FTC Staff Comment Before the Postal Rate Commission Concerning Monopoly Theory Inquiry

V890075 COMMISSION AUTHORIZED
BEFORE THE
UNITED STATES OF AMERICA POSTAL RATE 	COMMISSION
WASHINGTON, 	D.C. 	20268-001
Monopoly Theory 	Inquiry, 	1989
COMMENTS OF
Docket 	No. 	RM89-4
THE 	STAFF OF 	THE BUREAU OF 	ECONOMICS OF THE
FEDERAL TRADE COMMISSION*
(submitted September 	1, 	1989)
* These 	comments 	represent 	the 	views 	of 	the 	staff 	of 	the
Bureau 	of 	Economics 	of 	the 	Federal 	Trade 	Commission. 	They 	are
not 	necessarily 	the 	views 	of 	the 	Commission or 	any 	individual
Commissioner. 	Questions 	about 	these 	comments 	may be 	addressed 	to
John C. 	Hilke 	((202) 	326-3483), 	or Michael 	Vita 	((202) 	326-3493),
Federal 	Trade Commission, 	Bureau 	of 	Economics, 	6th 	Street 	and
Pennsylvania Avenue, 	N.W., 	Washington, 	D.C. 	20580,

BEFORE THE
UNITED STATES OF AMERICA POSTAL RATE COMMISSION
WASHINGTON, D.C. 20268-001
Monopoly Theory Inquiry, 1989 	Docket No. RM89-3
COMMENTS OF
THE STAFF OF THE BUREAU OF ECONOMICS OF THE
FEDERAL TRADE COMMISSIONl
(submitted September 1, 1989)
I. 	INTRODUCTION
The staff of the Bureau of Economics of the Federal Trade Commission
("the 	FTC") 	appreciate 	the 	opportunity 	to 	submit 	these 	comments 	to 	the
Postal Rate Commission ("PRC") concerning advances in the economic theory
of 	regulated 	monopolies 	since 	the 	Reorganization 	of 	the 	postal 	service 	in
1971. 2 	These comments address only 	efficiency issues, 	and do not discuss
other policy considerations raised by the invitation to comment.
Two theoretical developments are particularly relevant to the policy of
maintaining the government monopoly on letter mail.s 	First, although there
continues to be a potentially valid economic efficiency rationale for allowing
certain 	postal 	services 	to 	be 	produced 	only 	by 	a 	protected 	government
monopoly, the technological 	relationships supporting such a 	policy are now
understood to be considerably more limited than they were believed to be at
the time of the Reorganization.
Second, the efficiency justification for the government postal monopoly
has 	been 	based 	not 	only 	on 	the 	belief 	that 	technological 	considerations
1 These comments 	tepresent 	the 	views of 	the staff of 	the 	Bureau of
Economics of the Federal Trade Commission. 	They are not necessarily the
views of the Commission or any individual Commissioner. 	Questions about
these 	comments 	may 	be 	addressed 	to 	either 	John 	C. 	Hilke 	or 	Michael 	G.
Vita, 	Federal 	Trade 	Commission, 	Bureau 	of 	Economics, 	6th 	Street 	and
Pennsylvania Avenues N.W., Washington, D.C. 20580. 	Telephone: (202) 	326-
3483, and (202) 326-3493.
2 The invitation to comment appeared in the Federal Register (Vol. 54,
No. 	89) 	on 	May 	10, 	1989, 	pp. 	20220-20221. 	The 	Third 	Class 	Mail
Association's complaint, and comments from other parties on this complaint,
including comments of the FTC's Bureau of Economics staff, were received
under the PRC's Docket No. C89-1.
The Post Office Department, a cabinet-level executive 	branch agency,
was 	reorganized 	into 	the 	United 	States 	Postal 	Service, 	a 	government
en terprise, on J ul y 1, 197 I.
S Although 	there 	may 	be 	equity 	rationales 	for 	providing 	government
enterprises 	with 	statutory 	protection 	from 	entry, 	our 	discussion 	focuses
chiefly upon efficiency rationales. 	Equity considerations are briefly touched
upon in § V.

justify the continued existence of a protected monopoly, but also upon the
view 	that 	managers 	of 	government 	monopolies 	will 	vigorously 	attempt 	to
minimize costs. 	Developments in the theory of "principal-agent" relationships
and in the theory of "public choice" suggest that this latter assumption may
be incorrect.
There 	may 	be other 	rationales, 	unrelated 	to 	economic 	efficiency, for
perpetuating the postal monopoly, such as the belief that competition would
impair the government's ability to subsidize certain groups of postal service
consumers 	at 	the 	expense of others. 	Economic 	theory 	suggests 	that 	there
may 	be 	alternative, 	lower 	cost 	methods 	of 	achieving 	these 	distributional
goals.
II. 	EXPERTISE OF THE STAFF OF THE FEDERAL TRADE COMMISSION
The 	FTC 	is 	an 	independent 	regulatory 	agency 	responsible 	for
maintaining competition and safeguarding the interests of consumers.· 	The
staff 	of 	the 	FTC, 	upon 	request 	by 	federal, 	state, 	and 	local 	government
bodies, 	often 	analyze 	regulatory 	or 	legislative 	proposals 	that 	may 	affect
competition or the efficiency of the economy. 	In the course of this work,
as well as in antitrust and consumer protection research and litigation, the
staff 	apply 	established 	principles 	and 	recent 	developments 	in 	economic
theory 	to 	competition and 	consumer 	protection 	issues, 	including 	efficiency
rationales for rate and entry regulation.
The FTC staff have commented previously on various issues before the
PRC, including: (1) use of a single set of rate hearings to establish a series
of 	United 	States 	Postal 	Service ("USPS") 	rate 	changes;5 	(2) 	elaboration 	of
competition 	issues 	inherent 	in 	proposed 	rate 	and 	classification 	changes
related to electronic computer originated mail ("ECOM");6 (3) drawbacks to a
proposed 	modification 	of 	the 	test 	period 	for 	cost 	recovery 	in 	ECOM;7 (4)
advantages of setting ECOM rates to cover full costs;8 (5) costs and benefits
of 	current 	preferred 	mail 	rates;9 	(6) 	expedited 	procedures 	in 	reviewing
proposed rate changes for Express Mail;lO. (7) a complaint urging a study of
the 	potential 	public benefits of exempting addressed third class mail 	from
.( 15 U.S.C. Section 41 et seq.
5 PRC Docket No. MR82-3, filed November 4, 1982.
6 PRC Docket No. R83-1, filed June I, 1983.
7 PRC Docket No. R83-1, filed June 16, 1983.
8 PRC Docket No. ~84-1, filed December 23, 1983.
9 PRC Docket No. SS86-1, filed April 20, 1986.
10 PRC Docket No. RM88-2, filed October 14, 1988.
2

the 	private 	express statutes;l1 	and 	most 	recently, (8) 	proposals 	to 	improve
documentation of statistical analyses presented to the PRC.12
III. NARROWING THE EFFICIENCY RATIONALE FOR THE GOVERNMENT'S
POSTAL MONOPOLY
If 	the 	costs 	of 	providing 	postal 	services 	are 	minimized 	when 	these
services are 	provided by a single firm, 	then it could be efficient to allow
the 	continuation 	of 	a 	postal 	monopoly. 	However, 	even 	if 	costs 	are
minimized 	by 	the existence of a 	monopoly, 	it does 	not 	necessarily 	follow
that 	the 	monopolist should enjoy statutory protection 	from entry. 	In 	this
section we briefly review the cost conditions under which production by a
single 	firm 	will 	minimize total 	production costs, and 	the 	conditions under
which it would be efficient to protect the monopolist from entry.
A. 	Entry 	Prohibitions 	When 	the 	Firm 	Produces 	Only 	One 	Type 	of
Output
Since the Reorganization, advances in economic theory have narrowed
the 	range of cost conditions that can justify protecting a 	monopolist from
entry. 	Prior to the Reorganization, economic theory focused 	principally on
understanding 	production 	relationships 	within 	a 	firm 	assumed 	to 	produce
only one product. 	Up through the mid-1970s, it was commonly believed that
a protected monopoly could be justified if production of such a product was
subject to "economies of scale" over the relevant range of production. IS 	An
economy 	of 	scale 	exists 	when 	a 	proportionate 	increase 	in 	all 	of 	a 	firm's
inputs leads to a more than proportionate increase in its output. 	Economies
of scale imply that the per unit cost of providing a single good decreases as
the output of that good increases.
Theoretical work performed in the late-1970s has shown, however, that
monopoly may be the least-cost industry structure even when there are not
scale economies (or 	decreasing unit costs) over the entire range of possible
output 	levels. 14 	It 	is 	now 	recognized 	that 	monopoly 	is 	the 	least-cost
11 PRC Docket No. C89-1, filed February 28, 1989, was the predecessor
of the present matter.
12 PRC Docket No. RM89-3, filed April 24, 1989 and June 13, 1989.
13 See Schmalensee 	(1979), 	pp. 	3-7. 	For example, 	economies 	of scale
may exist in providing automated 	package sorting services. 	If the cost of
installing and maintaining machinery used for package sorting is the same,
regardless of the number of packages sorted (within some range), 	then the
sorting cost per package will fall as more packages are sorted.
1. This 	body 	of 	work 	is 	summarized 	in 	Baumol, 	Panzar, 	and 	Willig
(1982) and Sharkey (1982).
3

industry structure when the cost function 	has the property of subadditivity.
Costs are said 	to 	be subadditive at 	some 	level 	of 	output 	if one 	firm 	can
always 	produce 	that 	level 	of 	output 	at 	lower 	cost 	than 	can 	two 	or 	more
firms.
In a single product setting, continuously decreasing unit costs up to a
particular level of output are sufficient (but 	not 	necessary) to 	imply that
costs 	are subadditive at 	that output. 	In 	figure 	1, for 	example, 	unit costs
continue to fall 	until output Ql is reached. 	It can therefore be concluded
that costs are subadditive at any output level between 0 and Ql. 	What 	is
not immediately apparent, however, is that costs continue to be subadditive
(up to a point) even for outputs exceeding Ql, notwithstanding that average
costs 	begin 	to rise 	once 	Ql is exceeded. 	Monopoly 	therefore 	may 	be 	the
cost-minimizing 	industry 	structure 	even 	when 	per-unit 	costs 	do 	not 	fall
continuously over the entire range of possible output levels.
This 	is 	an 	important 	principle, 	especially 	in 	its 	implications 	for 	the
issue of entry 	protection. 	Legal 	protection from entry is not 	necessary to
ensure 	least-cost 	production 	when 	scale 	economies 	exist 	over 	the 	entire
range 	of 	possible 	output 	levels. 	For 	then, 	as 	one 	observer 	has 	noted,
"[l]arger firms always have lower costs than smaller competitors [when there
are 	scale economies]. 	The 	largest 	firm at 	any 	instant is 	thus 	in 	the 	best
position to compete for sales. 	If the largest firm is sufficiently aggressive,
it 	will 	drive 	all 	rivals 	from 	the 	field 	and 	still 	earn 	substantial 	excess
profits. lIls 	In 	this 	instance, 	the 	monopoly 	is 	said 	to 	be 	sustainable.
Sustainability 	means 	that 	the 	market 	demand 	and 	cost 	functions 	make
available to the monopolist a price such that (I) the 	market clears (i.e., the
monopolist produces all that is demanded at that price), (2) the monopolist
breaks 	even, 	and 	(3) 	entry 	is 	unprofitable. 	When 	the 	existence 	of 	a
monopoly 	rests 	entirely 	upon 	scale 	economies 	(or 	decreasing 	unit 	costs),
there 	is 	no 	need 	for 	a 	legal 	prohibition 	on 	entry 	to 	ensure 	lowest 	cost
prod uction. 16
The 	case 	for 	legal 	protection 	from 	entry 	is 	more 	compelling 	when
monopoly is the least-cost industry structure, and when scale economies (or
decreasing 	unit 	costs) 	do 	not 	exist 	over 	the 	entire 	range 	of 	possible
IS Schmalensee (1979), 	p. 	4. 	See 	Baumol et al. (1982), 	chapter 	8, for
conditions under which the threat of entry will provide a monopolist with
the incentive to charge a competitive price (i.e., a 	price at which 	it earns
no "excess profits").
16 Regulation 	may 	be 	necessary 	to 	ensure 	that 	such 	a 	monopolist
charges a competitive price. 	The literature on sustainability (see Baumol et
al. (1982) 	and 	Sharkey (1982» describes conditions 	under which 	the threat
of entry will provide a monopolist with an incentive to charge a competitive
price.
4

production 	levels. 	For 	example 	(see 	figure 	1),17 suppose 	that 	the 	firm's
long-run average cost function has a "U" shape (i.e., average costs fall until
they reach some minimum point, beyond which they begin to rise). 	Suppose
further 	that 	the market demand 	curve 	intersects 	this cost 	function 	to 	the
right of its minimum point (but not far enough to its right to accommodate
two firms producing at minimum average cost.) 	As drawn, the cost function
in figure I is subadditive at output Q*. 	This set of circumstances will result
in 	an 	unsustainable natural 	monopoly. 	That is, 	given 	the 	market demand,
total 	production 	costs 	would 	be 	minimized 	if 	a 	single 	firm 	produces 	Q*,
However, such a monopolist would not be able to charge a price that both
covers its costs and deters entry.
To see why, suppose this monopolist selects a price and output (denoted
as p* and Q*) that allow it to cover exactly its average cost at the level of
output 	where 	demand 	intersects 	the 	cost 	function 	(i.e., 	it 	chooses 	a 	price
exactly equal to average cost at output Q\ 	The monopolist is vulnerable to
an entrant which produces less than Q* (e.g., output level Ql, the 	level of
output at which average cost is lowest) and sells it at a price less than P*,
such 	as 	pl. 	Thus, 	if 	an 	entrant 	were 	to 	produce Ql, selling at 	pI, 	what
would remain for the monopolist to produce is Q* - Ql (= QO). 	The latter
could be produced only at a cost of po, which is above P*. 	In fact, if an
entrant 	produced 	Ql, 	the 	monopolist 	would 	not 	have 	available 	to 	it 	any
output between Q* - Ql that it could produce and cover costs, whereas the
total output Q* could be produced if the monopoly is protected from entry.
We note that if Q* is produced and priced at p* by a protected monopoly,
then Q* may be produced at lower cost than if Q* is produced by more than
one 	firm. 	If 	Ql 	is 	produced 	by 	an 	entrant 	and 	QO 	is 	produced 	by 	the
incumbent, the total cost of Q* is (pI X Ql) + (po X QO). 	With the market
protected 	from 	entry, 	the 	total 	cost 	Q* 	is 	p* 	x 	Q*. 	The 	total 	cost 	of
producing Q* will be higher with entry if (as is the case) shaded area (A)
exceeds shaded area (B). 	Absent entry restrictions, an excessive number of
firms may exist along with a consequent waste of resources.
If 	the 	monopolist 	initially 	charges 	a 	price 	below 	P*, 	say 	pI, 	and
supplies 	the 	whole 	of 	the 	amount 	demanded 	so 	to 	deter 	entry, 	then 	total
output would exceed Q*, and price would fall 	below cost, causing losses to
be incurred. 	If price is raised to p* to avoid the loss, and Q* is produced,
the monopoly would be vulnerable to entry. 	This is the situation described
just above. 	If the monopoly initially produces less than Q*, charging a price
above 	P*, 	the 	incentive 	to enter 	is 	not 	diminished 	by 	this. 	Thus, 	if 	the
monopoly is vulnerable to entry when it charges P*, it is vulnerable if price
exceeds p*, 	Thus, if the monopolist were initially to produce Ql and charge
pH, it would be vulnerable to entry by a firm producing Ql and selling at
pl. 	If the entrant charges pI and produces Ql, there is no output that the
monopolist could produce and sell profitably, as noted before.
17 This 	example 	was 	first 	presented 	in 	Baumol, 	Panzar, 	and 	Willig
(1982), pp. 29-32, and Sharkey (1982), pp. 88-9, and is discussed 	in greater
detail in Brock and Evans (1983), pp. 69-76,
5

«-
6
"0
c:
ctl
E
Q)
c
CD
,....
. 	(])
o 	L..
::J
C>
r" 	0-
o 	U.
o
o
o

B. Entry Protectloa Whea the Fir. Produces Many Types of Output
The analysis of entry protection becomes more complicated when a firm
produces more than one output. 	Prior to the mid-1970s, there was relatively
little formal analysis of the implications of multiple product production for
industry structure and entry regulation. 	Subsequent work has shown that, as
in the case of single output firms, the existence of a multiproduct natural
monopoly rests upon the notion of subadditivity. Subadditivity has the same
meaning in a multiproduct setting as in the single output case -- i.e., costs
are 	subadditive when the cost of producing some set of products is lower
when it is produced by a single firm than when the same set is produced by
more 	than one firm. 	However, when 	a firm 	produces several 	products, it
becomes difficult to determine whether the firm is a natural monopoly, and
if so, 	whether 	the monopoly 	is sustainable. 	This difficulty 	arises because
multiproduct production makes costs dependent upon the mix, as well as the
quantities, of the different products produced.
A full discussion of the conditions under which a multiproduct natural
monopoly exists, and when it is sustainable, extends far beyond the scope of
these 	comments. 	There 	are 	numerous 	excellent 	discussions 	of 	this 	issue
a vailable 	in 	the literature. 1S 	The chief implication of this literature can,
however, be succinctly summarized: 	as in the case of a single product firm,
there 	is no efficiency 	basis for 	protecting a 	monopolist 	from 	entry 	unless
there 	is 	a 	good 	reason 	to 	believe 	that 	the 	industry 	is 	an 	unsustainable
natural monopoly. 	Unless the monopoly is unsustainable, market forces will
induce and sustain the monopoly as the least-cost industry structure.
To 	determine 	whether 	any 	particular 	industry, 	such 	as 	the 	postal
service, possibly merits (on efficiency grounds) protection from entry, some
empirical 	evidence 	should 	be 	brought 	to 	bear 	on 	the 	subadditivity 	and
sustainability 	issues. 	The 	theoretical 	literature 	on 	multiproduct 	natural
monopoly 	has 	developed 	a 	set 	of 	necessary 	conditions 	and 	sufficient
conditions 19 that must be satisfied if it is to be concluded that an industry
is 	a 	natural 	monopoly. 	There 	is 	also 	a 	set. of 	necessary 	conditions 	and
sufficient conditions to establish whether' a natural monopoly is sustainable.
Whether the necessary conditions and sufficient conditions for the existence
of a natural monopoly are satisfied in any given industry can, in principle,
be assessed empirically via the estimation of cost functions. 	However, the
18 See 	Baumol, 	Panzar, 	and 	Willig 	(1982), 	Bailey 	and 	Friedlaender
(1982), and Sharkey (1982).
19 There are unfortunately no analytically tractable conditions that are
both 	necessary 	and 	sufficient 	for 	determining 	whether 	an 	industry 	is 	a
multiproduct natural monopoly. 	See Baumol, Panzar, and Willig (1982), p. 170.
7

data 	requirements 	for 	conclusively 	determining 	whether 	an 	industry 	is 	a
sustainable natural monopoly are formidable. 20
Fortunately, one 	can 	often 	derive 	information 	of 	enormous 	practical
significance 	to 	policymakers 	without 	answering 	the 	sustainability 	question.
To establish that an industry is an unsustainable natural monopoly requires
first a showing that the costs of production are subadditive (i.e., that total
costs 	are 	minimized 	when 	there 	is 	only 	one 	firm 	in 	the 	industry).
Subadditivity 	can 	be 	ruled 	out 	if 	it 	can 	be 	shown 	that 	the 	necessary
conditions for subadditivity are not satisfied. 	Economists have devised and
implemented 	empirical 	techniques 	for 	assessing 	these 	necessary 	conditions
whose data requirements are far less burdensome than the requirements for
affirmatively demonstrating the presence of a natural monopoly.21 	If cost,
output, and input price data are available for the various services provided
by the postal service, it should be possible to assess whether the necessary
conditions for subadditivity are met. 	If these conditions are not satisfied,
the sustainability issue need 	never be addressed, and a strong case can be
made 	for 	allowing 	free entry 	into the 	provision of all 	postal services. 	If
they 	do 	exist, 	then 	the 	case 	for 	entry 	prohibition 	is strengthened, 	though
not definitively established. 	Which condition exists is not known at present.
IV. THEORIES OF INEFFICIENT PRODUCTION
The natural monopoly theory discussed in the preceding section assumes
that managers of firms, whether government- or privately-owned, attempt to
produce 	goods 	and 	services 	at 	minimum 	possible 	cost, 	given 	whatever
constraints are imposed by existing technology and the prices of factors of
production. 	That 	is, 	firms 	are 	assumed 	to 	operate 	on 	the 	"efficiency
frontier."22
Recent 	extensions 	of 	theory 	in 	the 	area 	of 	"principal-agent"
relationships 	suggest 	that 	the 	assumption 	of 	least-cost 	production 	may 	be
inappropriate when competition does not constrain the behavior of agents. 23
20 Specifically, 	to 	establish 	subadditivity 	of 	the 	cost 	function, 	a
researcher 	would 	require 	enough data 	to estimate 	the 	properties 	of a 	cost
function 	at 	all 	possible 	levels 	of 	the 	different 	outputs. 	In 	practice, 	the
investigator 	will 	only 	have 	data 	on 	the 	output 	levels 	that 	the 	firm 	has
actually produced.
21 See Evans and Heckman (1983) for an example of this procedure.
22 The "efficiency frontier" gives the lowest possible cost combination
of production inputs for any given level of output.
28 Agency problems may arise whenever the interests of owners are not
identical 	with 	those of managers and workers. 	This literature has a long
history 	reaching 	back 	at 	least 	to 	Berle and 	Means. 	See 	Berle 	and Means
(1932). 	However, 	this 	theme 	has 	received 	a 	great 	deal 	of 	attention 	from
economists since the Reorganization. 	Much of this has centered around the
8

In situations where a firm's managers (the "agents") are not the same as its
owners 	(the 	"principals"), 	the 	managers 	may 	have 	the 	ability 	and 	the
incentive 	to 	pursue 	goals 	and 	objectives 	that 	differ 	from 	those 	of 	the
owners. 	Below we describe a rationale, stemming from work in the theory
of 	bureaucracy, 	for 	why 	a 	protected 	government 	monopoly 	may 	fail 	to
minimize coStS. 24
Developments 	in 	the 	public 	choice 	theory 	of 	government 	decision-
making may also be pertinent, since they help to explain why a principal-
agent problem (and a 	failure to minimize costs) may persist in government
monopolies. 	We also discuss this below.
Theory 	of 	Bureaucracy: 	Production 	inefficiency 	in 	monopolies 	can
arise because these firms are not subject to competition.25 	This absence of
competition 	provides managers with some relief from 	the constant pressure
to minimize production costS. 26 	If one regards taxpayers as the "principals"
market 	for 	corporate 	control. 	See 	Jensen 	(1988); 	Jensen 	and 	Meckling
(1976); Smiley (1976); Fama (1980); Williamson (1964), (1975).
24 Additional theoretical work has been done on two other sources of
higher costs 	in government enterprises: excessive rules and regulations, and
adoption of additional goals. For a discussion of these issues, see Millward
(1982); 	Frug 	(1987); 	Asher 	and 	Popkin 	(1984); 	and 	Perloff 	and 	Wachter
(1984).
25 Under competition, organizations that supply output of a higher level
of quality (at a given price) or at a lower price (at a given level of quality)
are likely 	to attract 	more customers and 	to be more profitable 	than 	those
that 	serve 	customers 	less 	well. 	Ultimately, 	firms 	that 	fail 	to 	meet 	the
challenges of competition will exit from the market, and investors, managers,
and other personnel associated with the firm may find this a costly process.
In 	contrast, 	managers 	and 	workers 	in 	monopolies 	often 	face 	very 	limited
competition 	for 	consumers' 	patronage, 	and, 	therefore, 	lack 	the 	same
incentives to increase quality and decrease costs. 	They may share in little-
- if any -- of the monetary gain from superior performance and may suffer
fewer consequences from poor performance. 	Without equivalent incentives to
perform 	well, they 	may 	not produce as efficiently as 	they 	might 	in 	more
competitive circumstances. 	Early work in this area includes: Alchian (1965);
Simon, Smithburg, and Thompson (1950); Tullock (1965); Lindsay (1976); Migue
and 	Belanger (1974), and 	Brenton and 	Wintrobe 	(1975); 	Downs (1967); 	and
Thompson 	(1969). 	More 	recently, 	see 	Pommerehne 	and 	Schneider 	(1985);
Vickers and Yarrow (1988), Chapters 2-4; and Wolf (1988), Chapter 6.
26 A related perspective on the efficiency of government enterprise is
known 	as 	the 	"X-inefficiency" 	theory. 	See 	Leibenstein 	(1976). 	For 	a
discussion of differences between the X-inefficiency theory of the firm and
the 	standard 	(or 	"neo-classical") 	approach, 	see 	Alam 	(March 	1983);
Leibenstein 	(March 	1983); 	De 	Alessi 	(March 	1983); 	Leibenstein 	(September
1983); and De Alessi (September 1983).
9

of a 	government-owned 	monopoly, 	this absence of competition 	may 	permit
managers to neglect taxpayers' presumed objective of cost minimization.
This 	attenuation 	of 	competitive 	pressure 	could 	manifest 	itself 	in 	a
variety of ways. 	Managers might find 	themselves able to expend resources
on managerial perquisites (e.g., plush offices), or to bargain less energetically
with 	factor 	suppliers (e.g., 	labor unions).27 	Because 	this 	ability 	to 	pursue
objectives other than cost-minimization is believed to be positively correlated
with 	the 	size 	of 	the 	enterprise, 	government 	managers 	may 	attempt 	to
maximize 	the size of their enterprises, rather 	than operate 	them at lowest
cost consistent with market demand. 28
It is also possible that managers of government enterprises have better
information 	(e.g., 	better 	information 	on 	production 	technologies and 	input
prices) than the elected or appointed officials to whom they report. 	If these
officials 	share 	the 	same 	goals 	as 	taxpayers 	(i.e., 	they 	desire 	cost
minimization), this lack of information may prevent them from monitoring
effectively 	the 	performance 	of government enterprises. 	In 	general, 	recent
work in 	the analysis of bureaucracy suggests that managers of government
enterprises 	are 	likely 	to 	produce 	different 	outputs, 	and 	use 	higher 	cost
production 	techniques, 	than 	would 	managers 	of 	private, 	competitive 	firms
operating in the same industry.29
Managers of any protected enterprise will have some ability to engage
in 	inefficient 	behavior, 	regardless 	of 	whether 	the 	enterprise 	is 	privately-
owned 	or 	government-owned. 	However, 	a 	privately-owned 	firm 	protected
from competition will face constraints on managerial discretion if there is an
active 	market 	for 	corporate 	control. so 	The 	market 	for 	corporate 	control
cannot discipline the managers of government-owned firms. 	Such discipline
must 	be 	imposed 	by 	political 	institutions. 	The 	theory 	of 	"public choice,"
described 	below, 	explains 	why 	the 	political 	system 	may 	be 	unable 	to
constrain effectively the behavior of government-owned monopoly enterprises.
Public Choice Theory: The theory of "public choice" provides a rationale
for 	why inefficient government monopolies may continue to exist. 31 	Public
27 Research 	into 	effects 	of 	entry 	regulation 	in 	other 	industries 	has
found 	that 	entry 	protection 	often 	creates 	"economic 	rents" 	(i.e., 	above-
competitive returns) that are captured by input suppliers. 	See, for example,
Rose (1987).
28 See Niskanen (197 I) and Baumol (1967).
29 There 	is 	a 	large 	literature 	comparing 	production 	costs 	of 	private
firms and government enterprises. 	See, for example, Boardman and Vining
(1989); Davies (1981); and Stevens (1984).
30 See Jensen (1988).
31 The public choice literature is reviewed in Mueller (1979). 	Also see
the references therein.
10

choice 	theory 	regards 	managers 	and 	employees 	of 	government 	enterprises
simply as two of 	the many special interest groups that attempt to 	use the
power of government for personal enrichment. 	From this perspective, it is
clear that, unlike taxpayers or the customers of the government enterprise,
employees of government enterprises do not have an interest in minimizing
the cost of the enterprise. 	Taxpayers and customers may be poorly situated
to 	force 	these 	firms 	to 	minimize 	costs, 	however, 	because 	they 	are
disorganized 	(relative 	to 	the 	employees). 	This 	lack 	of 	organization 	by
taxpayers 	and 	customers can arise 	because 	the 	benefits 	of 	lower 	costs 	by
government 	enterprises 	are 	widely 	dispersed 	(Le., 	they 	are 	shared 	by 	all
taxpayers 	and 	customers 	of 	the 	postal 	system), 	while 	the 	expenditures
necessary to secure these reductions are not.
This distribution 	of 	benefits and 	costs creates 	a 	"free-rider" 	problem
that 	discourages 	the 	formation 	of 	political 	coalitions 	to 	lower 	the
enterprise's costs. 	Since all taxpayers and postal service users share in the
gains from such cost reductions, whether or not the individual taxpayer or
customer participated in the effort to obtain these reductions, no individual
taxpayer 	or 	customer 	has 	the 	incentive 	to 	incur 	the 	costs 	of 	actively
opposing excessive enterprise expenditures, as 	the 	personal 	costs are likely
to exceed 	the personal 	benefits. 	Thus, individual taxpayers and customers
cannot 	profitably 	incur 	the 	costs 	necessary 	to 	oppose 	excessive 	enterprise
expenditures, even though collectively they would be made better off if such
reductions could be obtained.s2
The beneficiaries of government inefficiency, by contrast, are a much
smaller group. 	As a result, the personal benefits of maintaining the status
quo 	(e.g., 	greater 	managerial 	perks) 	may 	well 	offset 	the 	corresponding
personal costs.
The 	key 	implication 	here 	of 	the 	theories 	of 	bureaucracy 	and 	public
choice is that government monopolies may have inherent tendencies toward
inefficiency. 	The theory of 	bureaucracy suggests 	that 	private competition
with government enterprise can establish limits on the latter's costs through
ordinary 	market 	competition, 	and 	by 	providing 	elected 	officials 	with
increased information on minimum costs and on demanded levels of service
quality. 	With 	better 	informed supervisory 	officials, efforts 	to 	inflate 	an
enterprise's 	budget 	will 	increase 	the 	probability 	that 	the 	government
enterprise 	will 	be 	displaced 	by 	outside 	producers 	(private 	or 	public) 	or
otherwise be more strictly constrained. 	The theory of public choice suggests
that competing suppliers of an initially monopolized industry can reduce the
political 	advantages 	of 	enterprise 	employees 	by 	forming 	a 	countervailing
interest group that may oppose the interests of incumbent employees.
32 See Olson 	(1965); 	also 	see 	Lentz 	(1981) 	and 	Courant 	et 	al. 	(1980).
Some empirical 	work supports the hypothesis that tighter citizen control is
associated 	with 	reduced 	costs 	of 	municipal 	operations. 	Pommerehne 	and
Schneider found that municipalities with strong citizen control averaged 15%
to 30% lower costs, primarily because such control restrained wage increases.
Pommerehne and Schneider (1985). 	Also see Pommerehne and Frey (1978);
and Borcherding (1978).
II

The existence of a "principal-agent" problem may force policymakers to
make a trade-off. 	In certain situations, a protected monopoly might be the
least-cost market structure, absent any principal-agent problem. 	However, in
the presence of a principal-agent problem, permitting more than one firm to
enter the industry may be preferable. 	Even though additional entry would
entail 	some 	efficiency 	losses 	(because 	some 	of 	the 	advantages 	of 	a
subadditive cost functionS! would be lost), these losses conceivably could be
more than offset by the gains that would arise when firms are constrained
by competition to pursue cost minimization with greater vigor.
V. CROSS-SUBSIDIZATION AND "CREAM-SKIMMING"
The price structure of 	the postal service likely 	results in some cross-
subsidization. 	Cross-subsidization 	occurs 	when 	one 	group 	of 	customers 	is
charged 	a 	price 	that 	exceeds 	the 	cost 	of 	service 	while 	another 	group 	of
customers is charged a price that is less than the cost of service.s• 	Many
proponents of the current price system argue that cross-subsidization should
be 	deliberately 	pursued 	as 	a 	method 	of 	redistributing 	income 	to 	certain
deserving 	groups. 	These 	advocates 	maintain 	that 	removal 	of 	entry
restrictions would encourage the creation of new suppliers that would "skim
the 	cream" 	by 	producing 	only 	the 	services 	for 	which 	prices 	exceed 	costs.
Such entry would erode the ability of the postal service to provide below-
cost prices to preferred customers. 	Thus, increased competition induced by
free 	entry could result 	in higher prices for 	those services currently priced
below costs.
The extent of cross-subsidization in postal rates remains an empirical
question, 	and 	we 	take 	no 	position 	on 	the 	appropriateness 	of 	any
distributional objectives that may be reflected in the current rate structure.
However, 	we 	note 	that 	selected 	groups 	of 	customers 	could 	be 	favored
without 	using 	entry 	restrictions 	and 	a 	set 	of 	inefficient 	prices. 	The
alternative method involves the use of explicit subsidies. 	Explicit subsidies
make conspicuous what would otherwise be implicit taxes whose effects are
hidden 	from 	policy 	makers and 	the public.s5 	When subsidies are 	explicit,
voters and officials are better able to weigh rationally the costs and benefits
of transferring income to selected consumers.
SS See § III, above, for a discussion of subadditivity.
S4 Cross-subsidization 	within 	the 	same 	class 	of 	service 	may 	occur
between 	urban 	and 	rural 	consumers, 	between 	long-haul 	and 	short-haul
deliveries, and between door to door and postal box delivery.
S5 Brennen and Buchanan (1977) suggest that a primary purpose of the
tax 	system 	is 	to 	constrain 	government 	expenditures. 	Other 	methods 	of
financing 	government 	expenditures, 	such 	as 	cross-subsidization, 	effectively
circumvent the safeguards of the tax system.
12

Explicit subsidies could, for 	example, be 	instituted 	to 	provide single-
price 	first 	class 	mail 	service 	to 	higher 	cost 	areas, 	just 	as 	subsidies 	have
been 	provided 	to maintain air service 	to certain small communities in 	the
aftermath of airline deregulation.s6
VI. SUMMARY AND TESTS OF THE THEORIES
In the preceding sections, we discussed some developments in economic
theory 	that 	have 	narrowed 	the 	support 	for 	a 	protected 	government 	postal
monopoly, and we emphasized the possibility that the postal service currently
may 	lack the 	incentive to deliver mail efficiently. 	Our analysis indicates
that 	a 	government-protected 	monopoly 	will 	not 	be 	the 	most 	efficient
structure for the postal service unless such a monopolist (I) has subadditive
costs, (2) is unsustainable against entry, and (3) avoids inefficient conduct
on the part of its managers and employees.
Moreover, although we take no position on the appropriateness of any
distributional goals that may be embodied in the existing rate structure, our
discussion 	suggests 	that 	the 	same goals 	could 	be 	attained 	through 	explicit
subsidies. 	An explicit subsidy may be preferable to an implicit one because
it 	may 	enable 	voters 	to 	make 	better-informed 	decisions 	about 	government
taxation and expenditure policies. 	Further, fewer distortions in the pricing
of services to various customer groups would remain.
36 The 	Essential 	Air 	Service 	Subsidy 	Program 	provided 	subsidies 	to
small communities that feared the loss of air service after the deregulation
of the airline industry. 	See Adie (1989), pp. 69-70, and Ogur et at. (1988),
pp. 12-16.
13

REFERENCES
Adie, D., Monopoly Mail, New Brunswick, N.J.: Transaction Publishers, 1989.
Alam, M, "Intrafirm Productivity: Comment," American Economic Review 73
(1983),817-821.
Alchian, 	A., 	"The 	Basis 	of 	Some 	Recent 	Advances 	in 	the 	Theory 	of
Management of the Firm," 	Journal 0/ Industrial Economics 14 (1965), 30-41.
Allen, 	W., 	"Ramsey 	Pricing 	in 	the 	Transportation 	Industries," 	International
Journal 0/ Transport Economics 13 (1986), 293-329.
Asher, M, and J. Popkin, "The Effect of Gender and Race Differentials on
Public-Private Wage Comparisons: A Study of Postal Workers," Industrial and
Labor Relations Review 38 (1984), 16-25.
Bailey, 	E., 	and 	A. 	Friedlaender, 	"Market 	Structure 	and 	Multiproduct
Industries," Journal 0/ Economic Literature 20 (1982), 1024-48.
Baumol, 	W., 	Business 	Behavior. 	Value. 	and 	Growth, 	New 	York: 	Harcourt,
Brace, and World, 1967.
Baumol, W., J. Panzar, and R. Willig, Contestable Markets and the Theory 0/
Industry Structure, New York: Harcourt, Brace and Jovanovich, 1982.
______ , "On 	the 	Theory 	of 	Perfectly-Contestable 	Markets," 	in 	New
Developments 	in 	the 	Analysis 0/ Market 	Structure, 	edited 	by 	J. 	Stiglitz and
G. Mathewson, Cambridge: MIT Press, 1986.
Berle, A., and G. Means, The Modern Corporation and Private Property, New
York: Macmillan, 1932.
Boardman, A., and A. Vining, "Ownership and 	Performance in Competitive
Environments: 	A 	Comparison 	of 	the 	Performance 	of 	Private, 	Mixed, 	and
State-Owned Enterprises," Journal 0/ Political Economy 32 (1989), 1-34.
Borcherding, T., "Competition, Exclusion, and the Optimal Supply of Public
Goods," Journal 0/ Law and Economics 21 (1978), 111-132.
Brennen, G., and J. Buchanan, "Towards a Tax Constitution for Leviathan,"
Journal 0/ Public Economics 8 (1977), 255-273.
Brenton, A., and R. Wintrobe, "The Equilibrium Size of a Budget-Maximizing
Bureau: A Note on 	Niskanen's Theory of Bureaucracy," Journal 0/ Political
Economy 83 (1975), 195-207.
Brock, W., and D. Evans, "Creamskimming," in Breaking up Bell: 	Essays in
Industrial 	Organization 	and 	Regulation. 	Edited 	by 	D. 	Evans. 	New 	York:
North-Holland, 1983.
14

Courant, 	P., 	E. 	Gramlich, 	and 	D. 	Rubenfeld, 	"Why 	Voters 	Support 	Tax
Limitation Amendments: The Michigan Case," National Tax Journal 33 (1980).
Davies, 	D., 	"Property 	Rights 	and 	Economic 	Behavior 	in 	Private 	and
Government Enterprises: The Case of Australia's Banking System," Research
in Law and Economics 3 (1981), 111-142.
De 	Alessi, 	L., 	"Property 	Rights, 	Transaction 	Costs, 	and 	X-Efficiency: 	An
Essay in Economic Theory," American Economic Review 73 (1983), 64-81.
___-', 	"Property 	Rights 	and 	X-Efficiency: 	Reply," 	American 	Economic
Review 73 (1983), 843-845.
Downs, A., Inside Bureaucracy, Boston: Little Brown, 1967; and Thompson, V.,
Bureaucracy and Innovation, Alabama: University of Alabama Press, 1969.
Evans, 	D., 	and 	Heckman, 	J. 	"Multiproduct 	Cost 	Function 	Estimates 	and
Natural Monopoly Tests for the Bell System," in Breaking up Bell: 	Essays in
Industrial 	Organization 	and 	Regulation. 	Edited 	by 	D. 	Evans. 	New 	York:
North-Holland, 1983.
Fama, E., "Agency Problems and the Theory of the Firm," Journal of Political
Economy 88 (1980), 288-307.
Frug, 	J., 	"The 	Choice 	Between 	Privatization 	and 	Publicization," 	Current
Municipal Problems 14 (1987), 20-26.
Gallick, 	E., 	Exclusive 	Dealing 	and 	Vertical 	Integration: 	The 	Efficiency 	of
Contracts 	in 	the 	Tuna 	Industry, 	Bureau 	of 	Economics, 	Federal 	Trade
Commission, 1984.
Grawe, 0., "Postal History," unpublished manuscript, 1989.
Hall, 	R., 	Organizations: 	Structure 	and 	Process, 	Englewood 	Cliffs, 	N.J.:
Prentice-Hall, 1972.
Hart, 0., "The Market Mechanism as an 	Incentive Scheme," Bell Journal of
Economics 14 (1983), 366-382.
Hill, 	R., 	in 	First 	Report 	from 	the 	Select 	Committee 	on 	Postage, 	London:
House of Commons, (April 4, 1838), 13, cited in O. Grawe, "Postal History,"
unpublished manuscript, 1989.
Jensen, 	M, 	"Takeovers: 	Their 	Causes 	and 	Consequences," 	Journal 	of
Economic Perspectives 2 (1988), 21-48.
Jensen, M, and 	Meckling, 	W., "Theory of 	the Firm: Management 	Behavior,
Agency 	Costs 	and 	Ownership 	Structure," 	Journal 	of 	Financial 	Economics 	3
(1976), 305-360.
15

Kenney, R., and B. Klein, "The Economics of Block Booking," Journal of Law
and Economics 26 (1983), 497-540.
Leibenstein, H., Beyond Economic Man, Cambridge: Harvard University Press,
1976.
____-', 	"Intrafirm 	Productivity: 	Reply," 	American 	Economic 	Review 	73
(1983), 822-823.
____-',"Property Rights and X-Efficiency: Comment," American Economic
Review 73 (1983), 831-842.
____-', 	"Prisoners' 	Dilemma 	in 	the 	Invisible 	Hand: 	An 	Analysis 	of
Intrafirm Productivity," American Economic Review 72 (1982), 92-97.
Lentz, B., "Political and Economic Determinants of County Government Pay,"
Public Choice 36 (1981), 253-271.
Lindsay, 	C., 	"A 	Theory 	of 	Government 	Enterprise," 	Journal 	of 	Political
Economy 84 (1976), 1061-1077.
Luthans, F., Organizational Behavior, New York: McGraw-Hill, 1973, 21-32.
Migue, 	J., 	and 	G. 	Belanger, 	"Toward 	a 	General 	Theory 	of 	Managerial
Discretion," Public Choice 17 (1974).
Millward, 	R., 	"The 	Comparative 	Performance 	of 	Public 	and 	Private
Ownership," in The Mixed Economy, edited by Roll, Lord of Ipsden, London:
Macmillan, 1982, 58-93.
Mueller, 	D., 	Public 	Choice, 	United 	Kingdom: 	Cambridge 	University 	Press,
1979.
Niskanen, 	W., 	Bureaucracy 	and 	Representative 	Government, 	Chicago: 	Aldine-
Atherton, 1971.
___-', 	"Bureaucrats and 	Politicians," 	Journal 	of Law 	and 	Economics 	18
(1975),617-643.
Ogur, 	J., 	C. 	Wagner, 	and 	M 	Vita, 	The 	Deregulated 	Airline 	Industry: 	A
Review 	of the 	Evidence, 	Bureau 	of 	Economics, 	Federal 	Trade 	Commission,
1988.
Olson, 	M, 	The 	Logic 	of Collective 	Action, 	Cambridge: 	Harvard 	University
Press, 1965.
PerIoff, J., and M 	Wachter, "Wage Comparability in the U.S. Postal Service,"
Industrial and Labor Relations Review 38 (1984), 26-35.
Pommerehne, W., and B. Frey, "Bureaucratic Behavior in Democracy," Public
Finance 33 (1978), 98-113.
16

Pommerehne, W., and F. Schneider, Private or Public Production: A European
Perspective, Denmark: University of Aarhus, 1985.
Ramsey, F., "A Contribution to the Theory of Taxation," Economic Journal 37
(1927), 47-61.
Reissman, L., "A Study of Role Conception in Bureaucracy," Social Forces 27
(1949), 305-310.
Rose, N., "Labor Rent-Sharing and Regulation: 	Evidence From the Trucking
Industry," Journal of Political Economy 95 (1987), 1146-87.
Scharfstein, 	D., 	"Product-Market 	Competition 	and 	Managerial 	Slack," 	Rand
Journal of Economics 19 (1988), 147-155.
Schmalensee, R, The 	Control of Natural Monopolies, 	Lexington, MA: 	Heath,
1979.
Sharkey, 	W. 	The 	Theory 	of 	Natural 	Monopoly. 	New 	York:
University Press, 1982.
Cambridge
Sherman, 	R., 	and 	A. 	George, 	"Second 	Best 	Pricing 	in 	the 	U.S. 	Postal
Service," Southern Economic Journal 45 (1979), 685-695.
Simon, H., D. Smithburg, and V. Thompson, Public Administration, New York:
Alfred A. Knopf, 1950.
Smiley, R., "Tender Offers, Transactions Costs and the Theory of the Firm,"
Review of Economics and Statistics 58 (1976), 22-32.
Stevens, 	B., 	Delivering 	Municipal 	Services 	Efficiently: 	A 	Comparison 	of
Municipal 	and 	Private 	Service 	Delivery, 	U.S. 	Department 	of 	Housing 	and
Urban Development, 1984.
Tirole, 	J., 	The 	Theory 	of 	Industrial 	Organization, 	Cambridge: 	MIT 	Press,
1989.
Tullock, 	G., 	The 	Politics 	of 	Bureaucracy, 	Washington, 	D.C.: 	Public 	Affairs
Books, 1965.
United 	States 	Postmaster General, 	Office 	of 	the, 	Report 	of the 	Postmaster
General 	for 	1854, 	cited 	in 	O. 	Grawe, 	"Postal 	History," 	unpublished
manuscript, 1989.
Vickers, J., and 	G. Yarrow, Privatization: An Economic 	Analysis, Cambridge:
MIT Press, 1988.
Williamson, 	0., 	The 	Economics 	of 	Discretionary 	Behavior: 	Managerial
Objectives 	in 	a 	Theory 	of the 	Firm, 	Englewood 	Cliffs, 	N.J.: 	Prentice-Hall,
1964.
17

____--t' 	Markets 	and 	Hierarchies: 	Analysis 	and 	Antitrust 	Implications,
New York: Macmillan, 1975.
Wolf, 	C., 	Markets 	or 	Governments: 	Choosing 	between 	Imperfect 	Alternatives,
Cambridge: MIT Press and Rand Corporation, 1988.
18