The Economics of Payment Cards: Six Lessons from the Literature

Much of this discussion is taken from the author’s paper titled “Externalities in Payment Card Networks: Theory and Evidence” presented at the Federal Reserve Bank of Kansas City’s 2009 Retail Payments Conference.

The proliferation of payment cards has dramatically changed the ways we shop and merchants sell goods and services. Today, payment cards are indispensable. Recent payment surveys also indicate that consumers are using payment cards instead of cash and checks. Some merchants have started to accept only card payments for safety and convenience reasons. For example, American Airlines began accepting only payment cards for in-flight purchases on all its domestic routes since June 1, 2009. Wider acceptance and usage of payment cards suggest that a growing number of consumers and merchants prefer payment cards to cash and checks.

To date, there is little consensus on what constitutes an efficient fee structure for card-based payments. Reviewing the economic literature on payment cards, I find that no one model is able to capture all the essential elements of the market for payment services. It is a complex market with many participants engaging in a series of interrelated bilateral transactions. Much of the debate over various payment card fees is concerned with the allocation of surpluses from consumers, merchants, and banks, as well as the question of who is able to extract surpluses from whom. Economic models of payment cards generally ignore the allocation of surplus among participants at a given level of social welfare but instead focus on externalities that prevent achieving the highest social welfare.

There are several conclusions that I draw from the academic models. First, a side payment between the issuer and the acquirer may be required to get both sides on board.  In this case, the side payment is the interchange fee. This side payment may skew the prices paid by end-users.  This sort of asymmetric pricing exists in other industries such as newspapers (readers and advertisers), dating clubs (price differences for men and women), and software such as Adobe Acrobat (document readers and creators). Once fully adoption is reached or the market has reached saturation, the adoption externality disappears but the usage externality may remain.

Second, many economic models suggest that the socially optimal interchange fee structure may not be systematically lower than the network profit-maximizing fee. In other words, the lowest fee is not the one that maximizes social welfare. Wilko Bolt and I construct a model where underlying cost structures such as credit card defaults, crime, and system operating costs determine the optimal acceptance of payment cards. For certain sets of cost parameters, we find that the socially optimal merchant fee may be higher than the bank profit-maximizing merchant fee.

Third, removing merchant pricing restrictions generally improve market price signals. While consumers generally react to price incentives at the point of sale, merchants may be reluctant to charge higher prices to consumers using certain types of payment cards. However, surcharging is increasing in jurisdictions where it is allowed. Furthermore, the ability to surcharge may increase the bargaining power of merchants resulting in downward pressure on merchant and interchange fees.

Fourth, merchant, card issuer, or network competition may result in lower social welfare contrary to generally accepted economic principles. Merchants may use card acceptance as a tool to steal customers resulting in the willingness to pay higher fees. But, when all merchants accept payment cards, total sales across merchants remains constant. Card issuers may try steal cardholders from their competitors with incentives partially or wholly paid for by interchange fee revenue. The recent GAO report suggests that interchange fee revenue may be necessary for some smaller community banks and credit unions to issue credit cards so that they can be competitive with larger issuers especially if fewer of their cardholders revolve debt. Lastly, network competition may put upward pressure on interchange fees because networks are competing for issuers that prefer higher interchange fee revenue given all else equal.

Fifth, both consumers and merchants value credit extended by credit card issuers (along with other benefits such as security), and consumers and merchants are willing to pay for it. When credit cards were first introduced, many smaller merchants adopted general-purpose cards to reduce costs associated with direct lending to their consumers. Merchants often offer subsidized credit to their customers to gain loyalty or increase sales.

Sixth, if warranted, fees set by the authorities should not only consider costs but also benefits received by consumers and merchants, such as convenience, security, and access to credit that may result in greater sales. Policymakers in various jurisdictions often regulate interchange fees by only focusing on costs. Both consumers and merchants may benefit from cards and it is not clear that one party should not pay for it. Clearly, regulating interchange fees by costs and benefits would be difficult.

In reality, the motivation for why public authorities intervene differs across jurisdictions. In addition, the type of public institution that regulates payment cards also differs. The institution may be an antitrust authority, a central bank, or a court of law. Often public authorities intervene because the interchange fee is set by a group of competitors and the level of the fee is deemed to be excessive. In other cases, by mandating fee ceilings, authorities expect greater number of merchants to adopt payment cards instead of cash. In addition to cash handling and safekeeping costs, some public authorities may find the inability to trace cash transactions an unattractive feature of cash.  Alternatively, some policymakers argue that lowering card issuers’ interchange revenue may reduce incentives to cardholders to use more costly payment cards (for example, credit cards instead of debit cards).

Determining sound public policy regarding the allocation of payment fees is difficult. The central question is whether the specific circumstances of payment markets are such that intervention by public authorities can be expected to improve economic welfare. Efficiency of payment systems is measured not only by the costs of resources used, but also by the social benefits generated by them. Clearly, further research is warranted to explore the complex market for payment services, and policy recommendations should be based on more in-depth research, especially empirical studies that focus on the effects of government intervention.