Over at the International Center for Law and Economics website we’ve posted a link to a pdf e-book version of the collected content (including both posts and comments) from our recent “Interchange Fees and the Law and Economics of Credit Cards” symposium.  Head on over and download a copy if you’re interested in a dead tree version of the symposium.

Thanks to all of our participants and readers for the blog symposium–both the posts and the comments were engaging and thoughtful, and I hope these entries will be helpful in the ongoing debate over credit cards and interchange fees.

A concluding point or two:

Credit card networks are incredibly complex, and no one fully understands the full consequences of tinkering with these markets.  The best empirical evidence we have is difficult to interpret, and the broad interactions among the parts of the credit card system, between cards and other payment systems, and in the macro-economy more generally are simply unknown:  Richard’s do no harm principle seems like the strongest conclusion in this debate.

At worst, theory and empirical evidence suggest that lowering interchange fees does nothing to help consumers, and in fact harms them by raising annual fees and thus again by limiting competition among cards at the point of sale.  Perhaps there is some policy reason why we would want to help merchants at the expense of consumers, but the issue, often framed as merchants and consumers against banks and card networks, really seems to be merchants against consumers.  At best, we have no idea what the full social implications of capping interchange fees would be–but there is still a conflict between merchant and consumer interests, and we should be wary.

As I read the comments and posts in this debate, essentially all of us agree that, at minimum, there is a potential for consumer harm from government intervention in these markets.  Certainly all of us engaged in this discussion–even those with a more “pro-regulatory” bent–are far more circumspect about the prospects for positive social welfare effects and effects on consumers in particular than are the proponents of regulation.  I do wish our system limited the political salience of regulatory initiatives unsupported by evidence–the burden should be on the proponents of intervention to demonstrate affirmatively that regulation will likely have net positive effect.  Here, this is simply not the case.

As is so often the case, Richard has the last word:

The clear upshot is that it is difficult through informed speculation to identify all the collateral consequences of running a credit card system, both positive and negative.  The only sure piece of data that we have is that credit transactions have done far better than cash and checks, even if they are losing ground to the next generation of payment systems that rely on cell phones and other technologies that are untied to the now ubiquitous magnetic strip.  These dynamic changes could easily force down interchange prices without the need for administrative proceedings.

The hard institutional question therefore is why concentrate major reforms on the interchange fees when all these other components must be added into the mix.  On this question, priors really matter. And after reading the assembled posts, my own view is that technological innovation is a far more important driver of improvements than partial fine-tuning of the current system, whatever its flaws.

In one sense, therefore, we, the members of this blog-fest, may well be part of the problem.  By putting one part of a complex payment industry under a microscope we divert resources from cost reduction measures that have unambiguously positive effects.  How large a cost is this?  Frankly, no one knows.  But given the risks of error in implementation, the best response still seems to be, play for the next big breakthrough, and in the short run, leave well enough alone.

Thanks once again to all of our great participants, and to our readers.  The full set of posts and comments from the symposium are available by clicking on the “credit card symposium” link on the right side of the TOTM page.

I have now had a chance to review the excellent posts on the second day, all of which have a common flavor.  They expand the universe of relative considerations that need to be taken into account to decide whether imposing caps on interchange fees enhances or reduces overall social welfare.  The narrow perspective on this issue, which is difficult enough, is to master the dynamics of two-sided markets to figure out where the fixed costs of running the overall system should be allocated.

That model assumes that the credit card business operates in isolation from all other payment systems present and future.  Its effort is to run an efficient allocation of costs in the face of the famous marginal cost controversy that dates back to the 1940s.  Unless there is some outside subsidy all relevant players cannot be allowed to pay only marginal cost.  Yet to put in the subsidy is to create a tax distortion in some unrelated market whose welfare consequences are virtually impossible to track, given the difficulty that arises in discovery of the incidence of the tax as it works its way through the economy.  We are therefore necessarily in the world of second-best even on the simplest possible analysis.

Unfortunately, that simple analysis leaves a lot out of the equation.  One key issue is the competition that credit cards have with noncredit card systems, each of which may have built in distortions of their own.  We know that the United States has to print and police the use of cash. We also know that it can disappear from company coffers into the hands of dishonest employees.  It can be lost.  It can be stolen.  It can get waterlogged.  It can be deposited in the wrong account by accident.  Credit cards reduce these costs, and they do so arguably in a more efficient form than the use of checks, which of course clear at par, which means that the cost of interchange is borne by general tax revenues, with the usual set of static distortions. It also creates dynamic distortions because the want of price signals between the players makes it harder to introduce innovation into that space on such critical matters as error control, even if it would result in higher level of reliability in transactions.

In addition, it is also important to consider the other benefits that can arise with the use of credit card payments, one of which is the ability to key in all relevant data from a transaction at once.  Quite simply it may well be easier to link in inventory control, for example,  with a credit card system than it is with a cash or checking system. And it may speed up the rate of transactions so as to reduce the length of queues that are so important in many retail operations.

The clear upshot is that it is difficult through informed speculation to identify all the collateral consequences of running a credit card system, both positive and negative.  The only sure piece of data that we have is that credit transactions have done far better than cash and checks, even if they are losing ground to the next generation of payment systems that rely on cell phones and other technologies that are untied to the now ubiquitous magnetic strip.  These dynamic changes could easily force down interchange prices without the need for administrative proceedings.

The hard institutional question therefore is why concentrate major reforms on the interchange fees when all these other components must be added into the mix.  On this question, priors really matter. And after reading the assembled posts, my own view is that technological innovation is a far more important driver of improvements than partial fine-tuning of the current system, whatever its flaws.

In one sense, therefore, we, the members of this blog-fest, may well be part of the problem.  By putting one part of a complex payment industry under a microscope we divert resources from cost reduction measures that have unambiguously positive effects.  How large a cost is this?  Frankly, no one knows.  But given the risks of error in implementation, the best response still seems to be, play for the next big breakthrough, and in the short run, leave well enough alone.

In my first post I discussed the potential for interchange legislation from a consumer protection perspective, that is, would the combination of disclosure requirements coupled with a reduction of interchange fees be likely to improve consumer welfare.   I concluded that from the consumer protection perspective, the case for interchange legislation was weak.  I noted that a highly likely consequence of a direct or indirect reduction in interchange would result in an increase in the cost of credit to consumers (higher finance charges, other fees, annual fees) or a reduction of consumer benefits (loyalty and rewards programs).  The significant risk of a reduction of consumer access to credit, especially given the tenuous state of the economic recovery and the critical role of consumer spending in generating economic expansion and jobs, imposes a significant risk of consumer and social losses without strong evidence of offsetting consumer protection value.  However, consumer protection is not the only possible defense of such legislation.  This post will focus on defense of interchange legislation from a competition policy perspective.

As the commentators in this symposium suggest, as does the long and storied antitrust history of Visa and MasterCard, the more conventional story is that interchange fees are the product of a market power and the lack of competition between payment card systems.   Much of the discussion here has followed that general framework and focuses on the “cross-subsidy” question and the role of interchange legislation in increasing efficiency by reducing “usage” externalities.   The essence of this argument is that interchange fees should be regulated or eliminated in order to avoid cross-subsidization of payment card users by those using cash or checks (but see Ron Mann’s post here, focusing on the subsidy running from high interchange credit products to low interchange debit transactions).  So far, the symposium contributors have been largely skeptical of this defense.  For example, my colleague Todd Zywicki notes;

So it may be theoretically possible to imagine that credit cards are overused as a transaction medium.  On the other hand, it may also be possible that consumers underuse electronic payments because they don’t consider the social benefits of electronic payments, such as increasing efficiency, tax compliance, reduced risk of theft (and the police force and judicial system that accompany that)—in which case, it is possible that credit cards should be subsidized, not taxed.  Finally, it seems at least as plausible (probably more so) that consumers overuse cash and checks because those payment systems are subsidized by the government or that some of their costs are externalized, thus consumers don’t pay their full price.

Tom Brown and Tim Muris argue that the objection to cross-subsidies is overdone, emphasizing the ubiquity of such cross-subsidies and noting that the shift toward electronic payments render this objection largely moot:

At the outset, we note that discount fees, unlike interchange, are a feature of virtually all private payment instruments.  Thus, if there is something to the notion that discount fees tax other forms of payment, then the criticism applies as much to American Express and Discover as it does to MasterCard and Visa.  In our view, however, although this criticism is oft repeated, repetition obscures a number of problems.

First, cross-subsidies are ubiquitous in any complex economy.  Consumers receive free refills on drinks in restaurants, free parking at shopping malls, goods below cost in supermarkets (via loss leaders), relatively inexpensive newspapers because advertisers pay most of the costs, and many similar benefits.  To bring buyers and sellers together through such intermediaries as newspapers, supermarkets, and credit cards, one side frequently receives inducements to participate.  These inducements help maximize the joint value of the ultimate transaction for the parties.  Rather than an inefficient “subsidy,” these inducements are the lubricant necessary to make the economic machine work at its best.

I agree with these commentators that the cross-subsidy “problem” does not warrant a regulatory fix.  But I have a slightly different, and more antitrust-centric perspective.  Brown and Muris note the ubiquity of cross-subsidies in restaurants, supermarkets, and shopping malls.  These are just examples.  Cross-subsidization would occur not only in these settings, and in settings where firms do not plausibly have market power, but would also occur in closed-loop systems that do not use interchange fees, suggesting that this criticism has more to do with the necessity of balancing in two-sided markets rather than interchange per se.  But the important point from an antitrust perspective is that cross-subsidization is a normal and healthy part of the competitive process that generates substantial benefits for consumers.  The normal competitive process frequently does not result in customers being charged for all of the costs associated with their purchases.  Consumers face such cross-subsidies every time they go to Starbucks for their caffeine fix or an all you can eat buffet.  Some consumers are very sensitive to which products are allocated to the eye level shelf space in the grocery store, while others will purchase their favorite product regardless of where it is put on the shelf.   The very idea of promotion is to target what amount to effective discounts at marginal consumers rather than the infra-marginal ones.  See generally, Benjamin Klein, Kevin Murphy, Andres Lerner and Lacey Plache, Competition in Two Sided Markets: The Antitrust Economics of Payment Card Interchange Fees, 73 Antitrust L.J. 571 (2005).

Understanding the nature of promotion, and therefore cross-subsidization, as a part of the normal competitive process offers a new perspective on the potential for interchange legislation as an antitrust remedy.  Competition in highly competitive markets, such as grocery retail, results in supermarkets competing by offering various promotional services to marginal consumers.  Sometimes this competition results in free parking that some consumers use but others pay for, sometimes it results in dimensions of non-price competition (like offering a deli or keeping the store clean) that some consumers value more than others.  Competition between supermarkets to shift sales from these marginal consumers generate largely inter-retailer effects, but that cannot be said to be “inefficient” in any meaningful way.  This form of competition is essential to the competitive process.  Consider the interchange legislation in this light.  Do we, in response to supermarket competition resulting in “usage externalities” call for legislation that would allow the supermarkets to collude?  Of course not.  From a competition perspective, the very idea of replicating the collusive outcome for merchants and allowing a coordinated reduction in competition on the grounds that it would reduce cross-subsidies or costs wouldn’t make economic sense.  But notice that collusion between supermarkets to refuse to offer free parking, clean stores, or other promotional services would surely reduce the costs to the retailers in the same way that interchange would result in a reduction of costs to the merchants.

One possible explanation of our tolerance of these arguments is a failure to understand that, like in the case of supermarkets, competition between merchants on the acceptance of payment cards is a normal part of the competitive process.  But there is another possible and more plausible argument: countervailing power.  In other words, one could argue that legislation to allow collective monopsony conduct is appropriate to offset monopoly power (see, e.g., Steve Salop’s recent guest post here at TOTM on this issue in a different context).  Whether or not this justification is persuasive depends on the degree to which payment system market power explains interchange fees.  As it turns out, there is not compelling evidence that this is the case.  For example, consider that regulation reducing the interchange fees for open loop systems (and reducing their ability to balance both sides of the market) results in a shift of total credit purchase volume toward closed loop systems.  The loss in share that MC and Visa experienced in reaction to the Australian regulation suggests that interchange levels were not supra-competitive before the regulation.  Further, as Klein et al (2005) suggest, the time series evidence also casts doubt over the claim that market power explains interchange fee levels since fees were falling from 1977 to 91 while the importance of the payment systems was growing, and that fees remained lower in 2005 than they were in 1971.  In short, interchange fee levels appear to be a poor proxy for market power, and there does not appear to be convincing empirical evidence that market power explains changes in interchange fees.

In the absence of such evidence of a compelling problem, the regulatory “fix” of replicating the collusive outcome for merchants and interfere with the normal competitive process appears to be sure to shift rents between sides of the market, but more importantly, to impose a significant risk of doing more harm than good for the consumers it is purportedly designed to protect.

Most of the discussion related to pricing at the point of sale has emphasized the “cross-subsidy” between those that pay with cash and checks and those that pay with credit cards.  This discussion misses the core of the problem in a market where the use of cash and checks is rapidly declining; the central problem is the differential pricing of different card products.  The reaction of the card networks to their “loss” in the debit-card and American Express litigation was to create two new product lines (Visa Signature and World MasterCard) that have unusually high interchange fees, 1-2% higher than typical Visa and MasterCard products.  The rationale for these products from the network’s perspective is two-fold.  First, the increased interchange revenues compensate for lowered interchange revenues on debit-card transactions.  Second, issuers collect higher interchange revenues and thus would not shift their business out of Visa and MasterCard and toward American Express.

The problem from the merchant’s perspective is that these cards differ in no substantial way from the conventional credit products, except that they cost more.  The same customers that formerly used a typical Visa or MasterCard product now use a high-interchange product.  Although those customers often have multiple cards in their wallet from which to choose, they are likely to choose the high-interchange product because it brings them more rewards.  Merchants that do not believe the products motivate increased spending in their stores have no practical response except to refuse all Visa, or all MasterCard products.  Thus, the networks face no price pressure, because the only competitive pressure they face is to keep issuers from moving to other networks.

If the best way to identify prices is to let the market set them, perhaps the best reform is the simplest: allow merchants to discriminate among the products of the various networks, to surcharge or decline products priced at a level that is unattractive to the individual merchant.  Wal-Mart and Walgreen’s might immediately decline to accept Visa Signature and World MasterCard at their current price.  Their customers, predictably, would make identical purchases but simply pull a different card from their wallet.  Macy’s and Bloomingdale’s probably would continue to accept the high-cost products, worried that customers might spend less or go elsewhere if they can’t use their high-rewards cards.  Visa and MasterCard could judge for themselves whether it would be appropriate to decrease, or increase, the interchange fees for those cards.  The outcome, though, would be price levels determined by the attractiveness of the particular products to particular merchants.

Will reduction in interchange fees help or hurt consumers? Two posts yesterday made the conjecture that a reduction in one category of fees would only increase other fees, and that the overall sum of fees will not change. This is the fee-neutrality claim. Todd Zywicki writes:

The mathematics of the situation is inescapable: card issuers would have to increase the revenue generated from consumers from either interest payments or higher penalty fees.

And Josh Wright agrees:

It would be unwise from a consumer protection policy standpoint to assume that [reduction in interchange fees] represent the free lunch legislators have been looking for after all these years – or that those fees will not simply be reinstated in other guises elsewhere.

As a logical claim, I tend to agree with this “neutrality” conjecture. Indeed, the Australian experience can be explained in a way that is consistent with this dynamic, as Joshua Gans noted:

The interchange fee reduction causes merchant fees to fall but issuer fees to rise (or loyalty schemes to be curtailed) but otherwise does not impact on the consumer’s choice of payment instrument.

The question, though, is what are the implications of fee neutrality. Zywicki and Wright conclude, I believe, that in light of fee neutrality, it is pointless to try to help consumers by capping one component of the overall fee. It will not help, and might introduce an inefficiency.

My claim in this post is that the normative implications are not necessarily as Zywicki and Wright suggest. Fee neutrality, as I understand, applies only to the average cost of using credit cards. That is, consumers who use credit cards end up paying on average the same economic cost, regardless of the division of fees.  But when we consider other measures of consumer welfare, the neutrality claim no longer holds.

First, consumers who use credit cards as payment device and not for borrowing would benefit from the fee substitution. For them, the lower product prices when interchange fees decline are not offset by higher finance charges, because they don’t pay finance charges. So even if the neutrality proposition is correct on average, limits on fees have a distributive effect. This effect could also change the relative uses consumers make. Buying things becomes cheaper, borrowing becomes more expensive, and so we can predict some shift in primary conduct, which, again, violates the neutrality conjecture.

Second, even if for a given consumer the increase in finance and other charges exactly offsets the reduction in interchange fees, it is plausible to expect that a reduction in fees would lead to a reduction in prices of products and change the consumer’s purchasing decisions. Imagine that the interchange fee were to drop, in a hypothetical economy, from 5% to 0.5%. Do we think that product prices will drop accordingly? In response to a comment I posted yesterday, suggesting that such a price decline would occur, Todd Zywicki correctly responds that not all the saving will be rolled over to consumers. It depends on cross-elasticities of demand and supply. But at least in competitive markets, where prices equal marginal cost, the bulk of the savings in interchange fees would be enjoyed by consumers. It may be that nominal prices would display some stickiness, but it’s hard to imagine that in the long run consumers will be deprived of this benefit. One has to have very little faith in markets to imagine that the cost reduction will be enjoyed in its entirety by merchants, through higher profits.

If caps on interchange fees cause a non-trivial effect on prices, this regulation has the potential to reach far beyond the credit card market. It now affects primary decisions regarding the composition of consumption.

It is true that some of the increased demand due to lower prices is offset by the higher cost of credit. To buy these cheaper products with borrowed money would be just as costly, according to the neutrality claim. But it is important to unbundle the overall price into its two pure costs—the cost of the product and the cost of the credit. The potential efficiency of fee limits is in achieving an unbundled price, where the product component and the price component are priced separately.

Geoffrey A. Manne is Executive Director of the International Center for Law & Economics and a Lecturer in Law at Lewis & Clark Law School.

I take to heart Jim’s claim that fraud is too-little discussed in this realm given its cost, and thus I’ll try my hand at it.

Every discussion of the industrial organization of credit card networks owes a debt to Bill Baxter.  Baxter, a law professor and former Assistant Attorney General in the Antitrust Division of the DOJ, was one of the first (maybe the first?) scholars to discuss the economics of two-sided markets, in a paper, as it happens, on the economics of interchange fees in credit card networks.

In simple terms, the essence of Baxter’s analysis is that the role of the interchange fee in credit card networks is to balance and maximize demand for credit card transactions on both the consumer side and the merchant side–optimizing the system by drawing in as many consumers on the one side and merchants on the other as possible while still matching up demand for credit transactions on each side (thus maximizing network benefits).  The lever of the interchange fee allows the system to re-allocate some of the costs that are otherwise born by only one side of the market in order to effect this optimization.  One of these costs is the cost of fraud–and the interchange fee is, it seems to me, an essential lever for re-allocating the costs of fraud within the credit card system to where they can best be born.

Fraud costs are an important, if oft-neglected, component of payment systems’ functioning.  Every payment system by its nature includes the risk of fraud, and every payment system, by design or by default, imposes the risk of fraud on one or more parties in the system.  For example, a merchant that accepts cash in exchange for goods bears the risk that the cash will be counterfeit.  The cost of counterfeit currency to merchants is substantial.  (Although, speaking of cross-subsidies, the cost to merchants likely captures barely a fraction of the full cost of counterfeit currency—a cost born mostly by the government (and passed on to taxpayers) in policing and deterring counterfeiting).  The cash system, essentially by default, imposes the residual fraud costs on the merchant.  Checks present an even greater fraud problem than cash and, again, the costs are allocated essentially by default: A merchant that accepts a fraudulent check will bear the cost of the fraud.

In principle, the fraud costs of checks or cash could be allocated differently.  The government could offer some sort of guarantee, or the issuing bank could agree to bear the cost.  But in part because the government requires banks to clear checks at par—has, in other words, fixed the interchange fee at zero for checks—there is little opportunity for the system’s lever to operate to reallocate these costs, ensuring that the costs lie where they fall, and that redistribution is made only in the parts of the system governed by explicit contracts (thus, for example, depending on a host of factors, some of this cost may be redistributed from merchants to merchants’ banks via reductions in various fees in the agreement between merchant and bank).

In contrast, the flexible interchange fee in the credit card system allows fraud costs to be allocated differently throughout the system, presumably ensuring not that the costs lie where they fall, but rather that they are born by the party best positioned to bear the costs.  In the case of credit cards, assuming the merchant complies with the network’s rules for seeking authorization of payment, the issuing bank, in fact, guarantees the payment (and thus bears the risk of non-payment).  As Bill Baxter noted, “[t]his shifting of risk under the [credit card] system obviously increases [the issuing] bank’s cost, enhances [the merchant’s] demand for the system, and increases the amount of discount [the merchant] is willing to pay to [the acquiring] bank.”  It is this re-allocation of costs, facilitated by the interchange fee, that helps to optimize the system.

The GAO has a fairly extensive discussion of the costs and benefits of credit cards to merchants.  However, that discussion focuses on the individual benefits.  I would like to step back and put two of those benefits – increased merchant sales and fraud prevention costs – into the larger context that I discussed earlier.

First, there is the question of credit cards increasing merchant sales.  How exactly does this occur?  One possibility is that if some merchants accept credit cards and others do not, then some people will switch their business to the merchants that take credit cards.  From the point of view of the merchants taking credit cards, their sales most certainly go up.  From the point of view of the merchants which do not take credit cards, their sales go down.  From society’s point of view, sales are moving from one business to another, but total sales do not change.

Another possibility is that credit cards provide ready access to a line of credit, allowing people to make purchases on credit that they otherwise would not be able to make.  If so, it is not clear how much of an effect on sales that would really have.  Credit cards are not the only source of credit in the economy.  Also, credit has to be paid back.  In the short run, credit can certainly increase sales, but, as the economy is so painfully reminding us right now, in the long run the bills have to be paid, so it is not clear that total sales over time increase.

It is also possible that credit cards are just more efficient than other payment methods and save both consumers and merchants money.  If that is the case, then there is more money to spend in the economy and sales can go up.  Research suggests, however, that the differences between different payment methods (in terms of the real resources used to process a payment) are relatively modest, often less than one cent per dollar spent.

Overall, then, it seems likely that most of any sales increase will come from moving sales between merchants.  Intuitively, this makes sense.  If you were told that you could not use any credit cards for the next five years, would your total spending over those five years be substantially lower?  On the other hand, if you were told that a store down the street was not going to take credit cards anymore, would your spending at that store fall?  Increased sales for a merchant may be good for that merchant, but whether society is better off is a different question.

Fraud is a different matter, though.  Fraud takes money from some people and gives it to others.  However, we as a society disapprove of fraud and do not wish to reward criminals.  Thus, we view fraud losses as purely a bad thing for society.  Unfortunately, all payment methods are subject to fraud.  The GAO discusses costs of prevention for credit cards, but does not discuss the direct costs of fraud to merchants and consumers.  Criminals go where the money is, and a lot of money flows through credit card receipts.  Restaurant tips get changed, card numbers get stolen, transactions get rerun for higher amounts, cards are cloned – there is an endlessly changing list of fraudulent activities.  Many of these activities are difficult to detect.  For example, when the tip on a receipt is changed, many people will never notice, even though they just had money taken directly out of their pocket.  Estimates on the costs of fraud for different payment methods vary, but there is general agreement that all payment methods are subject to fraud and that debit cards (when authorized with a personal identification number) have some of the lowest overall fraud rates.  Different people bear the costs of fraud depending on the type of fraud and the payment method.  Merchant costs for losses and prevention are important, but they are not the only ones affected.

James Van Dyke is President and Founder of Javelin Strategy and Research.

I feel that at least two important issues are being left out of the raging controversy over the cost of interchange. (At this point my readers are probably deciding if I’ll follow with a pro-merchant or pro-bank POV…but guess what: here comes one of each to make my point that we’re being a bit simplistic in this debate!).

Point one: card fees replace other costly forms of payments, and this must be included in any policy discussion. Previous Javelin research of several hundred merchants found that total costs for handling checks and cash are often considered to be as high as those for cards. Cash comes with risk of employee fraud, and may prevent consumer sales for those without current access to paper or cash money. Every check is an incident of fraud waiting to happen, as these antiquated IOU instuments are essentially dead or dying in every country other than the U.S. Checks invite criminals to follow the simple methods documented by Frank Abagnale of “Catch Me If You Can” fame.

Point two: Any discussion over cost of interchange should include a review of who pays for fraud. Between merchants and banks, if there is a disparity over who handles the brunt of fraud (the recent study we did for LexisNexis found that merchants incur 90% of direct fraud cost) brings up issues of incentives. Simply put, if you can pass a cost on to someone else your incentive for minimizing the cost may be reduced.

And now that I’ve said something to anger both merchants and bankers, I’ll eagerly await the responses…

The GAO report raises concerns about card association the level of interchange fees (that acquirers pay issuers for credit card transactions processed) but also about other card association rules such as the ‘no surcharge rule.’ That rule prevents a merchant who accepts card transactions from charging a ‘point of sale’ premium to consumers who use a card rather than using cash or checks. However, while the report deals with concerns about each issue individually, what is not recognised is that concerns are related. From the perspective of economics, if you deal with no surcharge rules (by eliminating them) there is a diminished and perhaps non-existent case for regulating interchange fees.

To see this, let’s start with the interchange fee concern. A higher fee means a higher charge imposed on merchants. Not surprisingly, they would prefer those charges to be lower and so card associations will recognize that increase interchange fees may decrease card acceptance. But there is a flip-side. Those high interchange fees are an inducement to card issuers to get more cards issued and used. Hence, the proliferation of solicitations and reward programs as interchange fees have risen. Those consumers then become the marketing department of card associations with respect to merchants, putting pressure on them to accept cards despite the high fees.

Now merchants may be able to compensate in highly competitive markets by not accepting cards and offering lower prices to consumers. But if retail markets cannot separate payments with different retailers specializing in card or cash, there is a problem. Retailers who face both cash and card customers must charge them the same amount by virtue of the no surcharge rule. That means that cash customers must effectively cross subsidize the cost to merchants of accepting cards. This leads to numerous inefficiencies including that consumers may be over-selecting expensive cards rather than other instruments. It also leads to what is termed a ‘competitive bottleneck’ whereby competition cannot work to bring value to consumers.

One response to this is to regulate or cap interchange fees. That would mitigate the problem but would also bring with it the costs of regulation. The alternative would be to see if you could restore competitive structure to the payments industry by achieving payment separation another way. Specifically, if surcharges are permitted then merchants will face strong incentives to pass on the direct costs of card usage to card users. Consumers would then have to weigh up whether those additional charges were really worth the other benefits they are getting from card use. But the point is that where previously there was no cost pass through to the right consumers (as opposed to the pool of them), allowing surcharges ensures that happens.

This means that card associations face an additional cost if they increase interchange fees, that consumers will simply not use cards at the point of sale and save their retailers those costs. One might think that this would make the card association’s management and negotiation over interchange fees more complex. However, as Stephen King and I demonstrated in 2003, permitting surcharging makes the interchange fee neutral (see here for other papers on this topic). Put simply, changing it through association choice or through regulation impacts on prices but not on the total level of card transactions or mix of payment instruments. This makes us wonder why the Reserve Bank of Australia chose both to eliminate the no surcharge rule and to regulate interchange fees.

Disclaimer: These views are my own and not those of the Federal Reserve Bank of Chicago or the Federal Reserve System.  Much of this discussion is taken from my paper titled “Externalities in Payment Card Networks: Theory and Evidence” presented at the Federal Reserve Bank of Kansas City’s 2009 Retail Payments Conference.

Generally, merchants charge the same price regardless of the type of payment instrument used to make purchases. In many jurisdictions, merchants are not allowed to add a surcharge for payment card transactions because of legal (some states in the U.S. do not allow surcharges) or contractual (card networks generally do not allow surcharges) restrictions. But, merchants may be permitted to offer discounts for noncard payments. Economic models of payment cards generally conclude that social welfare improves if merchants set prices based on payment instrument used.

There are examples of jurisdictions where no-surcharge restrictions have been lifted. To encourage better price signals, the Reserve Bank of Australia removed no-surcharge restrictions. While most Australian merchants do not impose surcharges for any type of payment card transaction today, the number of merchants who do is increasing. At the end of 2007, around 23 percent of very large merchants and around 10 percent of small and very small merchants imposed surcharges. In addition to allowing price differentiation across payment instruments, the RBA allowed merchants to price differentiate across networks. The average surcharge for MasterCard and Visa transactions is around 1 percent, and that for American Express and Diners Club transactions is around 2 percent (Reserve Bank of Australia, 2008).

Some economists have stressed that merchants may surcharge consumers more than their costs resulting in suboptimal card use. A potential regulatory response is to cap the surcharge. In responding to the 2007/08 review of reforms by the Reserve Bank of Australia, some market participants suggested that merchants might be imposing higher surcharges than their cost to accept payment cards. The RBA has considered setting a limit for the surcharge amount but has not gone ahead with implementing one.

In the United States, merchants are allowed to offer cash discounts but may not be allowed to surcharge credit card transactions. In the 1980s, many U.S. gas stations explicitly posted cash and credit card prices. Barron, Staten, and Umbeck (1992) report that gas station operators imposed these policies when their credit card processing costs were high but later abandoned these policies when acceptance costs decreased because of new technologies such as electronic terminals at the point of sale. Recently, some gas stations brought back price differentiation based on payment instrument type, citing the rapid rise in gas prices and declining profit margins.

In the Netherlands, Bolt, Jonker, and van Renselaar (2009) study the impact of debit card surcharges. They report that a significant number of merchants are setting different prices, depending on whether cash or a debit card is used. Debit card surcharges are widely assessed when purchases are below 10 euro. Bolt, Jonker, and van Renselaar find that merchants may surcharge up to four times their fee. In addition, when these surcharges are removed, they argue, consumers start using their debit cards for these small payments, suggesting that merchant price incentives do affect consumer payment choice. Interestingly, in an effort to promote a more efficient payment system, the Dutch central bank has supported a public campaign to encourage retailers to stop surcharging and for consumers to use their debit cards for small transactions.

There are instances when card payments were discounted vis-à-vis cash payments. During the conversion to the euro from national currencies, one German department store offered discounts for using cards because of the high initial demand for euro notes and coins to make change for cash purchases (Benoit, 2002). It should be noted, however, that the retailer was in violation of German retailing laws for doing this. In a more permanent move, the Illinois Tollway charges motorists who use cash to pay tolls twice as much as those who use toll tags (called I-PASS), which may be loaded automatically with credit and debit cards when the level of remaining funds falls below a certain level. In addition to reducing cash handling costs, the widespread implementation of toll tags decreased not only congestions at toll booths but also pollution from idling vehicles waiting to pay tolls. In both of these cases, the benefits of using cards outweighed the costs.

Another rule that restricts merchants is the honor-all-cards rule. A payment card network may require that merchants that accept one of its payment products to accept all of its products. In other words, if a merchant accepts a network’s credit card, it must accept debit and prepaid cards from issuers belonging to that network. Such a rule enables a card network to innovate by producing different products that when introduced will have a large base of merchants that accept them bypassing the chicken-and-egg problem. The introduction of payroll cards, a type of prepaid card, is an example of an innovation that leverages a card network’s existing infrastructure.

In the United States, around 5 million merchants sued MasterCard and Visa over the required acceptance of the network’s signature-based debit card when accepting the same network’s credit card. The case was settled out of court. MasterCard and Visa agreed to decouple merchants’ acceptance of their debit and credit products. While few merchants have declined one type of card and accepted another type, the decoupling of debit and credit card acceptance may have increased bargaining power for merchants in negotiating fees.

A subset of the honor-all-cards rule is the honor-all-issuers rule. If a merchant accepts a credit card from one issuer, it must also accept credit cards from another issuer within the same network. Such a policy levels the playing field between large and small issuers. Otherwise, small issuers may not be able to compete with the large issuers because of economies of scale and network effects.

Another type of honor-all-cards rule could cover the acceptance of different credit or debit cards from the same issuer. For example, an issuer may have a plain vanilla credit card and also have others that earn different types of rewards. While merchants may not care what types of rewards their customers receive from their banks, merchants may pay different fees based on the type of card used by their patrons from a single issuer. More recently, certain policymakers are considering allowing merchants to discriminate within a card classification, such as a credit card, based on differences in interchange fees.

In my first post I argued that consumers as a group would likely be made worse off as a result of artificially imposed reductions in interchange fees.  This post considers a second line of attack—that even if consumers overall would be made no better off (or even worse off) as a result of regulating interchange fees, Congress should intervene in the name of “fairness” to regulate interchange fees.  This “fairness” argument, however, is a red herring, especially when advanced by merchants purporting to speak for consumers.  Indeed, the sincerity of the merchants’ concern is belied by their own behavior.

Merchants claim the current interchange price (typically about 1.75% of the price of the transaction) is “unfair” to those customers who pay by cash or check (and thus don’t incur interchange fees) because cash customers are essentially forced to subsidize credit users who pay the same retail price but incur this additional cost.  Note first that whether a reduction in interchange fees would be passed through to consumers is a question of market dynamics.  There is no evidence that Australia’s cap on interchange fees resulted in lower retail prices for consumers.  Even if retail prices did fall there is no evidence that any retail price reductions offset higher credit prices to consumers or would benefit consumers equally.  While capping interchange fees might eliminate the purported unfairness by making credit purchasers worse off, it is questionable whether it would actually make cash customers better off.

But merchant critics of credit cards on “fairness” grounds are playing with a stacked deck: cash and checks are both subsidized payment mechanisms.  The government prints and replaces worn currency and the Federal Reserve clears checks at par. By contrast, credit card issuers bear the cost of maintaining their payment network.  If merchants were serious about accurately allocating the costs of the payment network then they would insist that the government eliminate these subsidies from the system.  And this doesn’t even count the deadweight costs to the economy of cash, such as the time consumers spend making ATM transactions or the cost of paying guards to drive around pieces of paper in armored cars.  Studies find that consumers who write checks take twice as long at the check-out line as those who use payment cards—forcibly imposing an external cost on everyone in line behind the check-writer.  Should check-writers be required to compensate the rest of us for our wasted time standing in line?

So it may be theoretically possible to imagine that credit cards are overused as a transaction medium.  On the other hand, it may also be possible that consumers underuse electronic payments because they don’t consider the social benefits of electronic payments, such as increasing efficiency, tax compliance, reduced risk of theft (and the police force and judicial system that accompany that)—in which case, it is possible that credit cards should be subsidized, not taxed.  Finally, it seems at least as plausible (probably more so) that consumers overuse cash and checks because those payment systems are subsidized by the government or that some of their costs are externalized, thus consumers don’t pay their full price.

Moreover, federal law expressly permits merchants to give cash discounts (some do).  That most merchants choose to accept credit cards and charge one price for cash and credit reflects a simple business decision, just like offering free parking (thereby subsidizing those who drive versus those who walk or take the bus), manned check-out lines (subsidized by those who use self-check out), or free returns on merchandise or money-back guarantees (subsidized by those who don’t return products).  Starbucks customers who drink their coffee black subsidize those who use cream and sugar.  Movie-goers who attend primetime shows subsidize those who attend matinees. Consumers who pay full price subsidize those who buy the same product on sale a few days later.  In a free economy we allow the scope of these cross-consumer “subsidies” to be set by free contracts, not governmental mandates.

The insincerity of the merchants’ fairness concerns is illustrated by their own behavior.  Traditionally, many retailers operated their own in-house credit operations.  This included large department stores, but also many grocers, tailors, furniture, appliance, and hardware stores that offered credit to customers on open-book or installment credit.  Many an older lawyer has related to me the memorable experience of opening his first charge account at Brooks Brothers (or the local equivalent) when buying his first suit.  Maintaining these credit operations were quite expensive—the retailer had to bear the operational costs (employees, billing operations, underwriting, customer service), the risks of non-payment and fraud, and the time-cost of money of the delay in receiving payments from the billing cycle and grace period.  Despite this high cost, however, many merchants made a business decision to maintain credit operations because of consumer demand.

Today, many merchants (especially smaller one) have essentially outsourced their credit operations by terminating their in-house programs and accepting credit cards instead, a much less costly system.  Credit cards eliminate the operational cost and non-payment risk associated with maintaining an in-house credit operation.  Credit card issuers bear the cost of the delay in payment over the billing cycle and grace period.  Outsourcing credit also allows small businesses to compete on equal footing with larger businesses that could afford the cost and risk of in-house credit operations.  Some major retailers, however, continue to run their own proprietary credit operations, accepting the higher cost and risk in exchange for the benefits of retaining in-house control.

Why is this history significant?  Because during these decades when merchants operated their own credit operations (and where they continue to do so) they consistently charged the same retail prices for cash and credit consumers despite the higher costs of credit customers than cash customers.  Target’s proprietary credit operation, for example, has been battered by double-digit default rates on its credit portfolio—yet Target charges the same price for cash and credit consumers.  Some merchants even offer “twelve months same as cash” and other promotions that subsidize credit purchasers.  In a similar vein, empirical studies have found that during the 1970s when state usury laws limited the ability of lenders to charge market rates of interest on consumer credit, retailers responded by increasing the price of goods typically sold on credit (such as appliances), thereby burying the price of the credit in a higher price of the goods for all purchasers.

Thus, the merchants’ claim today that the interchange fee forces an unfair subsidy between cash and credit purchasers is a red herring: merchants were (and are) more than happy to force charge the same price for cash and credit—so long as the merchants were capturing all the benefits.  The difference today has nothing to do with fairness, but that the merchants don’t get to keep all the profits.  And that they want the benefits of credit cards (making the issuers bear the cost and risk) without the costs.  Indeed, given that the merchants have outsourced their credit operations to credit cards precisely because they are less expensive, the size of this subsidy is probably smaller today than it was when merchants ran their own operations.  And even this ignores the various costs associated with accepting and handling cash and checks that credit users implicitly pay as subsidies for those types of payment.

Merchants have made a business decision to accept credit cards because it is cheaper and less-risky than running their own in-house credit operations.  As such, the cost of accepting credit cards is a cost of business, just like rent, utilities, and employee salaries.  Let’s get the real issue clear then—the argument over interchange has nothing to do with fairness or benefits to consumers.  Merchants are speaking for themselves, not consumers, when they demand to pay lower interchange fees.  The merchants own behavior demonstrates the point.  Congress needs to stay out of this issue.

(NB:  We have consulted with Visa U.S.A. Inc. on a variety of issues; the views expressed herein are our own.)

In our earlier post, we observed that the GAO report on interchange got off on the wrong foot when it concluded that interchange fees were rising.  We infer from the silence which greeted our post that everyone agrees with this criticism.  Indeed, yesterday’s posts and comments appear to agree that the GAO’s report does very little to advance the discussion of interchange or the cost of electronic payment.  But we suspect that greater disagreement lies just around the corner.

A number of posts yesterday promised to address the claim on which the criticism of modern payment systems rests–the extent to which the discount that merchants pay to accept most electronic payment systems in the U.S. imposes a tax on legacy payment instruments such as cash and check  Mark Seecof seized upon this point in his comment on Ron Mann’s post.  According to Mark, the “big problem” with the payment card industry is that discount fees are used to fund rewards programs, and he claims that society as a whole would be better off if the government simply forbid networks from enforcing their honor all cards rules and force networks to negotiate acceptance on a program-by-program, issuer-by-issuer basis.  The claim that increasing transaction costs will produce more efficient outcomes is a curious one.  But we’ll save that issue for a later day.  Rather, with this post we intend to take up the predicate of Mark’s post–that discount fees on electronic payments shift costs to users of legacy payment instruments.

At the outset, we note that discount fees, unlike interchange, are a feature of virtually all private payment instruments.  Thus, if there is something to the notion that discount fees tax other forms of payment, then the criticism applies as much to American Express and Discover as it does to MasterCard and Visa.  In our view, however, although this criticism is oft repeated, repetition obscures a number of problems.

First, cross-subsidies are ubiquitous in any complex economy.  Consumers receive free refills on drinks in restaurants, free parking at shopping malls, goods below cost in supermarkets (via loss leaders), relatively inexpensive newspapers because advertisers pay most of the costs, and many similar benefits.  To bring buyers and sellers together through such intermediaries as newspapers, supermarkets, and credit cards, one side frequently receives inducements to participate.  These inducements help maximize the joint value of the ultimate transaction for the parties.  Rather than an inefficient “subsidy,” these inducements are the lubricant necessary to make the economic machine work at its best.

Second, from a social policy perspective, whether interchange forces legacy buyers to pay more should raise a concern only if legacy is more efficient.  But it’s not.  It is hard to believe, as some people suggest, that credit cards and other electronic payments are more expensive than cash and checks.  In fact, legacy payments have several limitations that create costs for both consumers and merchants.  Cash only works well when the good and payment are exchanged simultaneously.  And the technology of cash does not support the instantaneous decision to give credit to the person buying; rather, the buyer has to arrange credit separately with a financial institution.  In addition, with cash, you have no recourse against fraud, other than bringing suit.  (On the costs of cash, see Daniel D. Garcia Swartz, Robert W. Hahn, and Anne Layne-Farrar, The Move Toward a Cashless Society: A Closer Look at Payment Instrument Economics, Vol. 5, Issue 2, Review of Network Economics 175, 192 (June 2006) (describing cash as “among the most costly payment method[s] for society”)).  Similar transaction costs and risks accompany the use of checks.

By contrast, there are numerous benefits to using credit cards and other electronic payments.  For consumers, these benefits include the extension of credit real-time, the reduction of risk, automated dispute resolution, and better record keeping, as Garcia-Schwartz, Hahn and Layne-Farrar demonstrate.  For merchants, accepting credit cards allows them to make sales on credit at a generally lower cost than operating their own credit program.  And merchants can receive faster and more certain payment from customers using cards than from customers using other means, such as checks.

Third, and most significantly, the rapid growth of online payments within the retail industry is rendering legacy payments obsolete.  The GAO itself seems generally aware of the shift from legacy to electronic payments.  Indeed, it cites the Federal Reserve’s recent estimate that the use of both checks and cash have declined, or at least grown more slowly than credit and debit card use, since the mid-1990s as more consumers switched to electronic forms of payment.  Since 2005, more than half of total retail transactions have used either credit or debit cards.  Large national merchants report that sales made with cash and checks have decreased in recent years, while sales made with credit and debit cards have increased.

But the GAO ignores that the argument in favor of regulating interchange to protect cash and check users, whatever its overall merits, is logically limited to areas where legacy forms of payment can be used.  And those areas are quickly vanishing.  For example, even if a study of the 1980s retail gasoline market were to suggest the existence of cross-subsidies then—a debatable conclusion—that study cannot be read to suggest the existence of such a subsidy among people who shop on-line or who buy their gas at automated fuel dispensers.  According to scholars, we are rapidly moving towards a cashless society where no one uses legacy instruments such as cash or check.  And there is simply no reason to believe that this move is driven by the inherent inefficiency of electronic payment or an implicit tax on users of cash or check.

The GAO’s misplaced concern for users of legacy payments is yet another example of a theoretical objection to unregulated interchange that finds no support in the facts.  According to Garcia-Schwartz, Hahn and Layne-Farrar, “the shift toward a cashless society appears to improve economic welfare,” with consumers the party most likely to benefit.  But, if history repeats itself, we will likely have to continue to endure the interchange debate regardless of the facts.  As the GAO’s report again reminds us, merchants simply want to pay less for the benefits that credit cards provide.  Not surprisingly, they are in this debate for themselves, not their consumers.

The Law and Economics of Interchange Fees and Credit Card Markets

Welcome to day two of of our two-day symposium on the law and economics of interchange fees and credit cards.

Our symposium brings together several of the world’s leading experts on interchange fees and the law and economics of credit card markets.  Our participants will discuss a range of issues surrounding the regulation of interchange and credit card markets.

• Omri Ben-Shahar (University of Chicago Law School)
• Tom Brown (O’Melveney & Myers)
• Bob Chakravorti (Federal Reserve Bank of Chicago)
• Richard Epstein (University of Chicago and NYU Law Schools)
• Joshua Gans (University of Melbourne Business School)
• Ron Mann (Columbia University Law School)
• Geoffrey Manne (International Center for Law & Economics and Lewis & Clark Law School)
• Tim Muris (George Mason University School of Law and O’Melveney & Myers)
• Allan Shampine (Compass/Lexecon)
• Bob Stillman (CRA International)
• Jim Van Dyke (Javelin Strategy & Research)
  
• Joshua Wright (George Mason University School of Law)
• Todd Zywicki (George Mason University School of Law)

Today’s posts will cover the following topics:

• Assessing Cross-Subsidies.  Posts from Tom Brown & Tim Muris and Todd Zywicki
• Assessing the Network Rules.  Posts from Bob Chakravorti and Joshua Gans
• Considering the Costs: Fraud.  Posts from Jim Van Dyke, Allan Shampine and Geoffrey Manne
• Additional Responses and Closing Thoughts.  Posts from Omri Ben-Shahar and Joshua Wright and TBD

The posts will appear regularly throughout the day to allow time between posts for discussion: Check back for updates and comments.  Expect free-ranging discussion in the comments–most of these issues are inter-related and we will return to several themes throughout the symposium.

You can find all of the symposium posts under the “credit card symposium” link on the right side of the page.

Thank you for joining us!