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adjustments in cost attribution, particularly in Dockets R90-1
and R80-1.°

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A second example is that of Express Mail, also discussed in
chapter II of the draft. The markup history of this class
reflects the growing competitive challenge to which GAO refers:

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Here too, the Postal Service has presented probative evidence of
the nature and prospects of private-sector competition. As a
result, the Commission has reduced Express Mail's markup from the
highest in the system (as late as Docket R84-1) to a level well
below third-class bulk regular rate (27.8 percent versus 46.2
percent) and close to the markup of second class (at 23.8
percent), which benefits from special consideration under
S 3622 (b) (8).

Nearly exclusive concentration on markups has led GAO to ignore
another extremely important way in which firms (including the
Postal Service) respond to competition: improved product -- and
hence price - definition. Given the long history of Commission
decisions promoting such improved product definition, this is a
serious omission in any critique of the Commission's work.

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Lower markups have not always produced lower rates, since
Commission cost attributions have differed from those the Service
proposed.

Put briefly, the issue arises when two related but distinguishable Postal Service products are lumped together for pricing purposes. If these products, for example, have different cost characteristics, it is possible for a competitor to sell only the lower-cost one, at a price reflecting only those lower costs (and thus lower than the Postal Service's price which reflects an average of low and high costs). A common-sense remedy is to differentiate (separately cost and price) the two products, so that the "cream-skimming" entrant loses the cost advantage created by the incumbent's cost averaging in other words, the incumbent seeks to exploit the low cost of the second product, rather than letting the entrant do so." Of course, this approach may imply price increases for consumers of the highercost product. But the entrant would face the same necessity if it chose to offer that product as well.

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The draft report virtually ignores this method of facing competition, even though in the most recent rate case the Commission provided practical illustrations.

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The draft discusses (pages 48 et seq.) the potential for alternate delivery of third- and second-class mail matter. addition, at pages 39-40 it observes that more profitable or lower-cost business is a target for competitive entrants." GAO's examples of private delivery for magazines (pages 48-49) indicate that such competition is likely to arise in metropolitan markets where density is relatively high. Saturation advertising matter, of course, would exhibit even higher densities. All this implies that if high-delivery-density products are differentiated and priced on the basis of their own (lesser) costs, potential competition may be more effectively met than it would be by a broad-brush price-cutting initiative.

In Docket R90-1 the Commission endorsed the Postal Service's proposal to establish separate discount rate categories for walksequenced saturation third-class bulk mail. As suggested

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• GAO considers the "cream-skimming" issue in the draft, when it suggests (pages 39-40) that under some circumstances the Service could be left with only the higher-cost part of the traffic.

10 This observation is made in the Express Mail-parcel post context, but seems to be generally applicable.

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In fact, the Commission pressed the refinement of thirdclass bulk product definition farther than the Service had proposed, by recommending, on the basis of cost differences shown in the record, a discount for walk-sequenced mail at the 125piece-per-carrier-route level. The Governors rejected this

As

above, this mail is most attractive to alternative carriers. a result of the reclassification, its R90-1 rate increase was as low as 4 percent for mail entered at the destination facility, rather than the 25 percent average for the bulk regular subclass. This change, it should be noted, was independent of, though perfectly consistent with, the Commission's pricing decision respecting third-class regular mail as a whole.

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GAO's treatment of the issue -- again, with particular reference to third class essentially ignores this aspect of response to competition and concentrates on the markup decision applying equally to all existing or potential subcategories within the class. Attempting to meet competition by lowering the classwide markup, however, is likely to be an effective strategy only if competition is present throughout the class. This is by no means necessarily the case in either third or second class. Indeed, GAO's recommended general approach -- an increase in emphasis on demand as a determinant of rates -- would itself imply a need for more accurately focused demand information so that the demand characteristics of one identifiable subcategory of mail are not misapplied to other, perhaps very different, categories." By concentrating on the question of markup, the report seems not to call due attention to the fact that responding to competition may require differentiating competitive from noncompetitive subcategories, and at least considering increased prices of the latter to finance competitive price response on behalf of the former.

The draft quite correctly recognizes the importance to the Postal Service of avoiding both perceptions of product inferiority and operating costs that are higher than necessary. It might with

recommendation (an action currently pending on appeal) but later authorized the Service to request a similar classification change limited to flat-shaped pieces. This case (Docket MC91-2) was settled favorably to the proposal, which has just (January 7, 1992) been ordered into effect by the Board of Governors.

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Appendix II identifies numerous weaknesses in the currently available measures of price elasticity for postal products. This Appendix notes that price is not the principal cause of recent trends in demand for First- and third-class mail (page 121), and requires the conclusion that existing elasticity measures, while perhaps adequate for their limited use in the Postal Service's volume projection model, and to provide an indication of the relative ranking of mail classes in terms of value of the service to mailers, are subject to significant bias and are not sufficiently reliable for use in a demand pricing model.

advantage lay somewhat more emphasis on the interdependence of pricing policy with these other factors. Changing the relative burden of institutional costs as between competitive and noncompetitive categories will not secure a competitive position that is undermined by unduly high attributable costs;

competitors, insofar as willing to accept reduced profit margins, will still be able to offer lower prices. It should be remembered, in this connection, that the theory underpinning demand pricing assumes normal technical efficiency on the part of the firm whose prices are in question. Since it appears inevitable that more emphasis on relative demand would require less emphasis on other statutory pricing policies, with a corresponding decline in the system's ability to carry out all of Congress's directives, it becomes a question of considerable importance whether such demand-oriented pricing would in fact produce the benefits GAO expects from it. The draft could usefully make more explicit than it now does the dependence of such a policy on competitively adequate control of costs and maintenance of service quality.

We appreciate the opportunity to comment on this draft. can be of further assistance, please call on us.

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Mr. MCCLOSKEY. I would just like to ask Mr. LeBlanc a question. I appreciate all his vanguard work on the contingency account problems and aspects. In all candor, I don't think I have ever had a reply from the Postal Service as to my concerns, which are substantially identical to yours, Trey, as to disbursements and accounting on this so-called contingency fund.

Do you have any comments on that? Are we making any progress, or are we just up against Mount Olympus on that?

Mr. LEBLANC. Mr. Chairman, I think I look at it two ways. Without the task force study and work that they have done, then I would probably still have the concerns that I have. There has been, and as far as I know, no accountability on the contingency fund. As I have stated before, there is a lot of money out there, and from an accountability standpoint it only seems fair to the ratepayers and the American public that it gets done.

On the other hand, the task force has come out with an effect that will help the accountability of the contingency fund as well as the prior year losses, and without having a whole lot of time to dig into it and to reflect on it right now, I feel it is a start, if nothing else.

Mr. MCCLOSKEY. So you feel like we are making a start on that? Mr. LEBLANC. Yes sir, I do. Given the task force wording on it, if it can be accepted under those circumstances, it might be a step in the right direction.

Mr. MCCLOSKEY. Mr. Chairman, just one other question. This might border on overkill and it is not meant at all as negative. In fact, it is some degree to my political peril to mention this.

But Ralph Nader was recently in my district. I guess he swooped in unannounced one night and basically said that I was a tool of business interests and that the junk mail was being subsidized by first-class mail and Aunt Minnie. He said all of this was horrible. I am slightly exaggerating, but not by much. It is that ongoing idea, that third-class mail is being subsidized by first-class mail and people asking well, why do you allow this to happen?

But I do think the implications of that GAO report, are very profound. In the recent ratemaking controversy, as you said today, you stuck on the 29 cent stamp, Tony Frank wanted the 30 cent, and by sticking on the 29, third-class mail was paying higher rates.

As I understand it from what I have read recently, the volume of third-class mail is going down. That is a major part of the financial base of the Post Office. I want to hear more from Mr. Coughlin on this, but don't you think we have a responsibility perhaps to be more forthright about the future financial implications of the entire economic base of the Post Office? In effect what you did, which is politically popular-it helps me get reelected-but I don't know that is the right thing to do since third-class mail has taken several major hits from the few rate cases.

Again, this doesn't resolve the complexities of the case, but I am just telling you where I am coming from. I think we could lose the Post Office as we know it over the next 10 years on these unresolved trends.

Mr. HALEY. Mr. Chairman, every one of our classes pay the costs they cause, pretty much. Let me say that no one is being subsi

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