In this paper we discuss an incumbent postal operator’s incentives to invest in an innovation in the face of upcoming liberalization and deregulation of the letter market. Our contribution is a short description of recent innovations in the Swiss mail market and their interpretation in light of an illuminative yet tractable model. Following the literature, we distinguish between product and process innovation. We characterize competitive pressure by a reduction in the incumbent’s market share and an increase of his/her perceived price elasticity of demand due to consumers’ switching to competitors. This may result in adverse incentives to invest in an innovation. Likewise, deregulation leads to increased entrepreneurial freedom on the operator’s side and possibly a lower burden of USO (universal service obligations), reflected in lower cost. This sustains incentives to invest in both product and process innovation.post, liberalization, privatization, regulation

Christian Jaag

English

Research Papers in Economics

 
   
 
swiss economics swiss economics
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Christian Jaag 
 
Innovation in the Swiss mail sector: 
deregulation versus liberalization 
 
Swiss Economics Working Paper 0009 
December 2007 
 
 
 
 
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www.swiss-economics.ch Innovation in the Swiss mail sector: deregulation versus liberalization 
Christian Jaag 
 
 
Abstract  
In this paper we discuss an incumbent postal operator’s incentives to invest in an innovation in 
the face of upcoming liberalization and deregulation of the letter market. Our contribution is a 
short description of recent innovations in the Swiss mail market and their interpretation in light 
of an illuminative yet tractable model. Following the literature, we distinguish between product 
and process innovation. We characterize competitive pressure by a reduction in the incumbent’s 
market share and an increase of his/her perceived price elasticity of demand due to consumers’ 
switching to competitors. This may result in adverse incentives to invest in an innovation. 
Likewise, deregulation leads to increased entrepreneurial freedom on the operator’s side and 
possibly a lower burden of USO (universal service obligations), reflected in lower cost. This 
sustains incentives to invest in both product and process innovation. 
1.  Introduction  
Liberalization of the postal market is under way in the EU (European Union) as well as in 
Switzerland. Particularly, the reserved area securing the incumbent postal service providers’ 
monopoly position for letter mail conveyance is supposed to disappear soon. In the EU the 
reserved area is generally confined to mail weighing less than 50 g since the beginning of 2006, 
whereas in Switzerland this limit has been set to 100 g on 1 April 2006. It is often put forth that 
such market opening and the emergence of competition will finally be able to foster innovation 
in a sluggishly developing postal sector. This paper challenges that view and discusses the effects 
of liberalization and deregulation in the postal sector on the incumbent’s motivation to innovate. 
We argue that stringent governance by the operator’s owner and partial deregulation has well 
served as a driver for innovation in recent past and that competition in the mail sector will 
unlikely further increase them. The paper’s contribution is a discussion and analysis of recent 
innovations in the Swiss mail sector. While also specific entrant strategies such as cream-
skimming may influence the incumbent operator’s incentives to innovate, we abstract from such 
considerations and confine our argument to three general effects of competition and 
deregulation, namely–an increase in perceived price elasticity of demand, a loss of market share, 
and a decrease in unit-processing cost. 
1.1  Related Literature  
Early literature in the field of industrial organization predicted that innovation should decline 
with competition because increase in competition reduces monopoly rents that reward innovative entrants ( Dasgupta and Stiglitz 1980; Caballero and Jaffe 1993). Subsequent 
empirical work has found a positive correlation between competition and innovation which has 
spurred theoretical considerations explaining these findings. Aghion, Dewatripont, and Rey 
(1999) introduced competition as an incentive device into a Schumpeterian growth model. 
Aghion, Harris, Howitt, and Vickers (2001) extend that model by allowing incumbent firms to 
innovate. There, competition may increase the profits from innovation and encourage 
investments aimed at escaping competition. Aghion, Bloom, Blundell, Griffith, and Howitt 
(2005) argue that in levelled industries innovation incentives are higher than in unlevelled ones, 
reducing the fraction of industries of the former type in competition. They derive predictions of 
that model and confront them with data from a panel of firms from the UK. Their main finding is 
that low levels of competition spurs innovation by supporting attempts to escape such rivalry, 
while at high levels of competition, the laggard’s reward to catching up with the technological 
leader falls. Aghion, Blundell, Griffith, Howitt, and Prantl (2006) adapt this kind of reasoning to 
the analysis of entry on innovation incentives to an incumbent firm. Also, Boone (2001) finds a 
non-monotone relation between intensity of competition and the incentives to innovate. Dietl, 
Felisberto, Finger et al. (2005); Dietl, Grütter, and Lutzenberger (2006) analyse the effect of 
regulation and deregulation of letter markets on process and product innovation under various 
regulatory scenarios. 
1.2  Product innovation in the Swiss mail sector  
In recent years, Switzerland experienced a series of product innovations in the mail sector. 
Figure 1 displays revenues generated by new mail products at the Swiss Post which serves as a 
good proxy for product innovation. At first glance it seems compelling that progressive 
liberalization (or the expectation of it) must have had a major impact on innovation. 
Figure 1 Revenue from new products at Swiss Post Mail (in thousand Swiss Francs (CHF) per 
month) 
 
Source: Swiss Post It is typical for the Swiss mail market that this performance measure has been introduced only in 
2003.  Since then the management is accountable for new products and processes. Earlier, 
product innovation was obviously not an important issue but there has been a steady increase in 
product innovation since 2004. Products are considered new during their first three years of 
existence. In the considered time period, the products specified in Table 1 fell into this category. 
Most of these either reflect the positive trend in the use of direct marketing or depend directly on 
the emergence of the ubiquitous availability of telecommunication technology. 
Table 1 Recent product innovations at Swiss Post Mail 
2003  Direct Response Card; Direct Marketing Services; Hybrid Post; Geo Post; 
Mail2Paper 
2004  Direct Response Card; Hybrid; Virtual Direct Mail; Promo partially addressed; 
Geo; Address data; Sorting data 
2005  Free newspapers; On Time Mail; Direct Self-mailer 
2006  Free newspapers; On Time Mail; Direct Self-mailer; Prepayment Post 
Source: Swiss Post 
1.3  Process innovation in the Swiss mail sector  
Besides product innovations, there has also been important process innovations aimed at 
reducing cost. For example, Optical character recognition (OCR) technology allowed for 
introduction of automatic sorting. At Swiss Post Mail, project REMA (re-engineering mail 
processing), which will be in full operation in 2009, centralizes sorting activities by reducing the 
number of sorting facilities from eighteen to three (with six sub-centres). This yields large gains 
from the exploitation of scale economies. Another process innovation will be implemented by the 
project ‘move-it’ which introduces flexible working hours in personnel-intensive delivery. 
Another field of recent process innovation has been the optimization of the postal outlet 
network. In Switzerland, between 2001 and 2005, the number of full postal outlets was reduced 
from 3396 to 1767, while 657 outlets with a reduced choice of services and 126 postal agencies 
were newly created. Many households, beyond the reach of a postal outlet, are now being served 
with postal products at their doorstep by the postman during his mail delivery tour. During this 
time period, the overall reduction in access point amounted to 122 only. Swiss Post claims that 
600 outlets would be enough for full-area coverage. However, further restructuring is restrained 
by tight regulation. 
2.  The driving forces of innovation in mail  
It may be argued that the surge in innovation is primarily due to the prospect of liberalization in 
the mail sector. However, we will show that there are other forces driving innovation which are 
as important. It may be illustrative to start with a short history of recent legislative developments in the postal sector. In 1998, Swiss PTT (Post, Telegram, Telegraph) was broken up into 
Swisscom and Swiss Post operating in the telecommunications and postal markets, respectively. 
At the same time, Swisscom was fully privatized, while Swiss Post remained in full public 
ownership under public legal form. Only then did the Swiss government start prescribing 
concrete profit goals for postal operation. Table 2  summarizes the most important milestones in 
postal legislation which led to severe restructuring and innovation in this sector. 
Table 2 Important milestones in postal legislation 
2002  Liberalization schedule for postal market presented by the Swiss government 
2003  Reserved area reduction to 100 g in the European Union 
2004  Appointment of a regulatory authority for the postal sector in Switzerland 
2004  Reserved area reduction to 1 kg (parcels) in Switzerland 
2006  Reserved area reduction from 100 g to 50 g in the European Union 
Reserved area reduction from 1 kg to 100 g Switzerland 
Source: Swiss Post 
 
At the same time, new technologies have become available, enabling deep restructuring of the 
mail process. Hence, besides the mere prospect of liberalization, there are three major forces 
governing innovation. 
  Guidelines by the regulatory authority Only in 1998, with the break-up of the PTT, the 
Swiss government started to stipulate considerable profit from the Swiss Post. Prior to this, 
there was at most an informal instruction to break even with no incentives to improve. 
  Technological progress The emergence of ubiquitous availability of information 
technology allowed for the convergence of classic and electronic mail services, leading to the 
introduction of innovative products. Moreover, only recent technology advancements allow 
for a centralization of mail processing and network optimization. 
  Deregulation Deregulation gives a postal operator more freedom in its organizational 
structure, but also in its range of products and pricing. For instance, the recent re-
engineering of mail processing in Switzerland has been made possible through the possibility 
to reduce its workforce and centralize production. Deregulation also reduces the scope of 
USO, such as by allowing postal operators to reduce the number of outlets or merge them 
with local grocery stores. This also contributes to increased flexibility in the market. 
We conclude that the relationship between competitive pressure and innovation is rather a 
correlation than the effect of strict causality. There may be no direct economic relationship, but rather a political one—only the prospect of competition allows the politically responsible 
authorities to implement unpopular measures enhancing efficiency and endorsing cost-cutting 
measures by a postal operator. 
3.  The effects of liberalization and regulation  
The following considerations are based on a stylized market for mail delivery.2 Consider a setting 
of imperfect monopolistic competition in which the incumbent postal operator faces bounded 
price-elasticity of demand. We further assume that product innovation induces higher mail 
volumes. Then, the postal operator’s marginal benefit, with respect to product innovation is 
higher since the mark-up over marginal cost applies to the larger quantity. A higher mark-up 
induces increased investment in product innovation. This effect is smaller when the incumbent’s 
market share is lower. Hence, competition directly reduces innovation incentives at that margin. 
An increase in the price elasticity of demand lowers the optimum price and thereby raises 
quantity. Hence the effect of an increase in price elasticity of demand on a product innovation is 
ambiguous. 
A change in marginal cost, which may be induced by regulation, has two opposite effects on 
product innovation. On one hand, by inducing a higher optimum price, it decreases quantity and 
therefore reduces the incentives to innovate. On the other hand, increase in the absolute mark-
up encourages product innovation aimed at increasing volume. 
As to process innovation, marginal benefit emerges from higher quantity demand due to a lower 
optimum price as above. This effect is greater the higher the incumbent’s market share and the 
more price elastic the consumer demand. Another benefit arises from an increasing mark-up due 
to improved processes, which is tightened by high unit processing cost. However, an increase in 
the perceived price elasticity of demand lowers the mark-up, making process innovation less 
attractive. This effect prevails if the incumbent’s overall demand is low. Hence, its overall effect 
on process innovation is ambiguous. Liberalization (that is, market opening) increases 
competitive pressure in the market. There are two effects associated with it. First, the price 
elasticity of individual demand is increased. While the market price elasticity of demand is not 
affected, individuals now have a choice among several operators through a positive switching 
elasticity. Second, market opening reduces the incumbent’s market share. 
There are two main adverse effects of competition on innovation. First, competition reduces the 
incumbent’s quantity and hence the basis for the redemption of his/her investment in process 
innovation. Second, the attainable mark-up shrinks, such that gains in productivity have to be 
                                                 
2 The discussion is based on a small theoretical model discussed in Jaag (2007a).  
A more detailed model of the Swiss market for mail delivery is given in Jaag (2007b). 
 passed on to consumers. In our considerations, product and process innovation complement 
each other, and a reduction in process innovation drags down product innovation as well. Our 
considerations are much in line with Dietl, Grütter, and Lutzenberger (2006) in that it is 
quantity demanded which primarily drives the incentives to innovate. 
On the other hand, deregulation and a reduction in the scope of USO reduce a postal operator’s 
cost all else being equal. This gives rise to a lower price in equilibrium and higher quantity. 
Hence, the same reasoning as with respect to liberalization applies, albeit with a different 
(positive) sign. 
4.  Conclusion  
In this paper we have studied the effect of competition due to liberalization in the postal sector 
on the incumbent’s incentives to innovate. Product innovation bears a stimulating effect on 
demand while process innovation lowers unit cost. In recent years, Swiss Post Mail introduced 
many innovations – seemingly due to the impending opening of the letter market. We argue that 
there is no direct economic effect of competition on innovation but rather a political one. The 
dawn of competition enabled the government to sharpen the profitability demand for Swiss Post. 
This and the emergence of the relevant technologies (and the approval to use them) led the 
operator to restructuring and innovation. The effect of competition on product and process 
innovation in our considerations can be summarized as follows—a reduction in market share 
reduces investment in product and process innovation unambiguously. This is the standard 
effect known from the industrial-organization-literature that competition reduces monopoly 
rents and therefore innovation incentives. An increase in the consumers’ price sensibility reduces 
investment in product innovation if marginal cost is high. Its effect on process innovation is 
negative as well if volumes are low. 
Deregulation reduces cost, which in equilibrium is translated into a lower price. Higher resulting 
volumes increase the operator’s incentives to invest both in product and process innovation. Our 
considerations show that the forthcoming full liberalization of postal markets in Europe should 
be accompanied deregulation measures. The creation of increase commercial freedom for 
incumbent postal operators in their reaction to increased competition is the key to keeping 
incentives to innovate high in the postal future. References 
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obligations 
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Competition and innovation: an inverted-U relationship The Quarterly

How High are the Giants’ Shoulders? An Empirical Assessment of Knowledge Spillovers and Creative Destruction in a Model of Economic Growth Cambridge,

Intensity of competition and the incentive to innovate

Liberalization of the Swiss letter market and the viability of universal service obligations

The Effect of Deregulation and Liberalization on Innovation in the Swiss Mail Sector Berne: Discussion Paper, Swiss Post.

The Effect of Regulation on Innovation in the Postal Sector Zürich and Lausanne: Discussion Paper,

The effects of entry on incumbent innovation and productivity Cambridge,

W12027] Details available at < http://nber15.nber.org/papers/w12027> Aghion

Innovation in the Swiss mail sector: deregulation versus liberalization

http://www.swiss-economics.ch/RePEc/files/0009Jaag.pdf

Innovation in the Swiss mail sector: deregulation versus liberalization

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