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Disclaimer: These views are my own and not those of the Federal Reserve Bank of Chicago or the Federal Reserve System.  Much of this discussion is taken from my paper titled “Externalities in Payment Card Networks: Theory and Evidence” presented at the Federal Reserve Bank of Kansas City’s 2009 Retail Payments Conference.

Generally, merchants charge the same price regardless of the type of payment instrument used to make purchases. In many jurisdictions, merchants are not allowed to add a surcharge for payment card transactions because of legal (some states in the U.S. do not allow surcharges) or contractual (card networks generally do not allow surcharges) restrictions. But, merchants may be permitted to offer discounts for noncard payments. Economic models of payment cards generally conclude that social welfare improves if merchants set prices based on payment instrument used.

There are examples of jurisdictions where no-surcharge restrictions have been lifted. To encourage better price signals, the Reserve Bank of Australia removed no-surcharge restrictions. While most Australian merchants do not impose surcharges for any type of payment card transaction today, the number of merchants who do is increasing. At the end of 2007, around 23 percent of very large merchants and around 10 percent of small and very small merchants imposed surcharges. In addition to allowing price differentiation across payment instruments, the RBA allowed merchants to price differentiate across networks. The average surcharge for MasterCard and Visa transactions is around 1 percent, and that for American Express and Diners Club transactions is around 2 percent (Reserve Bank of Australia, 2008).

Some economists have stressed that merchants may surcharge consumers more than their costs resulting in suboptimal card use. A potential regulatory response is to cap the surcharge. In responding to the 2007/08 review of reforms by the Reserve Bank of Australia, some market participants suggested that merchants might be imposing higher surcharges than their cost to accept payment cards. The RBA has considered setting a limit for the surcharge amount but has not gone ahead with implementing one.

In the United States, merchants are allowed to offer cash discounts but may not be allowed to surcharge credit card transactions. In the 1980s, many U.S. gas stations explicitly posted cash and credit card prices. Barron, Staten, and Umbeck (1992) report that gas station operators imposed these policies when their credit card processing costs were high but later abandoned these policies when acceptance costs decreased because of new technologies such as electronic terminals at the point of sale. Recently, some gas stations brought back price differentiation based on payment instrument type, citing the rapid rise in gas prices and declining profit margins.

In the Netherlands, Bolt, Jonker, and van Renselaar (2009) study the impact of debit card surcharges. They report that a significant number of merchants are setting different prices, depending on whether cash or a debit card is used. Debit card surcharges are widely assessed when purchases are below 10 euro. Bolt, Jonker, and van Renselaar find that merchants may surcharge up to four times their fee. In addition, when these surcharges are removed, they argue, consumers start using their debit cards for these small payments, suggesting that merchant price incentives do affect consumer payment choice. Interestingly, in an effort to promote a more efficient payment system, the Dutch central bank has supported a public campaign to encourage retailers to stop surcharging and for consumers to use their debit cards for small transactions.

There are instances when card payments were discounted vis-à-vis cash payments. During the conversion to the euro from national currencies, one German department store offered discounts for using cards because of the high initial demand for euro notes and coins to make change for cash purchases (Benoit, 2002). It should be noted, however, that the retailer was in violation of German retailing laws for doing this. In a more permanent move, the Illinois Tollway charges motorists who use cash to pay tolls twice as much as those who use toll tags (called I-PASS), which may be loaded automatically with credit and debit cards when the level of remaining funds falls below a certain level. In addition to reducing cash handling costs, the widespread implementation of toll tags decreased not only congestions at toll booths but also pollution from idling vehicles waiting to pay tolls. In both of these cases, the benefits of using cards outweighed the costs.

Another rule that restricts merchants is the honor-all-cards rule. A payment card network may require that merchants that accept one of its payment products to accept all of its products. In other words, if a merchant accepts a network’s credit card, it must accept debit and prepaid cards from issuers belonging to that network. Such a rule enables a card network to innovate by producing different products that when introduced will have a large base of merchants that accept them bypassing the chicken-and-egg problem. The introduction of payroll cards, a type of prepaid card, is an example of an innovation that leverages a card network’s existing infrastructure.

In the United States, around 5 million merchants sued MasterCard and Visa over the required acceptance of the network’s signature-based debit card when accepting the same network’s credit card. The case was settled out of court. MasterCard and Visa agreed to decouple merchants’ acceptance of their debit and credit products. While few merchants have declined one type of card and accepted another type, the decoupling of debit and credit card acceptance may have increased bargaining power for merchants in negotiating fees.

A subset of the honor-all-cards rule is the honor-all-issuers rule. If a merchant accepts a credit card from one issuer, it must also accept credit cards from another issuer within the same network. Such a policy levels the playing field between large and small issuers. Otherwise, small issuers may not be able to compete with the large issuers because of economies of scale and network effects.

Another type of honor-all-cards rule could cover the acceptance of different credit or debit cards from the same issuer. For example, an issuer may have a plain vanilla credit card and also have others that earn different types of rewards. While merchants may not care what types of rewards their customers receive from their banks, merchants may pay different fees based on the type of card used by their patrons from a single issuer. More recently, certain policymakers are considering allowing merchants to discriminate within a card classification, such as a credit card, based on differences in interchange fees.

Sujit ‘Bob’ Chakravorti is a senior economist in the financial markets group at the Federal Reserve Bank of Chicago.

Disclaimer: These views are my own and not those of the Federal Reserve Bank of Chicago or the Federal Reserve System.  Much of this discussion is taken from my 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.