Academic Journal | January 01, 2002

Platform Competition In Two-Sided Markets: The Case Of Payment Networks

By: Sujit Chakravorti Roberto Roson
Source: Review of Network Economics

Two-sided markets are defined as platforms providing goods and services to two distinct end-users where platforms attempt to set the price for each type of end-user to “get both sides on board.” Armstrong (2002), Evans (2003), and Rochet and Tirole (2003) suggest various examples of two-sided markets such as yellow pages (advertisers and users), adobe acrobat (creators of documents and readers), and television networks (viewers and advertisers). In this paper, Chakravorti and Roson study an example of a two-sided market – payment networks (consumer and merchants).

They extend the literature on payment cards in several directions. They incorporate several features of the payment card industry that have received little attention. First, consumers and merchants have distinct preferences for payment cards. For example, American Express, Discover, MasterCard, and Visa compete for consumers in various dimensions. 

Most compete on credit terms such as interest rates, billing cycles, and lines of credit for the consumer side. Card networks also compete for merchants based on fees and benefits such as the type and number of cardholders. Second, payment instruments compete with one another based on consumer and merchant brand preferences. Third, they consider competition among different types of payment instruments. They study the effects on consumer and merchant welfare if two payment networks offering different payment features such as debit and credit cards were owned by one entity or by two different ones.

Their model investigates the pricing strategies of payment networks that maximize the joint profits earned from both types of end-users. Recent investigations of these markets have focused on the determination of various prices including interchange fees, merchant discounts, and retail prices of goods and services within a single payment platform (see Chakravorti and Emmons, 2003, Chakravorti and To, 2003, Rochet and Tirole 2002, Schmalensee 2002, Schwartz and Vincent, 2002, Wright, 2003 and 2004).1 Often policy discussions have focused on whether each participant is paying her fair share of the underlying cost of the payment service and the consumer and merchant benefits of competing networks.

Recently, Guthrie and Wright (2003) and Rochet and Tirole (2003) have investigated pricing decisions by payment networks when there are competing payment platforms. They build upon these two models by considering joint distributions for consumer and merchant benefits from participating on each network. In other words, each consumer and merchant is assigned a network-specific level of benefit from participating on each network. Consumers and merchants base their payment network usage decision on the difference between their individual network-specific benefit and that network’s participation fee. Their model also differs because they consider the effects of competition on price level and price structure. They consider three types of market structures for payment networks: cartel, non-cooperative duopoly under product differentiation, and Bertrand duopoly (price competition for homogeneous products). They find that competition unambiguously improves consumer and merchant welfare while reducing the profits of payment networks. However, neither competition nor cartel market structures yield welfare-efficient price structures.

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Academic Journal | June 01, 2007

A Theory Of Credit Cards

Chakravorti and To construct a two-period model to study the interactions among consumers, merchants, and a card issuer. The model yields the following results. First, if the issuer's cost of funds is not too high and the merchant's profit margin is sufficiently high, in every equilibrium of our model the issuer extends credit to qualified consumers, merchants accept credit cards and consumers face a positive probability of default. Second, the issuer's ability to charge higher merchant discount fees depends on the number of customers gained when credit cards are accepted. Thus, credit cards exhibit characteristics of network goods. Third, each merchant faces a prisoner's dilemma where each independently chooses to accept credit cards, however, all merchants' two-period profits are reduced because of intertemporal business stealing across industries.

Working Paper | November 01, 2008

Consumer Choice and Merchant Acceptance of Payment Media

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