Academic Journal | June 01, 2003

Theory of Credit Card Networks: A Survey of the Literature

By: Sujit Chakravorti
Source: Review of Network Economics

Credit cards are the second most popular non-cash instrument in the United States and growing in popularity around the world. While initially introduced as primarily a credit instrument, today it has become an extremely popular payment instrument. Some financial observers doubted the viability of credit cards in their initial years and many issuers exited the business only to return later. However, today, most observers agree that credit cards offer unique benefits to consumers and merchants and profit opportunities to banks.

The success of the two largest credit card networks – MasterCard and Visa – is critically dependent on the membership of thousands of financial institutions that jointly establish rules, standards, and interchange fees.3 Interchange fees are payments made between the merchant’s financial institution, known as the acquirer, and the consumer’s financial institution, known as the issuer. Regulators, especially antitrust authorities around the world have kept a watchful eye on the credit card industry. Recently, authorities in Australia, the European Union, the United Kingdom, and the United States have questioned some business practices of MasterCard and Visa. These business practices include no-surcharge and non-discrimination rules, the level and collective determination of interchange fees, honor-all-card provisions, and the competitive nature of credit card service providers.

Recently, several theoretical models have been constructed to study the effects of various regulatory policies. The results of the models are dependent on the underlying assumptions. The results are critically affected by the elasticity of consumer demand for goods and payment services, and the degree of competition in the markets for goods and card services. Given competitive markets for goods, one-price policies do not affect overall welfare. Welfare effects of one-price policies are ambiguous when merchants have some level of market power.

If competitive merchants are allowed to set prices based on the costs and benefits of the underlying payment instrument used, the level of the interchange fee would have no effect on welfare. Under such conditions, regulation of the interchange fee is not warranted. Alternatively, when merchants have sufficient market power, the socially optimal interchange fee may not be different than issuers and acquirers’ profit maximizing interchange fee.

Unfortunately, no one model is able to capture all the essential elements of each interrelated bilateral relationship, but the theoretical models do offer some guidance to policymakers. Some issues, such as network competition in the provision of credit card services and competition from other payment instruments, still remain understudied.

This article is organized as follows. First, this article discusses the costs and benefits of using credit cards for consumers and merchants along with the profit opportunities for issuers and acquirers and the role of credit card networks. Then, the economic models that study the interrelated bilateral relationships underlying credit card transactions are reviewed in the context of recent public policy concerns. The article concludes with suggestions for future research.

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