January 9, 2013 (RARC-WP-13-004)
As a follow-up to its paper, A Primer on Postal costing issues, the Office of the Inspector General asked Professor Michael D. Bradley of the Economics Department of George Washington University, an expert in postal economics, to co-author a paper on pricing and short-run costs. This paper defines what is meant by short-run and long-run costs, explores the issues associated with using short-run costs when developing prices, outlines what information is needed to measure short-run costs, and develops a multistep algorithm for estimating short-run costs that is consistent with the existing Postal Service cost system.
The Postal Service may be operating under short-run conditions and therefore may want to consider setting prices for at least some of its products using short-run costs. Under the proper conditions, this approach could help mitigate the costs of excess capacity by increasing volume through lower prices. However, the improper use of short-run costs to develop prices could worsen the Postal Service’s financial position. Therefore, the Postal Service should only move towards the use of short-run costs if and only if (1) it can be sure that a lower price will lead to sufficient net revenue and (2) it can measure short-run costs accurately and update them regularly.
Other issues that must be considered before using short-run costs to set prices include:
- Using short-run costs can result in prices that may generate additional revenue in the short term but will still not allow the Postal Service to cover its institutional costs.
- Prices based on short-run costs would be volatile.
- Prices act as price signals to consumers. Consumers may react to temporary price changes by changing the timing of their purchases. If mistakenly viewed as permanent price changes, consumers may inefficiently overinvest in technology needed to produce mail.
- If a lower price does not lead to an increase in demand, the Postal Service will simply lose revenue.
- Accurate measurement is difficult and would require significant effort from experts in postal operations.
- The Postal Service may lose the incentive to shed the excess capacity.
Even under the best scenario, setting prices based on short-run costs should be seen only as a temporary solution while the Postal Service continues to move toward a more optimal operating environment.