In my first post I discussed the potential for interchange legislation from a consumer protection perspective, that is, would the combination of disclosure requirements coupled with a reduction of interchange fees be likely to improve consumer welfare. I concluded that from the consumer protection perspective, the case for interchange legislation was weak. I noted that a highly likely consequence of a direct or indirect reduction in interchange would result in an increase in the cost of credit to consumers (higher finance charges, other fees, annual fees) or a reduction of consumer benefits (loyalty and rewards programs). The significant risk of a reduction of consumer access to credit, especially given the tenuous state of the economic recovery and the critical role of consumer spending in generating economic expansion and jobs, imposes a significant risk of consumer and social losses without strong evidence of offsetting consumer protection value. However, consumer protection is not the only possible defense of such legislation. This post will focus on defense of interchange legislation from a competition policy perspective.
As the commentators in this symposium suggest, as does the long and storied antitrust history of Visa and MasterCard, the more conventional story is that interchange fees are the product of a market power and the lack of competition between payment card systems. Much of the discussion here has followed that general framework and focuses on the “cross-subsidy” question and the role of interchange legislation in increasing efficiency by reducing “usage” externalities. The essence of this argument is that interchange fees should be regulated or eliminated in order to avoid cross-subsidization of payment card users by those using cash or checks (but see Ron Mann’s post here, focusing on the subsidy running from high interchange credit products to low interchange debit transactions). So far, the symposium contributors have been largely skeptical of this defense. For example, my colleague Todd Zywicki notes;
So it may be theoretically possible to imagine that credit cards are overused as a transaction medium. On the other hand, it may also be possible that consumers underuse electronic payments because they don’t consider the social benefits of electronic payments, such as increasing efficiency, tax compliance, reduced risk of theft (and the police force and judicial system that accompany that)—in which case, it is possible that credit cards should be subsidized, not taxed. Finally, it seems at least as plausible (probably more so) that consumers overuse cash and checks because those payment systems are subsidized by the government or that some of their costs are externalized, thus consumers don’t pay their full price.
Tom Brown and Tim Muris argue that the objection to cross-subsidies is overdone, emphasizing the ubiquity of such cross-subsidies and noting that the shift toward electronic payments render this objection largely moot:
At the outset, we note that discount fees, unlike interchange, are a feature of virtually all private payment instruments. Thus, if there is something to the notion that discount fees tax other forms of payment, then the criticism applies as much to American Express and Discover as it does to MasterCard and Visa. In our view, however, although this criticism is oft repeated, repetition obscures a number of problems.
First, cross-subsidies are ubiquitous in any complex economy. Consumers receive free refills on drinks in restaurants, free parking at shopping malls, goods below cost in supermarkets (via loss leaders), relatively inexpensive newspapers because advertisers pay most of the costs, and many similar benefits. To bring buyers and sellers together through such intermediaries as newspapers, supermarkets, and credit cards, one side frequently receives inducements to participate. These inducements help maximize the joint value of the ultimate transaction for the parties. Rather than an inefficient “subsidy,” these inducements are the lubricant necessary to make the economic machine work at its best.
I agree with these commentators that the cross-subsidy “problem” does not warrant a regulatory fix. But I have a slightly different, and more antitrust-centric perspective. Brown and Muris note the ubiquity of cross-subsidies in restaurants, supermarkets, and shopping malls. These are just examples. Cross-subsidization would occur not only in these settings, and in settings where firms do not plausibly have market power, but would also occur in closed-loop systems that do not use interchange fees, suggesting that this criticism has more to do with the necessity of balancing in two-sided markets rather than interchange per se. But the important point from an antitrust perspective is that cross-subsidization is a normal and healthy part of the competitive process that generates substantial benefits for consumers. The normal competitive process frequently does not result in customers being charged for all of the costs associated with their purchases. Consumers face such cross-subsidies every time they go to Starbucks for their caffeine fix or an all you can eat buffet. Some consumers are very sensitive to which products are allocated to the eye level shelf space in the grocery store, while others will purchase their favorite product regardless of where it is put on the shelf. The very idea of promotion is to target what amount to effective discounts at marginal consumers rather than the infra-marginal ones. See generally, Benjamin Klein, Kevin Murphy, Andres Lerner and Lacey Plache, Competition in Two Sided Markets: The Antitrust Economics of Payment Card Interchange Fees, 73 Antitrust L.J. 571 (2005).
Understanding the nature of promotion, and therefore cross-subsidization, as a part of the normal competitive process offers a new perspective on the potential for interchange legislation as an antitrust remedy. Competition in highly competitive markets, such as grocery retail, results in supermarkets competing by offering various promotional services to marginal consumers. Sometimes this competition results in free parking that some consumers use but others pay for, sometimes it results in dimensions of non-price competition (like offering a deli or keeping the store clean) that some consumers value more than others. Competition between supermarkets to shift sales from these marginal consumers generate largely inter-retailer effects, but that cannot be said to be “inefficient” in any meaningful way. This form of competition is essential to the competitive process. Consider the interchange legislation in this light. Do we, in response to supermarket competition resulting in “usage externalities” call for legislation that would allow the supermarkets to collude? Of course not. From a competition perspective, the very idea of replicating the collusive outcome for merchants and allowing a coordinated reduction in competition on the grounds that it would reduce cross-subsidies or costs wouldn’t make economic sense. But notice that collusion between supermarkets to refuse to offer free parking, clean stores, or other promotional services would surely reduce the costs to the retailers in the same way that interchange would result in a reduction of costs to the merchants.
One possible explanation of our tolerance of these arguments is a failure to understand that, like in the case of supermarkets, competition between merchants on the acceptance of payment cards is a normal part of the competitive process. But there is another possible and more plausible argument: countervailing power. In other words, one could argue that legislation to allow collective monopsony conduct is appropriate to offset monopoly power (see, e.g., Steve Salop’s recent guest post here at TOTM on this issue in a different context). Whether or not this justification is persuasive depends on the degree to which payment system market power explains interchange fees. As it turns out, there is not compelling evidence that this is the case. For example, consider that regulation reducing the interchange fees for open loop systems (and reducing their ability to balance both sides of the market) results in a shift of total credit purchase volume toward closed loop systems. The loss in share that MC and Visa experienced in reaction to the Australian regulation suggests that interchange levels were not supra-competitive before the regulation. Further, as Klein et al (2005) suggest, the time series evidence also casts doubt over the claim that market power explains interchange fee levels since fees were falling from 1977 to 91 while the importance of the payment systems was growing, and that fees remained lower in 2005 than they were in 1971. In short, interchange fee levels appear to be a poor proxy for market power, and there does not appear to be convincing empirical evidence that market power explains changes in interchange fees.
In the absence of such evidence of a compelling problem, the regulatory “fix” of replicating the collusive outcome for merchants and interfere with the normal competitive process appears to be sure to shift rents between sides of the market, but more importantly, to impose a significant risk of doing more harm than good for the consumers it is purportedly designed to protect.