Consumer Choice and Merchant Acceptance of Payment Media

A new set of economic models studies the e±cient pricing of services provided by a single platform to different types of end-users, such as payment networks, communication and media portals, or dating clubs. This growing literature blends together the multiproduct firm literature, which studies how firms set prices for more than one product, with the network economics literature, which studies how consumers benefit from increased participation in networks by other consumers. Models in this literature compare the social welfare maximizing and the platform's profit-maximizing fees under different market conditions. We contribute to this literature by constructing a model that incorporates various aspects of industrial organization and consumer theory with some elementary aspects of the medium of exchange literature. Our model serves as a useful benchmark for the policy debate regarding the pricing of payment services that has attracted antitrust scrutiny in various jurisdictions.

Over the last two decades, consumer usage and merchant acceptance of payment cards have increased in advanced economies while cash and check usage has declined. Many observers argue that movement away from paper-based payment instruments to electronic ones such as payment cards has increased overall payment system efficiency. However, policymakers in various jurisdictions have questioned the pricing of payment card services. The U.S. Congress is considering legislation that would grant antitrust immunity to merchants to collectively negotiate fees with payment providers. Recently, the European Commission came to an agreement with MasterCard to significantly reduce interchange fees--the fee that the merchant's bank pays the cardholder's bank|for cross-border European payment card transactions. In addition, some public authorities around the world have removed restrictions by payment networks that prevent merchants to set different prices for goods and services based on the payment instrument used.

Payment card networks consist of three types of participants|consumers, merchants, and financial institutions. Consumers establish relationships with financial institutions so that they can make payments that access funds from their accounts or utilize credit facilities. They may be charged fixed fees in addition to finance charges if they borrow for an extended period of time. For consumers to use payment cards, merchants must accept them. Merchants establish relationships with financial institutions to convert card payments into bank deposits and are generally charged per-transaction fees. The merchant's bank, the acquirer, generally pays an interchange fee to the cardholder's bank, the issuer. The underlying payment fee structure is determined by the interrelated bilateral relationships among the participants, their bargaining power, and the ability of the network to maximize profits for its members.

Our paper contributes to the growing theoretical payment card literature that started with Baxter (1983). In his model, consumers are homogenous with merchants, issuers, and acquirers operating in perfectly competitive markets. He argued that the interchange fee balances the demands of consumers and merchants and improves consumer and merchant welfare. Rochet and Tirole (2002) find that business stealing may result in the profit-maximizing interchange fee being higher than the socially optimal one when there is consumer heterogeneity. Wright (2004) shows that introducing merchant heterogeneity results in the profit-maximizing interchange fee being potentially above or below the socially optimally one.

For the most part, these models ignore the ability of merchants to steer consumers by imposing instrument-contingent pricing. Carlton and Frankel (1995) argue that if merchants are able to set instrument-contingent pricing, the interchange fee would be neutral. The interchange fee is said to be neutral if a change in the fee does not change the quantity of consumer purchases and the level of merchant and bank profits. Gans and King (2003) find that if payment separation is achieved, the interchange fee is neutral. Payment separation occurs in competitive markets where merchants separate into cash and card stores or if monopolist merchants impose instrument-contingent pricing where merchant acceptance of payment cards is invariant to changes in the interchange fee, merchant profits and quantities that consumers consume.

The models discussed so far do not consider an increase in total consumption resulting from payment card adoption. Chakravorti and To (2007) focus on a key aspect of certain types of payment cards|the extension of credit. They construct a model focusing on the credit aspect of payment cards where consumption occurs prior to the arrival of income benefitting both consumers and merchants. Chakravorti and To demonstrate that merchants may be willing to absorb higher payment fees if their sales increase sufficiently. However, they do not endogenously solve for the optimal price structure between the two types of end-users.

We construct a model in the spirit of Diamond and Dybvig (1983) that analyzes the pricing decision of banks in the provision of payment instruments to maximize profits in a two-sided market. In our model, some consumers want to consume before their income arrives. A market is said to be two-sided if two distinct sets of end-users are unable to negotiate prices and the prices charged to each end-user affects the allocation of goods or services (Armstrong, 2005, and Rochet and Tirole, 2006).

Our model differs from the existing literature in the following ways. First, for the most part, the payment card literature uses a reduced-form approach when considering the costs and benefits of payment cards. In our model, consumers participate in non-cash payment networks to insure themselves from three types of shocks|income, theft, and the type of merchant that they are matched to. Second, consumers are willing to pay a fixed fee as long as their expected utility when they participate in a card network is at least as great as their expected utility if they only use cash. In other words, consumers must balance income spent on consumption goods and payment services. Third, acceptance of payment cards may increase merchant profits resulting from increased sales. Merchants trade off increased profits from additional sales against payment fees. Fourth, we are able to provide insights into how merchants' ability to pass through payment costs to consumers through higher retail prices affects merchant acceptance, optimal structure of payment prices, and bank profits. Our analysis suggests that merchant acceptance may not be complete even when surcharging is allowed. Merchants that are unable to pass along their fees completely to consumers because of market conditions such as competitive pressures may choose to decline payment cards. Furthermore, evidence from countries that allow surcharging suggests that merchant acceptance is not complete.

Our main results can be summarized as follows. First, we solve for the optimal bank profit-maximizing fee structure for consumer and merchant fees. Our model predicts that the bank will extract all consumer surplus and extract merchant surplus to balance the network externality that greater merchant acceptance increases the total number of transactions against greater profits.

Second, bank profit increases when merchants are unable to pass on payment costs to consumers because cost absorption by merchants leads to lower goods prices and greater ability to extract merchant surplus. However, merchant acceptance may decrease as a result.

Third, if bank profits are restricted to be zero, different "Ramsey" price structures emerge where both consumers and merchants pay positive fees. Unlike the bank profit-maximization case, consumers are not fully extracted resulting in greater social welfare. Generally, extraction from consumers is preferred to merchant extraction given the network externality when costs are sufficiently low.

Fourth, whether the bank's profit-maximizing merchant fees is equal, higher, or lower than the Ramsey socially optimal fees for debit or credit cards crucially depends on the level of payment processing cost relative to the probability of getting mugged and the level of default risk. In particular, for low levels of processing cost, the Ramsey planner would want to fully exploit the positive externality of widespread merchant acceptance by setting zero merchant card fees, thereby avoiding aggregate theft and default risk. Yet, for low cost levels, the bank would have an incentive to extract merchant surplus by setting positive merchant fees reducing acceptance. In contrast, for high levels of processing cost, the Ramsey planner would stop issuing payment cards in favor of cash use, whereas the bank would still make a profit by providing card services.

Fifth, depending on card processing and default costs, banks may have an incentive to simultaneously supply debit and credit cards. For relatively low credit card costs, however, the bank would not supply debit cards and only offer credit card services. We also find that when merchants are restricted to setting a uniform price regardless of the type of payment instrument used, bank profits rise but consumers and merchants are worse off. This negative externality arises because consumers that are able to use debit cards do not have an incentive to use the less expensive payment instrument.

In the next section, we describe the environment, agents, and payment technologies. We consider economies with debit and credit cards in sections 3 and 4, respectively. In section 5, we discuss social welfare. We explore an economy where all three instruments exist in section 6 and conclude in section 7.