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Situation

When executives in a state-owned company face the liberalization of its industry, they may well encounter a trade-off long familiar to managers reared on competition: to what extent should they lower prices to gain market share or maintain those prices to protect their margins? That was the problem facing an incumbent European postal service eyeing the rapid growth of private delivery services in response to an EU directive calling for postal deregulation by 2009. The incumbent found that competitors were cherry-picking its most profitable segments: business customers and deliveries in densely populated regions. In response, it considered cutting its prices and relying on its superior economies of scale to muscle out the new players.

Complication

A simulation of the competitors' economics and of the likely effects of changing products and prices showed the incumbent that it couldn't undercut its rivals without incurring an unacceptable decline in profitability. One reason was the labor cost advantage the attackers enjoyed (exhibit). Moreover, the incumbent found that charging different prices for its urban and rural deliveries (a possibility given the regulatory environment) would also be counterproductive: increasing the price of mail in rural areas would simply make them more attractive to competitors, and its high fixed costs (including unionized labor and expensive sorting facilities) meant that even a small loss in volume would hurt profits. Indeed, a 20 percent decrease in utilization would slash margins by 70 percent.

Resolution

The incumbent therefore cut its costs by, among other measures, switching to more productive sorting equipment and negotiating new work hours with the union. It also improved its volume forecasting to adjust more quickly to fluctuating demand and focused on customer service by emphasizing its comprehensive household coverage, which it had previously regarded as a limitation. Meanwhile, the incumbent showed its business customers how its superior service and coverage had real financial value for them by speeding up invoice payments and responses to direct-marketing campaigns. The incumbent was able to maintain its margins while lowering its overall cost base by 2 to 4 percent.

Implications

Such tactics, though commonplace in competitive industries, are often unfamiliar to monopolies. They shouldn't be. Europe's incumbent postal services earn from one-third to three-quarters of their revenues—and the bulk of their operating profit—from mail delivery. Looming deregulation therefore makes that market tempting to a variety of competitors, including small logistics providers, newspapers, and even publishing houses. To fend them off, an incumbent must improve its understanding of both its own costs and their economics; some attackers can be profitable by gaining only 2 to 5 percent of the urban markets they serve. By modeling the cost to serve customers, the incumbent can make better pricing decisions and even identify new markets it might enter as a challenger.

technorati tags:economics, research, european, market, competition