The proliferation of payment cards-that is, debit, credit, and prepaid cards-has dramatically changed the way we shop and merchants sell goods and services. Today, payment cards are indispensable in most advanced economies. For Europe, Bolt and Humphrey report that the number of card payments increased by 140 percent across 11 European countries (Belgium, Denmark, France, Finland, Germany, Italy, the Netherlands, Norway, Spain, Sweden, and the United Kingdom) during the period 1987-2004. Recently, some merchants have started to accept only card payments for safety and convenience reasons. For example, American Airlines began accepting only payment cards for inflight purchases on all its domestic routes starting June 1, 2009. Also, many quick service restaurants and coffee shops now accept payment cards to capture greater sales and increase transaction speed.
As more consumers and merchants adopt payment cards, providers of these products may benefit from economies of scale and scope. Some European payment providers might enjoy these benefits in the future as greater cross-border harmonization occurs with the introduction of the Single Euro Payments Area (SEPA). The potential advantages of SEPA are increased competition among a greater number of payment providers and the realization of scale economies and more efficient payment instruments. Beijnen and Bolt provide estimates of scale economies that quantify the potential benefits of SEPA arising from consolidation of electronic payment processing centers across the euro zone.
The increased usage of cards has increased the value of payment networks, such as Visa Inc., MasterCard Worldwide, Discover Financial Services, and others. In 2008, Visa Inc. had the largest initial public offering (IPO) of equity, valued at close to $18 billion, in U.S. history. One potential reason for Visa to change its corporate structure from a card association to a publicly traded company is to reduce antitrust scrutiny by regulators and to lower the threat of lawsuits filed by certain payment system participants.
Some industry observers have suggested that the high profitability of payment card providers has increased scrutiny by public authorities in many jurisdictions. Several U.S. merchants have filed lawsuits against MasterCard and Visa regarding the setting of interchange fees. Interchange fees are generally paid by the merchant's bank to the cardholder's bank and are set by the network. In December 2007, the European Commission (EC) ruled that the (multilateral) interchange fees for cross-border payments in the European Union applied by MasterCard Europe violated Council Regulation (European Commission) No. 1/2003. Since July 1, 2009, MasterCard Europe established interchange fees for consumer card transactions that, on average, do not exceed 30 basis points for credit cards and 20 basis points for debit cards. However, the EC stressed that it will continue its antitrust investigation against Visa.
To date, there is still little consensus-either among policymakers or economic theorists-on what constitutes an efficient fee structure for card-based payments. In this article, we discuss several economic models that analyze whether intervention by public authorities might improve the welfare of payment system participants.
Payment Flows in a Card Network
The two-sided market literature has been used to analyze the structure of fees paid by consumers and merchants. Rochet and Tirole define a two-sided market as a market where end-users are unable to negotiate prices based on costs to participate on a platform and the price structure affects the total volume of transactions. In the payments context, consumers and merchants generally do not negotiate prices of goods and services based on the payment instrument used to make a purchase. While not common, some merchants do post different prices based on the payment instrument used to make the purchase. For example, the prices are the same regardless of whether the consumer pays in cash or with a payment card. However, when merchant fees increase, some merchants might refuse to accept payment cards, resulting in fewer potential card transactions. Similarly, raising consumer fees may reduce consumer participation.
Payment card networks comprise of consumers and their banks (known as issuers), as well as merchants and their banks (known as acquirers). Issuers and acquirers are part of a network that sets the rules and procedures for clearing and settling payment card receipts among its members. In Figure 1, we diagram the four participants and their interactions with one another. First, a consumer establishes a relationship with an issuer and receives a payment card. Consumers generally do not pay per transaction fees but often pay annual membership fees to the banks that issue the payment cards. In addition, many payment card issuers give their customers per transaction rewards, such as cash back or other frequent-use rewards. Second, a consumer makes a purchase from a merchant. Generally, the merchant charges the same price regardless of the type of payment instrument used to make the purchase. Third, if a merchant has established a relationship with an acquirer, it is able to accept payment card transactions. The merchant either pays a fixed per transaction fee (more common for debit cards) or a proportion of the total purchase amount, known as the merchant discount fee (more common for credit cards), to its acquirer. In some instances, merchants are charged a fixed fee and a proportional fee. For credit cards, the merchant discount can range from 1% to 5% depending on the type of transaction, type of merchant, and type of card, as well as whether the card is present or not, among other factors. Fourth, the acquirer pays an interchange fee to the issuer.
Figure 1: Payment Card Fees
Costs and benefits of different payment methods
Studying the costs to banks to provide payment services is difficult, given the proprietary nature of the cost data. However, there are some European studies that attempt to quantify the real resource costs of several payment services. In these studies, social cost refers to the total cost for society net any monetary transfers between participants, and reflects the real use of resources used in the production and usage of payment services. For the Netherlands in 2002, Brits and Winder report that the social costs of all point-of-sale (POS) payments (cash, debit cards, credit cards, and prepaid cards) amounted to 0.65% of gross domestic product (GDP). The social cost of payment services for Belgium in 2003 was 0.75% of GDP. Bergman, Guibourg, and Segendorff find that the social cost of providing cash, debit card payments, and credit card payments was approximately 0.4% of GDP in Sweden for 2002. Based on a panel of 12 European countries during the period 1987-99, Humphrey et al. conclude that a complete switch from paper-based payments to electronic payments could generate a total cost benefit close to 1% of the 12 nations' (Belgium, Denmark, Finland, France, Germany, Italy, the Netherlands, Norway, Spain, Sweden, Switzerland, and the United Kingdom) aggregate GDP.
These numbers confirm the widespread agreement that the ongoing shift from paper-based payments to electronic payments may result in large economic gains. Compared with cash, electronic payments also offer benefits in terms of greater security, faster transactions, and better recordkeeping; in addition, electronic payments offer possible access to credit lines. Some key benefits of using cash include privacy and anonymity that payment cards do not provide. Merchants may also benefit from increased sales or cost savings by accepting an array of electronic payment instruments. However, these benefits to consumers and merchants are often difficult to quantify.
Using U.S. retail payments data, Garcia-Swartz, Hahn, and Layne-Farrar attempt to quantify both the costs and benefits of POS payment instruments. They find that shifting payments from cash and checks to payment cards results in net benefits for society as a whole, but they also conclude that merchants may be paying a disproportionate share of the cost. Much of the payment card literature focuses on the proportion of the total price paid by merchants and consumers. In other words, economists are trying to answer the question: Do the sum of prices to end-users for card payments and their peculiar asymmetric structure reflect the exercise of market power by card providers or do they reflect the nature of the service provided? In the next section, we consider how the economics literature has attempted to answer this question.
Economic Models of Payment Cards
In this section, we review some important contributions to the theoretical payment card literature. The early models of payment cards ignored strategic interactions of consumers and merchants, and focused on the aggregate demand of each type of end-user and the level of the interchange fee. These models were extended to include explicit consumer and merchant interactions but assumed inelastic consumer demand for goods, no price differentiation by merchants based on the payment instrument used by consumers, and exogenous benefits from card usage. Several models extended this literature by considering merchants' ability to separate consumers by charging different prices. Another set of models expanded the literature by considering the ability of payment cards to increase sales because the cards provided greater security and eased consumers' liquidity and credit constraints. In addition, other models of payment cards have considered network competition, as well as competition among different types of payment instruments.
Models focusing on interchange fees
Here, we discuss the academic literature on interchange fees. Baxter argues that the equilibrium quantity of payment card transactions occurs when the total transactional demand for credit card services, which are determined by consumer and merchant demands jointly, is equal to the total transactional cost for credit card services, including both issuer and acquirer costs. A consumer's willingness to pay is based on her net benefits received and is greater than or equal to the fee in equilibrium. Similarly, the merchant's fee is less than or equal to the net benefits it receives. Hence, pricing each side of the market based on marginal cost-as would be suggested by economic theory for one-sided competitive markets-need not yield the socially optimal allocation. To arrive at the socially optimal equilibrium, a side payment may be required between the issuer and acquirer.
Unfortunately, Baxter's framework does not allow us to study the optimal setting of interchange fees by banks, since their profits are zero regardless of the level of the interchange fee. Schmalensee extends Baxter's analysis by allowing issuers and acquirers to exercise market power but still assumes that merchants operate in competitive markets. His results support Baxter's conclusions that the interchange fee balances the demands for payment services by each end-user type and the cost to banks to provide them. Schmalensee finds that the profit-maximizing interchange fee of issuers and acquirers may also be socially optimal.
Unlike Baxter and Schmalensee, Rochet and Tirole consider strategic interactions of consumers and merchants. They have three main results. The first result is that their socially optimal interchange fee is higher than the socially optimal Baxter interchange fee, since issuers exert their market power and capture merchants' surplus. Their second result is that the interchange fee that maximized profit for the issuers may be more than or equal to the socially optimal interchange fee, depending on the issuers' margins and the cardholders' surplus. Third, merchants are willing to pay more than their net benefit if they can steal customers from their competitors or retain their customers by accepting cards. However, overall social welfare does not improve when merchants steal customers from their competitors by accepting payment cards.
Wright extends Rochet and Tirole by considering a continuum of industries where merchants in different industries receive different benefits from accepting cards. His model is better able to capture the trade-off between consumer benefits and merchant acceptance when the interchange fee is increased because some merchants will not accept cards. He concludes that the interchange fee that maximizes overall social welfare may be higher or lower than the interchange fee that maximizes the number of transactions. In particular, restricting the total number of transactions by setting higher interchange fees raises total welfare if the gain in surplus of the marginal card user who now starts using his card along with all those merchants who accept his card exceeds the loss in surplus of the inframarginal merchant who now stops accepting cards along with all those card users who can no longer use their cards for purchases at her store.
Models with price differentiation at the point of sale
The models discussed so far have largely ignored the ability of merchants to pass on a part or all of their payment cost to consumers-whether in the form of higher prices to their card-based consumers or as a higher uniform price to all consumers. In some cases, merchants are not allowed to add a surcharge for payment card transactions because of legal or contractual restrictions, but they may be allowed to give cash discounts. However, in jurisdictions where merchants are free to set higher prices for purchases made with payment cards, they usually do not. Even if differential pricing based on the payment instrument used is not common, the possibility to do so may enhance the merchants' bargaining power in negotiating their fees. If merchants charged different prices, cash-paying consumers would not be paying or they would be paying less for card-paying customers.
Wright extends Rochet and Tirole to consider the effects of no-surcharge rules. He finds that no-surcharge rules generate higher welfare than when monopolist merchants are allowed to set prices based on the payment instrument used. He argues that merchants are able to extract consumers' surplus ex post from payment card users, while cash users are unaffected. Wright only considers equilibria where merchants will continue to sell the same quantity of goods to cash users at the same price. When merchants are allowed to surcharge, they extract "too much" surplus ex post from customers who use payment cards because merchants set higher prices for card purchases.
Schwartz and Vincent study the distributional effects among cash and card users with and without no-surcharge rules. They find that the absence of pricing based on the payment instrument used increases network profit and harms cash users and merchants. The payment network prefers to limit the merchant's ability to separate card and cash users by forcing merchants to charge a uniform price to all of its customers. When feasible, the payment network prefers rebates (negative per transaction fees) given to card users. Granting such rebates to card users boosts their demand, while simultaneously forcing merchants to absorb part of the corresponding rise in the merchant fee, because any resulting increase in the uniform good's price must apply equally to cash users. In this way, the network uses rebates to indirectly extract surplus from cash-paying customers in the form of higher prices. If rebates are feasible, card users are always better off. Overall welfare rises if the ratio of cash users to card users is sufficiently large and merchants' net benefits from card acceptance are sufficiently high.
Gans and King argue that, as long as there is "payment separation," the interchange fee is neutral regardless of the market power of merchants, issuers, and acquirers. The interchange fee is said to be neutral if a change in the interchange fee does not change the quantity of consumer purchases and the profit level of merchants and banks. When surcharging is costless, merchants will implement pricing based on the payment instrument used, taking away the potential for cross-subsidization across payment instruments and removing the interchange fee's role in balancing the demands of consumers and merchants. In effect, the cost pass-through is such that lower consumer card fees (due to higher interchange fees) are exactly offset by higher goods prices from merchants. Payment separation can occur if one of the following is satisfied: There are competitive merchants, and they separate into cash-accepting or card-accepting categories, in which each merchant only serves one type of customer and is prevented from charging different prices; or merchants are able to fully separate customers who use cash from those who use cards by charging different prices. Therefore, they argue that policymakers should remove any merchant pricing restrictions, such as no-surcharge rules.
Models with competition between networks
We have not yet considered models where competition among payment networks is explored. Economic theory suggests that competition generally reduces prices, increases output, and improves welfare. However, with two-sided markets, competition may yield an inefficient price structure. A key aspect of network competition is the ability of end-users to participate in more than one network. When end-users participate in more than one network, they are said to be "multihoming." If they connect only to one network, they are said to be "singlehoming." As a general finding, competing networks try to attract end-users who tend to singlehome, since attracting them determines which network has the greater volume of business. Accordingly, the price structure is tilted in favor of end-users who singlehome.
Rochet and Tirole extend their previous work by considering network competition. Their primary focus is on the price structure or balance between consumers and merchants in a three-party network. They do not explicitly model the interchange fee but study the impact of competition on the structure of prices. Under a set of plausible assumptions they find that the price structures for a monopoly network and competing platforms are the same, and if the sellers' demand is linear, this price structure in the two environments generates the highest welfare under a balanced budget condition.
Guthrie and Wright extend Rochet and Tirole by assuming that consumers are able to hold one or both payment cards and that merchants are motivated by "business stealing" in deciding whether to accept payment cards in a four-party network. They only consider networks that provide identical payment services, and they find that network competition results in higher interchange fees than those that would be socially optimal. In this model, competition results in both networks charging the same interchange fee because both networks offer identical payment products.
Chakravorti and Roson extend Rochet and Tirole by considering the effects of network competition on total price and on price structure where networks offer differentiated products. They only allow consumers to participate in one card network, whereas merchants may choose to participate in more than one network. They compare welfare properties when these two networks operate as competitors and as a cartel where each network retains demand for its products from end-users. Like Rochet and Tirole and Guthrie and Wright, they find that competition does not necessarily improve or worsen the balance of consumer and merchant fees from the socially optimal one. There are other fee structures for a given sum of consumer and merchant fees that would improve consumer and merchant welfare. However, they find that the welfare gain from the drop in the sum of the fees from competition is generally larger than the potential decrease in welfare from less efficient fee structures.
Models accounting for the role of credit
So far, we have considered models that ignore the extension of credit as a benefit to consumers and merchants. Given the high level of antitrust scrutiny targeted toward credit card networks, we find this omission in most of the academic literature surprising. In the long run, aggregate consumption over consumers' lives may not differ because of access to credit, but such access may enable consumption smoothing that increases consumers' utility. From a merchant's perspective, extension of credit may lead to intertemporal business stealing. In other words, merchants attract consumers who do not have funds today by accepting credit cards, resulting in merchants tomorrow being unable to make sales to consumers who bought today on credit. In addition to extracting surplus from consumers and merchants, banks have an additional source of surplus-liquidity-constrained consumers. How much surplus can be extracted depends on how much liquidity-constrained consumers discount tomorrow's consumption.
Chakravorti and Emmons consider the costs and benefits of consumer credit in a four-party network where consumers are subject to income shocks after making their credit card purchases and some are unable to pay their credit card debt. To our knowledge, they are the first to link the insurance aspect of credit cards to their payment component. Observing that over 75% of U.S. card issuer revenue is derived from cash-constrained consumers, they consider the viability of the credit card system if it were completely funded by these types of consumers. They also study the convenience use of credit cards-that is, the usage by those who do not need credit to make purchases and its impact on social welfare.
Chakravorti and Emmons derive three main results. First, if consumers sufficiently discount future consumption, liquidity-constrained consumers who do not default would be willing to pay all credit card network costs ex ante, resulting in all consumers being better off. The key assumption is that at least a certain number of consumers face binding liquidity constraints and do not default. Second, if merchants charge a single price for a good regardless of how consumers pay, and if there are no side payments made by issuers to convenience users, card-accepting merchants who charge a single price for all purchases will attract only liquidity-constrained consumers because some merchants charge a lower price and only serve cash-paying customers. Note, only those consumers who are liquidity-constrained use credit cards, and there is no convenience use. Third, if card issuers extend rebates to convenience users, a merchant can, under certain conditions, attract all types of consumers-including consumers who carry a credit card balance month to month and those who do not¾when a single price is charged.
Chakravorti and To consider a scenario with monopolist merchants and a monopolist bank that serves both consumers and merchants where the merchants absorb all credit and payment costs in a two-period dynamic model. Their model yields the following results. First, if merchants earn a sufficiently high profit margin and the cost of funds is sufficiently low, the economy is able to support credit cards. In other words, the benefits to consumers and merchants must be greater than the cost to support the credit card network. Second, the fee that merchants are willing to pay their banks increases as the number of credit-constrained consumers increases. Third, a prisoner's dilemma situation may arise: Each merchant chooses to accept credit cards, but by doing so, each merchant's discounted two-period profit is lower. In other words, there exists intertemporal business stealing among merchants across different industries, potentially resulting in all merchants being worse off.
Models with competition among payment instruments
Most of the literature ignores competition between payment instruments, with one payment provider offering multiple payment options to its customers and setting prices to maximize profits. Moreover, most economic models of payment cards generally do not consider price incentives offered by merchants to steer consumers to a specific type of payment card.
In Bolt and Chakravorti, we study the ability of banks and merchants to influence the consumer's payment instrument choice when they have access to three payment forms-cash, debit card, and credit card. To our knowledge, this model is the first to analyze payment network competition by combining elements of models that stress price balance with those that consider liquidity constraints and safety concerns of consumers.
In our model, consumers participate in payment card networks to insure themselves from three types of shocks-uncertain income flows, theft, and the merchant they are matched to. Our key results can be summarized as follows. With sufficiently low processing costs relative to theft and default risk, the social planner sets a zero merchant fee to completely internalize the card acceptance externality. The bank may also set zero merchant fees but only if merchants are able to sufficiently pass on payment costs to their consumers or if payment costs are zero. If payment card costs are too high, the social planner sets a higher merchant fee than the bank so as to contract card acceptance in favor of cash. We find that bank profit increases when merchants are unable to pass on payment costs to consumers due to lower goods prices and greater ability to extract merchant surplus. The relative costs of providing debit and credit cards determine whether the bank will provide both or only one type of payment card. Finally, uniform price policies increase bank profits when the bank supplies both types of payment cards than when merchants adopt pricing based on the payment instrument used. However, consumers and merchants are worse off when consumers without liquidity constraints use credit cards because they do not receive the proper price incentives, resulting in use of a less efficient payment instrument.
In summarizing the payment card literature, we 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. Moreover, appropriate pricing arrangements for payment instruments is difficult, since payment networks are subject to large economies of scale and give rise to strong usage and adoption externalities. Much of the debate over various payment card fees is concerned with the allocation of the surpluses from consumers, merchants, and banks, as well as who is able to extract surpluses from whom.
We are able to draw the following conclusions. First, a side payment between the issuer and the acquirer may be required to get both sides on board. There is no consensus among policymakers or economists on what constitutes an efficient fee structure for card payments. Second, while consumers generally react to price incentives at the point of sale, merchants are reluctant to charge higher prices to consumers who benefit from card use. Third, network competition may not improve the price structure but may significantly reduce the total price paid by consumers and merchants. Fourth, consumers and merchants both value credit extended by credit card issuers (along with other benefits such as security), and consumers and merchants are willing to pay for it.
Sound public policy regarding 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. While the theoretical literature on payment cards is growing, there are still too few empirical investigations to guide policymakers. We hope that recent regulatory changes in different parts of the world will generate rich sets of data that can be exploited by economists to test how well the theories fit the data.
Wilko Bolt is a Senior Economist at De Nederlandsche Bank. Sujit Chakravorti is a Senior Economist at the Federal Reserve Bank of Chicago. The views expressed are not necessarily those of De Nederlandsche Bank, the Federal Reserve Bank of Chicago, or the Federal Reserve System. This article is a revised and shortened version of their article titled "The Economics of Payment Cards: A Status Report," that appeared in the Federal Reserve Bank of Chicago's Economic Perspectives in the 4th quarter 2008 issue.
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