The Economic Implications of “Density-Based Rate Authority”

At the 23rd Postal Conference, Brennan and Crew (2016) proposed a formula to adjust postal rates under price cap regulation in the face of exogenous declining demand, in order to preserve the ability of a postal service operated to support universal service and remain solvent. That formula was based on the elasticity of average cost with respect to volume—which, in simple terms, turn out to be the ratio of fixed to total cost—with an adjustment for demand elasticity since increasing price also reduces volumes. The US Postal Regulatory Commission (PRC) instead proposed to adjust rates on the basis of changes in mail volume per location, i.e., “density”. The PRC’s assumption that average cost per unit is constant if density is constant implies that total cost is a simple sum of the marginal cost per unit times volume, plus the marginal cost per location times location. Qualitative and policy implications of this result are discussed.