For nearly a decade, MasterCard has run a successful ad campaign that touts the benefits of its cards as “Priceless.” But this is hardly the case. Merchants see the price tag for payment systems, and credit cards are expensive as payment systems go. On average, credit card transactions cost American merchants six times as much as cash transactions and twice as much as checks or PIN-based debit cards.
But these are only the average costs of credit cards. Some credit cards cost merchants much more than others. Merchants’ costs of accepting credit cards vary tremendously among and within brands. Credit cards with rewards programs cost more for merchants to accept than cards without rewards. Similarly, corporate cards cost merchants more than consumer cards. A transaction on a rewards card or a corporate card can cost a merchant twice as much as the same transaction on a regular consumer card. Thus, merchants fund rewards and corporate card programs, but see no marginal benefit from having accepted a rewards card or corporate card instead of a regular nonrewards consumer credit card.
While the cost differences between payment systems are often a matter of cents per transaction, they are significant in absolute terms. In 2006, American merchants paid banks nearly $57 billion in fees to accept payment cards4 more than the total size of the biotech industry, the music industry,the microchip industry, the electronic game industry, Hollywood box office sales, or worldwide venture capital investments.
Payment costs what a transaction costs are the ultimate transaction cost, and credit card fees are merchants’ most ubiquitous transaction cost. One would expect merchants to pass this cost on, at least in part, to consumers who use credit cards. Why, then, do all consumers pay the same for a purchase, regardless of whether they use cash, checks, debit, regular credit cards, or high-priced rewards or corporate cards?.
The answer lies in a set of credit card network rules that leverage credit cards’ market power to limit merchants’ ability to steer consumers to cheaper payment systems through pricing. Credit card network rules are incorporated by reference in merchants’ contracts with their banks. These rules restrict merchants’ ability to choose which payment systems to accept and how to price them. They also force merchants to bundle the pricing of payment services with the underlying goods and services being sold. Further, these rules exploit consumers’ cognitive bias of reacting differently to mathematically equivalent surcharges and discounts in order to prevent merchants from pricing according to payment system costs.
These rules thus prevent merchants from signaling to consumers the costs of different payment methods. Accordingly, consumers never internalize the costs of their choice of payment system, which results in more credit card transactions at higher prices than would occur in a perfectly efficient market. Credit card network rules also prevent merchants from avoiding the cost externality created by rewards programs.
This Article argues that a set of credit card network rules, which it collectively refers to as “merchant restraints,”7 are antitrust violations that distort competition within the credit card industry and between payment systems in general. It shows how credit card networks have chosen to forgo interbrand competition in order to erect a barrier to entry against new, more cost-efficient payment systems. The Article demonstrates that the economic justifications proposed for merchant restraints are historically and logically flawed and suggests that merchant restraints represent a failure in the payment systems market that requires intervention.
The Article proceeds in four Parts. Part I reviews the complex structure and economics of credit card networks, including merchant restraints. It shows how transaction-based revenue, which is protected from market discipline by merchant restraints, has increased in importance relative to interest-based revenue for credit card companies, making merchant restraints increasingly critical to credit card networks’ profitability.
Part II then considers the problems created by merchant restraints. Credit card networks use merchant restraints to impose the cost externality created by rewards and corporate card programs upon merchants. Merchants are forced to fund rewards and corporate card programs from which they derive no benefit. Part II also shows how the externality of rewards programs is passed on to non credit card consumers and how card networks leverage their market power to forgo price-based competition in order to negate other payment systems’ cost advantage. This leads to higher levels of credit card use at higher prices, the costs of which are again borne by merchants and non credit card consumers.
Part III examines the main argument in defense of merchant restraints—the assertion that merchant restraints are an economic necessity for credit card networks. Legal academics and economists contend that merchant restraints are necessary for networks to avoid what is known as a negative network effect or network externality the phenomenon of a decrease in a network’s size resulting in a decrease in the network’s value for the network’s remaining participants. These scholars argue that absent merchant restraints, merchants would accept credit cards on inconsistent terms, which would make credit cards less desirable to consumers. This in turn would make card acceptance less desirable for merchants, setting off a downward death spiral in the size of credit card networks that would decrease social welfare.
Part III also argues that the network effects claim and its subsidiary consumer protection claim are mistaken. It shows how the network effects argument is both historically inaccurate and inapplicable to the current competitive environment. The history of merchant restraints has been all but ignored by legal and economic scholarship, which has focused on theoretical arguments about the role of merchant restraints. The history of merchant restraints shows, however, that they were adopted because of regulatory and business reasons relating to branch banking regulations and usury laws, not because of network effects and consumer protection concerns. The regulatory and business factors behind the original adoption of merchant restraint rules, however, are no longer extant; branch banking and usury restrictions have been largely abolished. Moreover, network effect concerns make little sense in the current competitive environment, where well-established networks compete against other established networks. Any negative network effect on one credit card network will be offset by a positive network effect on another credit card network or on another payment system. Indeed, the ability of credit card networks to thrive in Europe and in Australia absent certain merchant restraints calls into question the importance of network effects.
Likewise, consumer protection concerns about inconsistent credit card acceptance originated in the context of 1960s banking regulation, which inhibited interstate branch banking. Because banks operated in only one state, there was a serious concern that merchants would not honor cards issued by unfamiliar out-of-state banks. Regulatory changes, however, have since allowed the creation of interstate branch banking, and most credit cards are issued by banks with national operations, obviating the original reason for concerns about inconsistent card acceptance. Today, consumer protection concerns about inconsistent credit card acceptance make sense only so long as there is significant price variation among credit cards. Absent merchant restraint rules, however, there would only be de minimis variation in credit card fees, so merchants would have no reason to distinguish between cards.
Part IV conducts an antitrust analysis of merchant restraints, and explores the difficulties of defining the proper market for merchant restraints and of fitting merchant restraints into existing categories of Sherman Act section 1 violations. This Article concludes that merchant restraints distort competition within the credit card industry and among payment systems in general. Because merchant restraints are restraints on trade lacking a procompetitive justification, they should be banned as antitrust violations.
CONTENTS
INTRODUCTION
I. THE STRUCTURE AND ECONOMICS OF CREDIT CARD NETWORKS
- A. Network Structure
B. Costs of Credit Card Transactions
C. Merchant Restraints
D. Importance of Interchange Revenue for Card Networks
II. THE EFFECTS OF MERCHANT RESTRAINTS
- A. Benefits and Costs of Credit Cards
B. Merchants’ Dilemma: The Rewards Card Externality
C. Limited Utility of Discounting for Cash to Avoid the Rewards
Card Externality
- 1. Psychological Limitations
2. Idiosyncratic Limitations
3. Legal Limitations
D. Effects on Consumers
E. Effects on Payment System Competition
III. ARE MERCHANT RESTRAINTS AN ECONOMIC NECESSITY FOR CREDIT
CARD NETWORKS?
- A. The Network Effect and Two-Sided Networks
B. The History of Merchant Restraints
- 1. Honor-All-Cards Rules and No-Differentiation Rules
2. No-Surcharge and No-Discount Rules
3. Origins of Interchange
4. History of the Cash Discount Act
C. The Cash Discount Act as Consumer Protection?
D. The Contemporary Relevance of Network Effects
- 1. The No-Surcharge Rule
2. The Honor-All-Cards Rule and Other Merchant Restraints
IV. ANTITRUST ANALYSIS OF MERCHANT RESTRAINTS
- A. Defining the Relevant Market
B. Tying
C. Horizontal Price-Fixing
D. Vertical Price-Fixing
E. Hybrid Section 1 Violations?
CONCLUSION
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