter price. However, even if this policy were abandoned and Australia Post were allowed unrestricted freedom in pricing there is no guarantee that cream-skimming would not take place.
The current system of postal service pricing appears to involve a large element of cross-subsidy. The charge for taking a standard letter from say, Charters Towers to Carnarvon is the same as for taking it from a mailbox in the Sydney CBD to a GPO post office box a couple of streets away. The precise extent of the cross-subsidy is rather harder to determine, and involves complex conceptual issues. There are several competing definitions of cross-subsidy, depending on whether we look at the source or the beneficiary of the subsidy. We might begin by saying that a service is subsidised if it is provided at less than marginal (i.e. avoidable) cost. On the other hand, we might say that a service provides a cross-subsidy to other services in the same network if the charge for that service exceeds the standalone cost of providing the service. Under conditions of constant returns to scale, the two definitions coincide, but otherwise they will not.
If we strictly apply the first definition to individual services, the extent of cross-subsidy is probably quite limited. Even in the extreme case of service from Charters Towers to Carnarvon, it is unlikely that the marginal cost of carrying one additional letter is much greater than 45c (pricing below marginal cost might apply in the case of services to individual rural properties). Thus, the avoidable cost definition must be applied to the mail service as a whole rather than to individual items of mail.
From the viewpoint of the current debate, however, it is the second definition that is most relevant. If, as seems entirely probably, the revenue from urban postal services exceeds the standalone cost of providing those services, then the existing system of uniform pricing could not survive under open competition. Under a system of open competitive entry prices in excess of standalone cost are not sustainable.
From a policy perspective, we need to consider two separate questions about subsidised provision of a network good. First, is the subsidy desirable? Second, if it is desirable, who should pay for it ? Regarding the first question, it is necessary to specify the alternative. In the case of postal services we could imagine three methods of reducing the subsidy to country mail services. First, charges could be increased. Second, quality of service could be reduced. Finally, service to and from some points could be abandoned altogether.
On the whole, it seems unlikely that there would be great benefits from increasing charges. As already argued, existing prices are probably above short-run marginal cost in most cases. The most effective method of reducing the subsidy would be to reduce the frequency of service to and from rural areas and to abandon service to outlying areas altogether.
In considering these alternatives, it seems reasonable to conclude that a standard economic analysis would support abandonment of the cross-subsidy. That is, it appears unlikely that there exist external benefits of postal services of the type usually considered by economists, sufficient to offset the difference between the cost of providing the current service and the amount the customers would be willing to pay for this service relative to a lower quality alternative.
The case for preservation of the cross-subsidy must be based on social considerations. In most countries, and particularly in 'frontier' societies such as that of Australia, the provision of postal services at a uniform, fairly low price has been seen as an expression of national solidarity. It is worth observing that the cost of the cross-subsidy in Australia today is almost certainly smaller, in relation to GDP, than in the past. It might therefore be argued that if we could afford a proportionately larger subsidy in the past, we can afford to maintain it. Against this, it may be argued that the reduction in the cost of long-distance telephone services, and particularly the widespread availability of fax machines has reduced the social importance of postal services and therefore the the social significance of uniform pricing. My personal view is that this latter argument is somewhat premature, and that it would be more convincing if the issue of access to broadband telecommunications had been resolved in a more satisfactory fashion. In particular, it seems likely that the current policy approach in telecommunications will result in most urban areas being provided with duplicate services before rural areas receive any service. The resulting waste will involve the loss to society of an amount sufficient to fund the current postal cross-subsidy for at least 50 years.
If uniform pricing is to be maintained, the question arises of who should pay. I have previously analysed this question in relation to telecommunications. The basic answer is that the ideal policy is a mixture of cross-subsidy and explicit payments from taxpayers, designed to equate the marginal welfare cost of pricing urban postal services above their social cost with the administrative and incentive costs associated with raising additional revenue.
However such a policy is only feasible if competitive entry is prevented or at least constrained. Under a policy of open competitive entry, the only option for preserving uniform payment is a taxpayer subsidy. Considerable difficulties will arise in determining the amount required. Furthermore, given that the political pressure to cut measured government expenditure is much greater than the pressure to maximise the returns of government business enterprises (even though, from a public finance viewpoint the two are identical) it is reasonable to predict that budgetary support for the maintenance of uniform pricing would not be long-lived.
The formulation of policy regarding postal services raises two key questions. The first is that of the industry structure that will minimise the social cost of providing postal services. The second is that of the continued desirability and feasibility of the uniform letter rate. Both of these questions require detailed empirical analysis. In addition, questions regarding changes to the uniform letter rate must be the subject of social debate.
Advocates of a naive competitive framework frequently claim to have a priori valid answers to these questions. These answers have been shown to be doubtful at best in the case of telecommunications. They should not be accepted unquestioningly in the case of postal services.
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