Ebook Must-Take Cards: Merchant Discounts and Avoided Costs
In payment cards systems such as Visa or MasterCard, the interchange fee (IF) paid by the merchant’s bank (the “acquirer”) to the cardholder’s bank (the “issuer”) allocates the total cost of the payment service between the two users, cardholder and merchant. In several regions of the world, competition authorities, banking regulators, and courts of justice have recently considered, or even implemented, regulatory caps on interchange fees that are based on issuers’ costs. The premise for these regulatory caps is that unregulated IFs are set at unacceptably high levels. Merchants, the argument goes, accept to pay the resulting high merchant discount because they are concerned that turning down cards would impair their ability to attract customers; that is, cards are “must-take cards” (Vickers 2005).
However, there is no logical connection between this “must-take cards” argument and the issuers’ cost benchmark used by regulators. The main objectives of this paper are to analyze the validity of the argument and to derive policy implications for possible regulatory intervention. To this purpose, the paper develops a model of the payment card industry that is sufficiently rich to account for the complex effects of IFs on volumes of card payments, banks’ profits, consumer welfare, and retail profits and prices, yet simple enough to assess their regulation.
First, the paper validates the “must-take cards” argument by showing that retailers may be willing to accept cards even if the fee they have to pay exceeds their convenience benefit for card payments. This is because accepting cards increases the retailer’s quality of service by offering to his customers an additional payment option. This property holds whether retailers are perfect competitors, Hotelling Lerner Salop competitors or even local monopolists. Thus it is not due to an hypothetical “prisonner’s dilemma” situation where retailers would accept cards only to steal business from each other.
Second, the paper provides an alternative benchmark for regulatory intervention. This benchmark is not based on issuers’ costs, but on the retailer’s avoided-cost when a cash (or check) payment is replaced by a card payment. The empirical counterpart of this benchmark, which we call the “tourist-test”, gives some operational content to the notion of “must-take card”: would the merchant want to refuse a card payment when a non repeat customer with enough cash in her pocket is about to pay at the cash register? Put differently, the merchant discount passes the tourist test if and only if accepting the card does not increase the merchant’s operating costs. The paper analyzes the test’s relevance as an indicator of excessive interchange fees. We show that, when issuers’ margin are constant, the tourist test is an exact test of excessive interchange fees from the point of view of short-term consumer surplus, and yields false positives if the criterion is social welfare.
Third, the paper identifies four key sources of potential social biases in the payment card associations’ determination of interchange fees: internalization by merchants of card holder surplus, issuers’ per-transaction markup, merchant heterogeneity, and extent of cardholder multi-homing. It compares the industry and social optima both in the short term (fixed number of issuers) and the long term (in which issuer offerings and issuer entry respond to profitability).
The paper is organized as follows: Section 2 assesses the impact of the pricing of payment cards services on card acceptance decisions by merchants and card usage decisions by consumers. It also introduces the avoided-cost benchmark and its empirical counter part, the tourist test. Section 3 investigates whether the interchange fees maximizing short-term welfare and total user surplus (the latter equal to the former minus banks’ profits), respectively, meet the tourist test. Section 4 compares privately and socially optimal interchange fees, first in the case of a monopoly platform, then when several platforms compete. Section 5 performs the same exercise as Section 3 in the long term, in which issuer entry and offerings respond to industry profitability (and so welfare and total user surplus coincide). Section 6 shows that retailer heterogeneity makes the tourist test more likely to produce false positives. Section 7 concludes. Relation to the literature.
The paper borrows from and extends a number of contributions to the literatures on card payments and two sided markets. It elaborates on previous the oretical analyses (surveyed in Rochet (2003)) of the impact of IFs, in particular Rochet and Tirole (2002), Schmalensee (2002), and Wright (2003a, 2003b, 2004). In particular, the idea that merchants may accept cost increasing means of payment is drawn from our earlier paper on card payments. Our analysis of merchant heterogeneity borrows from Schmalensee (2002) and Wright (2004). Wright built on Schmalensee and showed how the privately and socially optimal IFs depend on the elasticities on the two sides (merchants, cardholders). He argued that there is no systematic bias between the IF chosen by the association and the socially optimal IF. We also borrow from Wright the modelling of cardholder demand, which is a bit simpler than our initial modelling: Wright assumed that cardholders’ convenience benefit is drawn at the moment of purchase while we presumed that cardholders differ systematically in the benefit that they derive from card payments. While ex post (Wright) and ex ante (Rochet-Tirole) heterogeneity deliver broadly convergent results, ex ante heterogeneity makes merchants’ card acceptance decisions strategic complements rather than independent.
Finally, there is also a sizeable, less formal literature (surveyed in Schmalensee (2003)) on the potential anticompetitive effects of IFs, in particular Carlton and Frankel (1995), Evans and Schmalensee (1995), Frankel (1998), Chang and Evans (2000) and Balto (2000).
While these contributions have substantially influenced this paper, none emphasizes the distinctions between the relevant measures of welfare (social welfare, total user surplus, consumer surplus) and their horizon (short vs. long term) and relates them to the tourist test, as we do. To the best of our knowledge, the literature has left largely unexplored the role of issuer, acquirer and merchant margins (Section 3) and of entry into credit card services (Section 5), and the link between the average merchant benefit and efficient IFs (Section 6).
Download
PDF Ebook Must-Take Cards: Merchant Discounts and Avoided Costs
Posted in :
