Universal service obligations in the postal sector: The relationship between quality and coverage

Abstract

This paper examines competition in the postal sector when one private incumbent and one entrant play a three-stage game. First, firms choose their coverage. Then, they choose the quality of the mail. Finally, firms choose the price. I modify the traditional model of product differentiation proposed by Mussa and Rosen [Mussa, M., Rosen, S., 1978. Monopoly and product quality. Journal of Economic Theory 18, 301–317] in order to consider that firms decide their quality and coverage. Valletti et al. [Valletti, T., Hoernig, S., Barros, P., 2002. Universal service and entry: the role of uniform pricing and coverage constraints. Journal of Regulatory Economics 21 (2), 169–190] show that when an incumbent is regulated by a uniform pricing constraint the entrant will choose a low level of coverage to increase the incumbent’s uniform price and weaken competition. In this paper, I show that by increasing product differentiation, the entrant can obtain the same price increase with a smaller reduction of coverage. Acknowledgement of the strategic link between quality and coverage can be very useful in the design of a regulatory policy. The paper also considers a mixed duopoly in which the public firm covers the entire market and offers high quality service. In this context, I explain that the mixed equilibrium implements the first-best qualities and coverage levels.

Introduction

In a liberalized postal market, Universal Service Obligations (USOs) guarantee that all consumers have access to a basic package of services at affordable uniform prices and that the services have a minimum level of quality.¹ However, the viability of the USO may be threatened when entrants limit service to profitable mailers, opt for niche markets or choose product differentiation strategies. This paper analyzes the conduct of firms in a competitive postal market when one firm is regulated to provide some universal services. My objective is to understand how the imposition of a uniform price affects firms quality and coverage decisions and, also, to assess whether minimum quality standards and coverage obligations might usefully increase welfare.

An important contribution of this paper is its recognition that firms are able to determine both quality and coverage. To my knowledge, the analysis of the relationship between quality and coverage has not been addressed in the literature before, and can be useful for guiding public intervention in network industries. Recent contributions to the study of universal service obligations such as Valletti et al. (2002) show that when an incumbent operator is required to provide a uniform price, the entrant seeks to weaken competition by strategically covering only part of the country. In this paper, I explain that when the entrant can modify its quality of service, it chooses a larger area of coverage than when quality is fixed. In general, firms prefer increasing product differentiation over reducing coverage when attempting to reduce competition.

A second contribution of this paper is to extend the product differentiation model developed by Mussa and Rosen (1978) in order to study the strategic link between quality and coverage. I analyze the competition between one incumbent firm and one entrant engaged in a three-stage game. In the first stage, firms choose their coverage area. In the second, firms determine the quality of the mail and, in the third stage, set the price. This framework allows me to identify how firms coverage choices influence their quality decisions.

An entrant’s equilibrium coverage is the result of two opposing forces. The entrant prefers wide coverage in order to reach more consumers. However, if the incumbent charges a uniform price, then the entrant may have an interest in restricting its coverage. In such a case, the incumbent, effectively the monopolist of the region not covered by the entrant, will establish a higher price than the duopoly price, thus allowing the entrant to charge a higher price. In a private duopoly, the second effect dominates, and as a consequence, the entrant covers only part of the country.

Equilibrium quality determinations are also the consequence of two opposing forces. The firms interest in supplying the quality variety that is most profitable in terms of consumer preferences and costs will tend to make firms choose the same quality level. However, firms in equilibrium commercialize different services because product differentiation weakens price competition and raises profits. The main result presented in this paper is that a difference in coverage increases the extent to which firms differentiate products. When the entrant covers only part of the country, competition is moderated and firms are able to increase their prices. In this situation, the larger the difference between the incumbent and the entrant’s coverage, the greater the profit that they will both obtain by increasing product differentiation.

This conclusion complements previous research on the effects of uniform prices in liberalized markets. It implies that an entrant’s coverage strategy depends upon its ability to modify the quality of services. Moreover, this result alerts regulators to the need to establish minimum quality requirements in order to reduce inefficient quality differentiation and keep prices down.² Thus, while imposing a minimum quality requirement on the entrant is welfare-enhancing, limiting the quality of the incumbent moderates product differentiation and reduces welfare. In addition, this paper demonstrates the benefits of complementing quality regulations with minimum coverage requirements.

This paper also analyzes competition in a mixed duopoly. In the European Union, some countries such as Belgium, Germany and Netherlands, have partially privatized the incumbent postal operators, and in Argentina and Japan the government have completely privatized them.³ Nevertheless, at present, the most common form of postal market competition is between a public incumbent and one or several private entrants. Taking this scenario into account, I analyze the conduct of firms in a mixed duopoly and I show that the presence of a public firm has two remarkable effects: first, firms set their qualities efficiently; second, entrants have incentives to cover a greater part of the country. These results are interesting for regulatory policy because they indicate that the presence of a public firm can, by itself, be enough to improve equilibrium quality and coverage allocations.

Finally, the last part of the paper analyzes the conduct of firms in the presence of network externalities. The importance of network externalities has been neglected in previous analyses of the USO. In my model, network externalities appear when senders value the size of a firm’s distribution network.⁴ Cremer et al. (2001) consider a duopoly in which the senders see the size of the network as a quality attribute. They show that the larger the entrant’s coverage, the lower the price differential at which the entrant can capture a positive market share. Following this idea, the present paper considers that mail service has two quality attributes, the intrinsic quality of mail (frequency of delivery and reliability) and coverage. This extension is useful to show how firms use their coverage as a substitute for the intrinsic quality of the mail. When network externalities are important, the entrant prefers a wide coverage in order to increase the valuation of the service. Therefore, network externalities might compensate for the distortions of the entrant’s coverage that are created by the imposition of a uniform price on the incumbent.

The results of this paper are connected with the previous literature about USOs in the postal sector. Nevertheless, very few papers have taken into consideration the quality of the mail. Crew and Kleindorfer (1998) develop a model that simultaneously determines USOs characteristics and the reserved area necessary for an incumbent to finance the USOs. The importance of quality is also highlighted by Crew and Kleindorfer (2005) when they claim that “it seems unlikely for most countries that lettermail USO can be supported without a reserved area, unless service standards are relaxed.”

Although the previous papers explicitly consider the quality of mail, the present analysis is more closely related to the model of vertical product differentiation developed by Cremer et al. (1997). These authors consider a duopoly that plays a two-stage game: first firms choose qualities and then prices. In this context, private duopolies result in an inefficient provision of quality. However, if one firm is public, the equilibrium qualities are close to the first best.⁵ In my model, the duopolists choose the coverage level, the quality of the mail and the prices. As a result, I can identify the effect of coverage on the quality provided by the firms.

The present paper is also closely tied to the work of Valletti et al. (2002). These authors show that the imposition of a uniform price on an incumbent telecommunications operator critically affects the ratio between the entrant’s and the incumbent’s coverage. This happens because the entrant wants to enlarge the incumbent’s monopoly region in order to increase its uniform price. The authors demonstrate that a uniform price creates a strategic link between the monopoly region covered by the incumbent and the duopoly region covered by the two firms. Under a uniform price the entrant chooses to serve a smaller area than the incumbent in order to reduce competition. In this paper, I show that the effect of a uniform price persists when firms determine both the quality of the mail and their coverages. In this case, however, as product differentiation depends upon the firms’ relative coverage, the entrant can obtain the same increase of the incumbent’s uniform price with a smaller reduction of its own coverage.

Finally, Fabra et al. (2004) consider competition in a private duopoly in which the incumbent covers the entire population and has a regulated uniform price. The entrant is free to decide its coverage and can price discriminate with respect to the path of the letter mail. However, in their model the qualities are set exogenously. The duopolists play a two-stage game. First, the regulator establishes the incumbent’s uniform price and a transfer payment that covers the incumbent’s costs. Second, after having observed the incumbent’s price, the entrant chooses its coverage and the price for each path. The authors conclude that the higher the entrant’s quality advantage, the larger the coverage that the entrant choose. In my paper, by contrast, product differentiation depends on the firms coverage levels. Moreover, I assume that both firms establish uniform prices. This assumption restricts the entrant’s strategy, but it reflects the present situation in many liberalized markets, such as those in Sweden and Spain.

The remainder of the paper is organized as follows. Section 2 explains the main features of the model. Section 3 presents the optimal qualities and coverage levels that a benevolent regulator would establish. Section 4 considers a private duopoly when the incumbent covers the entire market and must establish a uniform price. Sections 5 analyzes the effect of imposing different quality and coverage obligations on the firms. Section 6 analyzes the strategies of firms in a mixed duopoly. Section 7 analyzes the interaction between quality and coverage in the presence of network externalities and Section 8 concludes the paper.