1. Postal Sector Reform Market Entry and Pricing Simulation EPFL, February 4, 2010 Christian Jaag, Ph.D. Managing Partner Swiss Economics

2. Christian Jaag Page 2 Agenda 0900-1015Postal Sector Reform: Competition and Regulation 1015-1045 Break 1045-1230 Market Entry and Pricing Simulation

3. Introduction Recent Developments in the Market for Mail

4. Overall mail volumes in different countries Who is who? Sweden (fully liberalized) vs. Switzerland (partially liberalized) vs. US (not liberalized / worksharing) Christian Jaag Page 4

5. Overall mail volumes – a puzzle? Sweden: Complete Market Opening in 1993 Switzerland: Market opening >100g in 2006, >50g in 2009 United States: Rigid monopoly, highest volumes per capita Christian Jaag Page 5

6. The Postal Value Chain Example: Switzerland Collection Processing 15m letters per day, 85% of which business originated 2500 Post offices 1000 other access points 20000 letter boxes 3+6 sorting centers 6000 employees 20000 vehicles and 470 train carriers 15000 mailmen (employees) delivering to 3m households per day We build our network every day from scratch The postal infrastructure focuses mainly on the 15% private customers The main difference between posts and telecoms is probably that carbon wires are not unionized Delivery Christian Jaag Page 6

7. Competition I Mail vs. Email

8. Long-term Effect of E-Substitution Sources: Annual Reports Swiss Post1998-2008; SECO Actual Volumes Hypothetical Volumes without E-Substitution Christian Jaag Page 8

9. Regulation Market Opening and Universal Service Provision Market Opening: EU vs. U.S. Economic Market Characterization Why Liberalize? Universal Service Obligations

10. Modes of Liberalization Collection Delivery Processing 100 g 50 g Liberalization EU/CH by Weight Liberalization USA by Processing Step Protected USPS Monopoly in Delivery Collection Processing Christian Jaag Page 10

11. Natural Monopoly? Need for Regulation? With Sunk CostsWithout Sunk Costs Natural MonopolyMonopolistic Bottleneck Contestable Monopoly No Natural Monopol Competition Natural MonopolySunk Costs Collection?No Sorting?No TransportNo DeliveryYesNo Christian Jaag Page 11 No need for regulation due to structural market power

12. The Role of the USO USO narrowly defined: - Area Coverage (Access Points, Delivery) - Uniform Prices - Delivery Frequency - Product Range USO broadly defined - Working Conditions - Infrastructure Mandate Regulation due to underprovision or for distributinal reasons? Christian Jaag Page 12

13. Why a Monopoly is Good Incremental Cost 0% Market Coverage 100% Incremental Revenue q Incumbent Competitor Cost per Item M P C Regional Balance Economies of Scale – Consumer Choice – Innovation – Pricing or Bad Christian Jaag Page 13 After full market opening: Are competition and USO compatible?

14. The Net Cost of USO I Third Postal Directive, Annex I, Part B: The net cost of universal service obligations is to be calculated, as the difference between the net cost for a designated universal service provider of operating with the universal service obligations and the same postal service provider operating without the universal service obligations. Christian Jaag Page 14 Third Postal Directive Article 7: Where a Member State determines that the universal service obligations, as provided for in this Directive, entail a net cost, calculated taking into account Annex I, and represent an unfair financial burden on the universal service provider(s), it may introduce: (a) a mechanism to compensate the undertaking(s) concerned from public funds; or (b) a mechanism for the sharing of the net cost of the universal service obligations between providers of services and/or users.

15. The Net Cost of USO I Christian Jaag Page 15 Incremental Cost 0% 100% Incremental Revenue (Several Operators) Incremental revenue (Single Operator) Competitive Market Segment Monopolistic Market Segment Unserved Market Segment Market Coverage

16. Competition II Incumbents vs. Entrants Market Entry Delivery Network Post Office Network Pricing

17. Market Shares in Liberalized Countries Christian Jaag Page 17

18. Determinants for Market Development –Legal aspects –Legal monopoly –Regulatory aspects –USO and their financing –VAT –Minimum wages –Network access –Pricing flexibility –Economic aspects –Cost structure (proportion of fixed costs, geography) –Volume development Christian Jaag Page 18 Uncertainty

19. Statutory Market Opening vs. Actual Liberalization CountryState of liberalizationEntry barriers GermanyFull liberalization since Jan. 2008 Working conditions VAT exemptions SwedenFull liberalization since March 1994 Working conditions FranceMarket > 50g liberalizedVAT exemptions for USO products FinlandFull liberalization since July 1991 Licensing fee (pay or play) Christian Jaag Page 19

20. Direct Competition: Market Shares Source: UBS Investment Research 2006

21. New players in postal markets –Former customers (newspapers, letter shops, mail order): downward integration to guarantee volumes Hermes, redmail, iq.letternet –Existing local networks for unaddressed mail / parcels / newspapers: use of economies of scope and density –Incumbent operators from abroad –to leverage international network (e.g. parcels, UPS, DHL) –in mail if local market is of strategic importance (e.g. Germany) –New players –due to low entry barriers (depending on regulation, incumbent price and quality, unemployment rate, and access conditions) –due to a lack of customer specific solutions (e.g. hospital solutions, innight services) Example: Dutch Mail Market Christian Jaag Page 21

22. Dutch Sandd in Figures Key Figures: 15% market share in liberalized market segments Average Price: 0.2 EBIT 8%; Turnover per Employee: 5500 20012002200320042005200620072008 Turnover (mio )471432506880 Volumes (mio #)153072130230320390400 # Clients251002694001000150020002200 # Fulltime Employees 60120180650900100011001150 # Distributors????9000120001250013000 # Distribution bases45809095 80 Coverage45%80%95%100% Source: Sandd Christian Jaag Page 22

23. Dutch Mail Market Services Offered in 2006 Source: Sandd 2008 Christian Jaag Page 23

24. Dutch Mail Market Services Offered in 2008 Source: Sandd 2008 Christian Jaag Page 24

25. Swedish Mail Market CityMail Regulation - Full market opening in 1993 - Labor market strongly regulated Strategy CityMail - Delivery of electronically sorted economy bulk mail - Delivery only twice per week in metropolitan areas - Approx. 1100 Employees, paid on a per-piece basis - Many full-time jobs, similar wages as Posten AB Reaction Posten AB - Aggressive Pricing, price increase for small customers - Dramatic reduction in post offices Christian Jaag Page 25

26. Christian Jaag Page 26 Post Office Network

27. Postal NetworkUniversal NetworkPostal Bank Network Leading exampleSwedenFranceNew Zealand Required authorizations Supply of Financial Services / Banking license Banking license Products (by incumbent) Postal Services onlyPostal Services Financial Transactions Financial Services Other Postal Services Financial Transactions Banking Services Agency types- Business Centers Agencies Doorstep Services Full range offices Postal business counters Full range offices Postal business counters Agencies Doorstep Services FranchisingOnly AgenciesNoMixed External FinancingNoYesNo Ideal for incumbents … … who are not allowed to provide financial services … who can count on external financing and are limited in outsourcing possibilities … who have a banking license Source: Buser, Jaag, and Trinkner (2008 ) Post Office Network Development Stylized Sustainable Models Christian Jaag Page 27

28. Post offices are not really needed for mail and parcels second best optimization problem Conflict between universal service provision and competition Should the post office network be part of universal services? Alternative networks? Alternative use: P.O. box delivery? Post Office Network Development Conclusion Christian Jaag Page 28

29. Pricing Issues Who should pay for postal services? How much? Felisberto et al. (2006), Friedli et al. (2007) Pricing the last mile could contribute to finance universal service Jaag (2007), Jaag and Trinkner (2008) Yes, but… Christian Jaag Page 29

30. Pricing Issues Welfare Aspects of Pricing Mail Source: Jaag (2007) Issues If sender pay, they may choose to send too little mail If receivers pay they may choose inefficient P.O. box delivery Christian Jaag Page 30

31. Pricing Issues Two-Sided Market Sender Receiver Operator 1 Upstream Downstream (delivery) Operator 2 Upstream (collection, processing)Downstream (delivery) Symmetric access to other platforms exclusive addresses (P.O. boxes) Private redistribution of postage between sender and receiver Source: Jaag, and Trinkner (2008) Christian Jaag Page 31

32. Observation – pricing structure Optimal pricing strategy: - Senders pay stamp price - Receivers pay subscriber fee and get money for every letter received (These results replicate partially observations from New Zealand) In such a setting, net profits on end-to-end services are about break even, whereas upstream services incur a loss and downstream business is profitable (i.e. running P.O. boxes and collecting access fees) The results indicate that competition in two-sided postal markets forces operators to strongly cross-subsidize large receivers Pricing Issues Optimal Pricing Structure Christian Jaag Page 32

33. How to Enter the market –Focus on high volume customers. –Distribute only on a few days per week to reach economies of scale. –Limit distribution to dense regions (in the beginning). –If available, use access to incumbent networks selectively. –Let subcontractors hire flexible, non-unionized staff on a part-time / per piece / per address base, let them walk-sequence on their own (e.g. at home) –Take advantage of having no stranded costs, no universal service obligation, no historically determined network, no pension funds deficits nor poorly negotiated collective agreements –Charge 20% lower prices Christian Jaag Page 33

34. Conclusions Incumbent s Point of View There are plenty of possible market entry strategies Liberalization means multiple, parallel and competing distribution channels. A significant loss of market power is inevitable. Know your weaknesses and tackle them both in business strategy and regulatory strategy (USO, working conditions, access, etc.) Pricing is key, but: Market share comes at the cost of margins (SE, NZ, UK), profits at the cost of market entries (see NL, GE). Christian Jaag Page 34

35. Break Time.

36. Market Simulation Pricing and Market Entry

37. Objective and Initial Situation Objective of the simulation: Convey an idea about… …possible market entry strategies …possible market developments …the importance of regulation Initial situation Starting date is February 4th 2010. The simulation covers the markets for addressed business originated mail above 50g and newspapers. Competitors consider market entry, incumbent defends. Christian Jaag Page 37

38. Simulation Rules Input Participants 3 Groups (stay in the room), no collusion Timing: 3 Rounds. Groups hand in their decisions on paper. Market simulation short feedback If no decisions are handed in on time, the values from the previous round are applied. Timing 15 Min. Introduction 30 Min. Simulation 10 Min. Conclusion Pricing for business customers Prio / Eco / News Metro/Urban under competition Assignment: 20 Min.15 Min. Christian Jaag Page 38

39. Market Characteristics I There are four products (partial markets): Priority Single Piece Mail (PRIO S) requires daily delivery and investment in modern processing technology. Delivery in rural areas causes high transportation costs. Economy Single Piece Mail (ECO S) requires delivery twice per week and investment in modern sorting technology. Economy Bulk Mail (ECO B) requires delivery twice per week. As these mails are sequenced electronically, they do not require investment in sorting technology. Newspapers (NEWS) require daily delivery and investment in modern processing technology. Private operators need early- morning delivery in order to be competitive in this market. Christian Jaag Page 39

40. Market Characteristics II Incumbent plus two entrants: Publishers and foreign postal operator 70% of the Swiss population live in metropolitan areas Entrants must underprice the incumbent Christian Jaag Page 40

41. Simulation Tool: Market Equilibrium Christian Jaag Page 41

42. Simulation Tool: Inputs Input parameters: 1) Price per region and product 2) Remarks: opportunities, challenges (optional) Switching behavior Cost structure: 1) Variable cost 2) Fixed cost Current price for mail > 50 g (business customers) Christian Jaag Page 42

43. Conclusion Possible market developments? How to attack / how to defend? What is the role of regulation? Strategic alternatives? Christian Jaag Page 43

44. Game-Theoretic Analysis The Market for Early-Morning Delivery

45. Status Quo 2008 In the 1970s, the first publishing company in Switzerland established its own early morning delivery network (5 to 6:30 am). Markets for early morning delivery are dominated by big publishers. From 2008 on: reduced subsidies for newspapers Daytime delivery becomes less attractive. Increasingly, magazines are being delivered in the early morning (market opening!). What can be done by Swiss Post? Would entry into the market for early-morning delivery be profitable? What would competitors do? Christian Jaag Page 45

46. -2 +1 0000 Early-morning delivery (Post) Expansion (Competitor) yes no yesno There are no dominant strategies! Strategic Game I Christian Jaag Page 46

47. -2 +1 0000 There are two nash equilibria in pure strategies which one can be reached? Strategic Game II Early-morning delivery (Post) Expansion (Competitor) yes no yesno Christian Jaag Page 47

48. NZZ, 19.1.2008 Christian Jaag Page 48 Swiss Post establishes ist own early-morning delivery network.

49. Basler Zeitung, 19.6.2008 Christian Jaag Page 49 Basler Zeitung sells ist delivery organization to Swiss Post.

50. Berner Zeitung, 3.10.2008 Christian Jaag Page 50 Swiss Post becomes number one.

51. www.kepmail.ch, 2.10.2008 Christian Jaag Page 51 Swiss Post establishes a new monopoly in the market for early- morning delivery.

52. Sonntag MZ, 11.1.2009 Competition commission investigates Swiss Posts newspaper-deal.

53. Natural monopoly Market consolidation is inevitable BUT: Currently, there are parallel delivery organizations! Contestability Potential competition Efficiency gains by neutrality of delivery platform Independence of early mornig delivery and daytime delivery (time slot) Core Arguments Christian Jaag Page 53

54. NZZ, 26.9.2009 Christian Jaag Page 54 Early-morning newspaper delivery is Swiss Posts business.

55. Christian Jaag, Ph.D. Swiss Economics Managing Partner Abeggweg 15 christian.jaag@swiss-economics.ch8057 Zürich www.swiss-economics.chSwitzerland Thank you for your attention!