Underlying Incentives in Credit Card Networks

The usage of third-party general-purpose credit cards in the United States has increased dramatically during the last decade. Credit cards have surpassed checks as the most frequently used payment instrument at the point of sale and are the primary payment instrument for Internet transactions. From 1990 to 1999, credit card transactions more than tripled from 4.6 billion to 14.2 billion in the United States. Dollar volume increased from $337 billion to $1,096 billion over the same period.

Although there are thousands of different financial institutions that issue credit cards, they usually participate in one of four major credit card networks operated by American Express, Discover, MasterCard or Visa. The two largest networks—MasterCard and Visa—accounted for over 75 percent of the dollar volume in 1999. American Express and Discover operate their own “proprietary” networks, whereas MasterCard and Visa are credit card associations comprised of member banks.

Recently, some market participants have argued that the lack of competition at the network level may harm consumers and stifle innovations. This article discusses two antitrust cases against the two credit card associations. In a recent antitrust case, the U.S. Department of Justice (DOJ) alleged that MasterCard and Visa through various policies limited competition in the credit card market. The two main issues were: exclusivity—member banks issuing MasterCard and Visa products are not allowed to issue products from other credit card networks—and governance duality—members of one association have significant influence in the other association. In a pending antitrust case, Wal-Mart along with many other small and large retailers alleges that MasterCard and Visa use illegal tying arrangements that require retailers to accept all of their branded payment products. Specifically, merchants are challenging the mandatory acceptance of MasterCard and Visa offline debit cards if they accept the associations’ credit cards.

To better understand credit card antitrust issues, the underlying bilateral relationships in credit card networks are explored to investigate if any participant benefits or is harmed by various incentives existing in today’s marketplace. Recently, the effects of some pricing practices at the network level have been questioned. Some analysts have argued that the common practice of charging one price regardless of the type of payment instrument used distorts the allocation of goods and services in the economy. While there may be substantial competition in the issuer and acquirer markets, some analysts question the setting of interchange fees by the network operators. The interchange fee is the fee that the merchant’s bank pays the cardholder’s bank.

Whether the credit card market is competitive or whether certain participants are able to earn high rents is debatable. However, technological improvements in payment technologies may reduce transactions costs for all participants. Specifically, when online debit cards are used, the time lag between when a payment is made and when it is converted into good funds has essentially been eliminated. If credit card customers do not require an extension of credit when they make purchases, their use of the less expensive and less risky online debit cards may improve overall welfare. However, incentives in today’s marketplace may lead consumers to use more expensive alternatives when less expensive ones exist.

This article provides an in-depth analysis of the underlying incentives in credit card networks by drawing upon institutional detail, recent academic research, and antitrust challenges. A framework to study credit card networks and payment networks is presented along with suggestions for future research. The rest of the article is structured as follows. First, the set of major bilateral relationships is discussed in credit card markets to understand the underlying incentives for credit card usage. Second, the recent literature on credit card networks is summarized. Third, competition at the network level is discussed in light of the recent antitrust cases. Finally, we conclude.