Transactions through electronic payment networks (EPNs) in the U.S. exceeded $1.18 trillion in 1999 and are growing rapidly. Several practices in this important industry have attracted controversy and antitrust scrutiny. One such practice involves constraints on the ability of merchants to set different prices depending on the means of payment employed such as credit or debit cards, cash or checks. We examine these constraints as instruments of vertical control, assess their welfare effects, and show that their presence may explain the growing phenomenon of rebates and reward programs in payments markets.
Uniform pricing constraints were at various times imposed by law or by EPN rules that prohibited merchants from imposing surcharges (or adverse non-price terms) for payments with an EPN card, even though merchants may face higher costs for such transactions due to fees charged by the EPN. Even in the absence of formal prohibitions, merchants are often reluctant to set different retail prices depending on the means of payment. We refer to all these limits as the No-Surcharge “Rule” (NSR).
Our analysis is relevant to assessing the desirability of the rule when it is imposed by law or private regulations. For example, the practice of prohibiting surcharges is banned in the United Kingdom and has come under scrutiny in Australia (Reserve Bank of Australia (RBA) 2001 and RBA/ACCC Study 2000). When the “rule” instead derives from other characteristics of merchant’s trading environment (and its repeal is therefore not an option), our analysis helps evaluate the effects of restricting an EPN’s ability to offer rebates to its cardholders. Finally, the analysis is a necessary step towards evaluating card tying policies (see fn. 2 above), since such tying would have no force if merchant surcharges were unrestricted.
We consider a monopolist EPN that contracts with a representative merchant. The merchant faces downward-sloping demand from consumers, who pay with the EPN card or other means (“cash”). The EPN may set charges to the merchant and to card users. In this setting, one might expect an NSR to increase total consumer surplus and overall welfare, drawing on intuition from optimal taxation (or Ramsey pricing), where inefficiency is reduced by using a broader tax base so as to lower the tax rate. The analogy is that, for a given above-cost charge from the EPN to the merchant for card transactions, an NSR leads a merchant to set a “moderate” uniform price for card and cash transactions instead of a higher price for card transactions alone; such price uniformity can reduce misallocation between card and cash transactions.
The optimal tax analogy is flawed, however. Here, the EPN is unregulated and its profit is not held constant. Allowing it to tax non-card sales as well indirectly via the NSR leads the EPN to raise its charge to the merchant. As a result, the NSR can lead to a higher retail price for both cash and card transactions. In that case, welfare declines for both cash users and card users as well as merchants. This contrasts with standard comparisons of uniform pricing and third degree price discrimination where, under regularity conditions also satisfied here, a requirement of uniform pricing causes at least some price(s) to fall (Nahata et al. 1990; Malueg 1992).
Our analysis also highlights a contrast between the NSR and a well-known instrument of vertical control maximum resale price maintenance (RPM). Both practices enable a supplier to reduce the margin charged on its product by an imperfectly-competitive downstream firm. Maximum RPM, however, affects only the targeted product, lowering its price and benefitting consumers and overall welfare (Tirole 1988). In contrast, an NSR squeezes the merchant’s margin indirectly, by requiring the same retail price to be charged for the other product (here, cash transactions). Thus, the retail price for cash users rises; moreover, since the EPN is induced to raise its charge to the merchant, the merchant’s (now uniform) retail price is pushed up.
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