Competition Policy and Regulation in Credit Card Markets: Insights from Single-sided Market Analysis

Dennis Carlton, Ralph Winter, Jan 30, 2015

This paper reexamines the economics of two common features of credit card networks: the interchange fee paid by merchant banks, or acquirers, to cardholder banks, or issuers; and the restraint commonly placed on merchants against surcharging for credit card transactions. We show that the parallels with the economics of conventional one-sided markets offer insights that have been overlooked in the credit card economics literature, which stresses the two-sided nature of the market. The characterization of the optimal interchange fee is equivalent to the Dorfman-Steiner theorem from conventional price theory. The principle that the interchange fee maximizes output when an optimum exists and the possibility of interchange fee neutrality also have precise parallels in one-sided markets with promotion. Our analysis shows that the no-surcharge rule is equivalent to a retail MFN constraint. The no-surcharge rule raises prices to merchants due to a competition-suppression effect as well as a cost-externalization effect. The market condition underlying interchange neutrality (when surcharging is allowed) eliminates the impact of the no-surcharge rule in the case of a credit-card duopoly. Yet the same condition magnifies the impact in the presence of cash customers.