Economic Theory of Interchange Fees

February 22, 2011

(Executive Summary of Comment Submitted to the Federal Reserve Board Regarding the Implementation of the Durbin Amendment)

I. Introduction and Overview

Interchange charges within the payment card industry are transfers set by card networks to cope with a basic feature of two-sided markets. Consumers when deciding to have and use cards and merchants when deciding to accept them do not account for the externality that their choices exert on their current and future trading partners. Without an explicit mechanism for allowing agents to internalize these externalities (for instance by bargaining over the choice of the means of payment) interchange transfers can and should be instituted to enhance market efficiency. [1] 

In Section II, I provide a brief survey of the economic literature on market-set and socially efficient interchange fees and on the relation between them, supplementing and updating the survey by Prager et al. (2009) at the Board of Governors of the Federal Reserve System (“Board”). This literature is almost entirely theoretical, and the models it contains cannot support any particular regulatory outcome until they are used as frameworks to construct empirically-based models of real markets. In addition, this literature does not explicitly consider the implications of debit cards’ essential links with depository accounts. Nonetheless, we believe the insights from this literature have some important general mplications for the proper regulation of debit card interchange.

Abstract, theoretical models can serve to make clear what empirical questions need to be answered in order to devise regulations that serve the public interest. And here the literature is clear and unanimous: information about cost is not enough. Interchange fees serve to determine how costs are shared between acquirers and merchants on the one hand and issuers and consumers on the other; knowing only the costs provides no information on how they should be shared. Efficient regulation cannot be promulgated without knowledge of the demand functions and behavior of merchants and consumers.

In Section III, I consider the theoretical model of Bedre-Defolie and Calvano (2010) (“BC (2010)”) in more detail. This model emphasizes a feature of the market that was emphasized by Dr. Prager in her discussion of market failure in response to Chairman Bernanke at the Board’s open meeting to discuss the proposed interchange rules:2 merchants can only decide which payment methods to accept; consumers get to decide which of the accepted methods to use for any particular transaction. In the BC (2010) model, the market-set interchange fee is generally above the socially efficient fee. The calibration exercise reported below suggests that the gap is small in this case, certainly much smaller than the fee reduction proposed by the Board. Read the full report

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[1] See Prager et al. (2009) for a comprehensive introduction to the economic theory of interchange.

[*] Professor of Economics, Department of Economics, Bocconi University and IGIER. This paper was prepared on behalf of Market Platform Dynamics which received funding from large members of the Electronic Payments Coalition. The views expressed in this paper are my own and do not necessarily reflect those of any of these institutions. I appreciate comments from Richard Schmalensee on this paper and thank Scott Walster of Market Platform Dynamics for research assistance.