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Assessing the Social Effects of the Use of Credit Cards

Allan Shampine —  9 December 2009

The GAO has a fairly extensive discussion of the costs and benefits of credit cards to merchants.  However, that discussion focuses on the individual benefits.  I would like to step back and put two of those benefits – increased merchant sales and fraud prevention costs – into the larger context that I discussed earlier.

First, there is the question of credit cards increasing merchant sales.  How exactly does this occur?  One possibility is that if some merchants accept credit cards and others do not, then some people will switch their business to the merchants that take credit cards.  From the point of view of the merchants taking credit cards, their sales most certainly go up.  From the point of view of the merchants which do not take credit cards, their sales go down.  From society’s point of view, sales are moving from one business to another, but total sales do not change.

Another possibility is that credit cards provide ready access to a line of credit, allowing people to make purchases on credit that they otherwise would not be able to make.  If so, it is not clear how much of an effect on sales that would really have.  Credit cards are not the only source of credit in the economy.  Also, credit has to be paid back.  In the short run, credit can certainly increase sales, but, as the economy is so painfully reminding us right now, in the long run the bills have to be paid, so it is not clear that total sales over time increase.

It is also possible that credit cards are just more efficient than other payment methods and save both consumers and merchants money.  If that is the case, then there is more money to spend in the economy and sales can go up.  Research suggests, however, that the differences between different payment methods (in terms of the real resources used to process a payment) are relatively modest, often less than one cent per dollar spent.

Overall, then, it seems likely that most of any sales increase will come from moving sales between merchants.  Intuitively, this makes sense.  If you were told that you could not use any credit cards for the next five years, would your total spending over those five years be substantially lower?  On the other hand, if you were told that a store down the street was not going to take credit cards anymore, would your spending at that store fall?  Increased sales for a merchant may be good for that merchant, but whether society is better off is a different question.

Fraud is a different matter, though.  Fraud takes money from some people and gives it to others.  However, we as a society disapprove of fraud and do not wish to reward criminals.  Thus, we view fraud losses as purely a bad thing for society.  Unfortunately, all payment methods are subject to fraud.  The GAO discusses costs of prevention for credit cards, but does not discuss the direct costs of fraud to merchants and consumers.  Criminals go where the money is, and a lot of money flows through credit card receipts.  Restaurant tips get changed, card numbers get stolen, transactions get rerun for higher amounts, cards are cloned – there is an endlessly changing list of fraudulent activities.  Many of these activities are difficult to detect.  For example, when the tip on a receipt is changed, many people will never notice, even though they just had money taken directly out of their pocket.  Estimates on the costs of fraud for different payment methods vary, but there is general agreement that all payment methods are subject to fraud and that debit cards (when authorized with a personal identification number) have some of the lowest overall fraud rates.  Different people bear the costs of fraud depending on the type of fraud and the payment method.  Merchant costs for losses and prevention are important, but they are not the only ones affected.

In Credit Cards, Financial Regulation, Law & Economics, The Law & Economics of Interchange Fees Symposium
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Credit Cards in Context: Framing the Discussion

Allan Shampine —  8 December 2009

Allan L. Shampine is a Vice President at Compass Lexecon in Chicago

While the GAO report provides a useful summary of many of the issues being debated within the credit card community, the GAO’s mandate was, in some ways, rather narrow.  The GAO was asked to “review (1) how the fees merchants pay have changed over time and the factors affecting the competitiveness of the credit card market, (2) how credit card competition has affected consumers, (3) the benefits and costs to merchants of accepting cards and their ability to negotiate those costs, and (4) the potential impact of various options intended to lower merchant costs.”  We will be talking a lot about their conclusions on these issues, but first I would like to set the stage by talking about where credit cards fit in the economy as a whole.

Credit cards are a way of buying things, but they are only one of many.  Other common methods include cash, checks and debit cards.  Each payment method touches different groups, directly and indirectly.  Academics, central banks and regulators around the world have debated for many years as to which payment methods are best for society as a whole.  The research into this question suggests that there is no simple answer.  Indeed, researchers have not even agreed on how to ask the question.  Some researchers say that trying to figure out all the costs and benefits is just too hard and we should concentrate on the overall costs of the system.  In particular, electronic payment methods are often regarded as less costly than paper payment methods.  Other researchers (including myself) point out that consumers stubbornly continue using paper payment methods even as they become more expensive (relative to other payment methods), showing that there must be benefits to doing so, and that those benefits are important enough to influence people’s choices.  Most researchers agree, though, that different payment methods are better in different circumstances.  For example, for a small transaction at a garage sale, cash is very efficient.  You don’t need any terminals, electricity or approvals.  You hand over the cash and you’re done.  If you’re buying a house, though, cash is not a good choice.  You’re almost certainly going to use a wire transfer.  If you’re at Starbucks getting a cup of coffee, you might use cash or credit, although the cashier and the other people in line are likely to grind their teeth if you choose credit.

That examples brings up another problem that regulators wrestle with.  When you pull out your wallet to pay for something, you ask yourself questions like “Do I have enough cash?  Should I use my credit card for the rewards?  Should I use my debit card to stick to my budget?”  You do not ask yourself, “How much will this cost the merchant?  How much will this cost the bank?  Are other people going to pay a higher or lower price because of this?  Am I going to slow down the line?”  (Well, most people don’t.  If you’re reading this blog, you may be the exception that proves the rule).  That is, you choose how to pay for things, but the “price” you face for using whatever payment method you choose may not reflect all of the costs and benefits to everyone else.

This distinction is important because whether something is good for an individual does not necessarily mean that it is good for society.  If networks take money from some merchants and give it to people using credit cards, at first blush, those merchants are worse off while credit card users are better off.  But what does that mean for society?  Do prices go up?  How does that affect consumers?  How does that affect merchants?  How are the owners of the networks affected?  These are not simple questions.  Hopefully this overview will provide something of a framework to discuss them in.

In Credit Cards, Financial Regulation, The Law & Economics of Interchange Fees Symposium
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