Economics of Payment Cards: A Status Report

The proliferation of payment cards—that is, debit, credit, and prepaid cards—has dramatically changed the way we shop and merchants sell goods and services. Today, payment cards are indispensable in most advanced economies. According to a recent U.S. survey, the percentage of payment cards used for in-store purchases increased from 43 percent in 1999 to 56 percent in 2005 (American Bankers Association and Dove Consulting, 2005). For Europe, Bolt and Humphrey (2007) report that the number of card payments increased by 140 percent across 11 European countries during the period 1987–2004. Amromin and Chakravorti (2009) find that greater usage of debit cards has resulted in lower demand for small-denomination bank notes and coins that are used to make change. Furthermore, without payment cards, Internet sales growth would have been substantially slower.

Debit, credit, and prepaid cards are three forms of payment cards. Debit cards allow consumers to access funds at their banks to pay merchants; these are sometimes referred to as “pay now” cards because funds are generally debited from the cardholder’s account within a day or two of a purchase. Credit cards allow consumers to access lines of credit at their banks when making payments and can be thought of as “pay later” cards because consumers pay the balance at a future date. Prepaid cards can be referred to as “pay before” cards because they allow users to pay merchants with funds transferred in advance to a prepaid account. (Prepaid cards are not discussed in this article.)

Recently, some merchants have started to accept only card payments for safety and convenience reasons. For example, a cafe in Washington, DC, stopped accepting cash for purchases primarily because the cost of safekeeping cash was too expensive (Rafsanjani, 2006). Also, many quick service restaurants and coffee shops now accept payment cards to capture greater sales and increase transaction speed. Wider acceptance and usage of payment cards suggest that a growing number of consumers and merchants prefer payment cards to cash and checks.

As more consumers and merchants adopt payment cards, providers of these products may benefit from economies of scale and scope. In the United States, being able to operate on a national level allowed some issuers (banks that issue cards to consumers), acquirers (banks that convert payment card receipts into bank deposits for merchants), and payment processors to benefit from economies of scale and scope. Some European payment providers might enjoy these benefits in the future as greater cross-border harmonization occurs with the introduction of the Single Euro Payments Area (SEPA). The primary focus of SEPA is to create a uniform framework not only for card payments, but also for electronic credit transfers and direct debits, so that these retail payments can be completed in the euro area without intermediation by other banks. The potential advantages of SEPA are increased competition among a greater number of payment providers and the realization of scale economies and more-efficient payment instruments.

The increased usage of cards has increased the value of payment networks, such as Visa Inc., MasterCard Worldwide, Discover Financial Services, and others. Earlier this year, Visa Inc. had the largest initial public offering (IPO) of equity in U.S. history, valued at close to $18 billion (Benner, 2008). The sheer magnitude of the IPO suggests that financial market participants value Visa’s current and future profitability as a payment network. One potential reason for Visa to change its corporate structure from a card association to a publicly traded company is to reduce antitrust scrutiny by regulators and to lower the threat of lawsuits filed by certain payment system participants. In 2006, MasterCard Worldwide became a publicly traded company. Also, in 2007, Discover Financial Services was spun off by Morgan Stanley.

Some industry observers have suggested that the high profitability of payment card providers has increased scrutiny by public authorities in many jurisdictions. Several U.S. merchants have filed lawsuits against MasterCard and Visa regarding the setting of interchange fees. Interchange fees are generally paid by the merchant’s bank to the cardholder’s bank. These fees are set by the network—and not bilaterally negotiated among the banks in the network. In addition, the U.S. Congress is considering legislation about the level and determination of merchant fees. Recently, the European Commission (EC) ruled that the (multilateral) interchange fees applied by MasterCard in Europe violated Council Regulation (European Commission) No. 1/2003: The EC said that MasterCard’s fee structure restricted competition among acquiring banks and inflated the cost of card acceptance by retailers without leading to proven efficiencies.

To date, there is still little consensus—either among policymakers or economic theorists—on what constitutes an efficient fee structure for card-based payments. In this article, they discuss several theoretical economic models that analyze whether intervention by public authorities might improve the welfare of payment system participants. These models consider the costs and benefits of payment card usage versus other types of payments—for example, cash—and the underlying pricing of payment services under various types of market structures for payment providers and merchants. The following questions are addressed in this article:

• What is the optimal structure of payment fees between consumers and merchants?
• Will competition among payment providers, networks, or instruments improve consumer and merchant welfare?
• What guidelines should policymakers follow when regulating fees for payment services?