Butchering Credit Cards

In my last post, I explained that all credit card systems in the United States charge merchants a fee above marginal cost and that the systems use this revenue to stimulate card use. The Visa and MasterCard systems call this increment above cost their interchange fees, but all systems effectively do the same thing. At first blush, this sort of above cost pricing suggests serious antitrust concern. Aren’t card systems extracting supra-competitive profits from merchants? And even if they compete these profits away simulating card use, doesn’t overcharging merchants distort resource allocations? This post explains why the answers may be no.
In a typical market in which a producer competes for a single type of customer, an efficient price – one that will lead to an optimal consumption level – will generally approximate the marginal cost of production plus the profit necessary to attract investment to the industry. This pricing model is efficient because it maximizes short-run output consistently with the producer earning sufficient revenue to continue providing the product or service.
Credit card markets are not typical, however, in that card systems must price their products in a way that appeals to two inter-related sets of customers, merchants and cardholders. In such a two-sided market, a purely cost-based rule – such as “set the price charged to the cost-causer at marginal cost” – is unlikely to produce an optimal pricing structure. Although the economic literature is riddled with papers written by consultants for the card systems – not that there’s anything wrong with that – economists on all sides generally agree on this basic point. Compare Meg Guerin-Calvert and Janusz Ordover’s analysis with Michael Katz’s take, from which I quote above.
In a two-sided market, efficient pricing must take account of both total cost and the relative elasticities of demand between the two customer sets. If customers in such a market were charged the marginal cost of serving them, they would fail to internalize the benefits of their decisions to the customer set on the other side. If demand elasticities diverge to any significant degree, industry output under a marginal-cost pricing policy would be inefficiently low. To obtain an efficient output level, a producer must charge the customer set that is more sensitive to price less than marginal cost (effectively enabling those consumers to internalize the benefits to both sides of the market).
The classic example is the daily newspaper. Readers have many sources of news, including television, magazines, and the internet. Reader demand for newspapers is thus likely to be quite elastic, leading them to turn away from the morning paper if the subscription price were to approach the marginal cost of producing and delivering it. By contrast, advertisers perceive significant benefits in print advertising (so long as readership is high) and are thus willing to pay substantially above the newspapers’ marginal cost of printing and providing associated services. As a result, readers pay significantly below marginal cost and advertisers pay substantially more. Competition between newspapers and other media for advertising space still drives pricing, but not to marginal cost plus normal profit for each customer set.
This pricing pattern efficiently optimizes newspaper circulation, satisfying both the advertisers’ need for broad exposure and the readers’ need for information. Assuming that newspapers have little market power, both advertisers and readers would be worse off if pricing were forced into line with marginal cost. Were advertising fees to drop, and reader fees proportionally increased, prices would move toward marginal cost on each side of the market. Because reader demand is more elastic, however, readership would drop more than advertising would increase, and advertising rates would thus fall. As a result, the paper would (1) earn lower overall revenue; (2) be less valuable to advertisers because readership would fall; and (3) be less valuable to readers because the paper would have less revenue for newsgathering.
To the extent that the elasticity of demand varies significantly between merchants and cardholders, credit systems resemble newspapers. Assuming that merchants, like print advertisers, are willing to pay significantly above the marginal cost of credit card acceptance services, but cardholders, like newspaper readers, would be unwilling to pay the marginal cost of providing credit cards and associated services, then efficient credit card pricing should place a greater share of the costs on merchants.
One might question whether this analysis explains the array of interchange fees that the card systems now charge. Even if efficient pricing requires merchants to pay more, why should they pay more still for reward cards used primarily by wealthy customers who would arguably make roughly the same purchasing decisions with a simple basic credit card? The answer may be that price discrimination can result in competitive markets. Michael Levine’s work is instructive. He uses the example of cattle, which are generally sold as whole animals in a competitive market. The butcher’s cost of preparing particular cuts does not vary in any significant way, and those cuts are again sold in quite competitive markets. Yet, ultimate consumer prices vary considerably depending on the desirability of the cut of meat. Although the comparison between wealthy customers and filet mignon may be somewhat crude, the value of high spending consumers to merchants may justify higher card acceptance fees for the cards used by big spenders in much the same way that the desirability of the tender cuts leads to higher prices despite competition.
All this suggests that interchange fees and price discrimination based on type of card would exist in an efficient and competitive credit card market. But these pricing practices do not ensure that the market we have is in fact efficient and competitive. If above cost pricing and discrimination are not determinative, what can we look to in order to evaluate the competitive performance of credit card markets? My next post will comment on that issue.

The Ubiquity of Interchange Fees

I am very pleased to join the Commercial Law Blog as a guest, blogging about credit card payments. Before discussing the economic effects of current fee structures and how card pricing might be improved, this post lays some groundwork, suggesting that these fees are best understood as the portion of the merchant discount fee that a credit card system uses to support card issuing. Viewed in this way, all credit card systems in the United States charge the economic equivalent of interchange fees.

Back in the early days of credit cards, virtually all banks in the associations both issued cards and signed merchants to accept them, a function known as merchant acquiring. The systems then required that the entire merchant fee go to the issuing bank. Over time, this fee structure, channeling all revenue to the issuer, did not provide sufficient incentives to add merchants to the network. To remedy the problem, the two bank associations that became Visa and MasterCard adopted a system-wide formula for dividing the merchant fees between issuers and acquirers.

Functionally, acquirers paid merchants a discounted price for credit card paper and then sold that paper to the card-issuing bank at a somewhat lower discount. The total merchant fee came to be called the “merchant discount” and the portion passed on to the card-issuing bank was labeled the “interchange reimbursement fee.” The amount retained by the acquirer never got a formal name, but might have been called the short-end-of-the-stick fee. From early on, interchange raised antitrust concern because it enabled card-issuing banks to avoid competition on the fees that they effectively charged to merchants. Nevertheless, it has withstood legal challenge for more than three decades.

Over the years, the interchange fee has evolved. Although Visa’s and MasterCard’s fees differ in some ways, they have both followed a similar path. Initially, each charged a single fee to all merchants. In the 1980s, the associations developed separate fees for paper and electronic transactions. The 1990s brought different fees for certain merchant types, as the systems sought to bring in lower margin retailers such as supermarkets. They also added a separate fee for situations in which the magnetic stripe could not be swiped, reflecting perceived fraud risks. Today, interchange fee schedules are a complex array of charges that vary depending upon the type of merchant and its card sales volume, the type of transaction, and the type of card used. The most significant factor may now be what one might term the incremental reward fee, a higher interchange fee that applies when a customer uses a card that rebates cash, awards airline miles, or provides some other benefit for using the card. In addition, as technology has improved and merchant acquiring has become more competitive, acquirers have reduced their margins at the same time that the systems have increased interchange fees. As a result, the percentage of the merchant discount paid to issuers has increased.

Because the phrase interchange fee was created by the bank-card associations, and antitrust challenges -- including the on-going merchant litigation -- principally attack the lack of competition among Visa and MasterCard issuers, it is often assumed that the economic implications of interchange are limited to the bank card associations. But that isn’t true. Although American Express and Discover do not have a formal interchange fee, they have the functional equivalent: A merchant fee that exceeds the marginal cost of providing the retailer with card-acceptance services plus normal profit.

The four-party (issuer/cardholder & acquirer/merchant) nature of a Visa or MasterCard transaction makes this economic equivalence in fee structure apparent. Visa/MasterCard acquirers now operate profitably on about one quarter of the merchant discount that they take from retailers, passing the remaining three quarters to card issuers. Three-party systems (joint issuer-acquirer/cardholder/merchant), such as American Express and Discover, charge merchant fees that exceed substantially the revenue that Visa and MasterCard acquirers retain. Surely, the three-party systems, like Visa and MasterCard banks, use this excess merchant revenue to stimulate card use. For example, American Express now uses some of its merchant revenue to pay banks to issue AmEx cards. Although the percentage of the merchant fee used to support card issuing varies across systems, in all cases more than half of what retailers pay probably supports card issuing. Next time, I will blog about the economic effects of generating revenue from merchants that is used to stimulate card use.

Why just go when you can Boingo? Just be careful you don’t go when you don’t want to!

This morning, I was reading Bob Lawless’ post on Creditslips about his own tale of bad things that can happen with credit cards (see Unauthorized Charges Go Wild on Me). Bob’s tale reminded me of a nagging matter of my own that I’d found on my checking account statement this week for a $15.90 charge to my debit card for Boingo Wireless. Back in February, I created a Boingo Wireless account while travelling back from the AALS Contracts Conference so that I could use the Internet at the airport. Fortunately, I don’t travel too often because the Boingo service would log me on and charge my debit card whenever I visited anywhere with service. So, when I stayed at the Marriott Residence Inn in Pittsburgh recently, Boingo charged me for two days of service even though the wired Internet service I used was free at the Residence Inn.

Boingo does not send invoices, so unless you check your credit/debit card statements, you are not likely to notice the charges or any errors. Boingo uses another little trick that Bob mentioned . . . they keep the charges small. They never charged me more than $15.90 at one time and spread them out over time.

Inspired by Bob Lawless, I called the Boingo folks this morning (and removed the software from my computer). Knowing my travel history, I kindly explained that this must be a billing error. The first line representative I spoke with employed the “confuse the caller” tactic by discussing the initial set up of the account back in February. Then, she explained their method of billing whereby charges are not made at the time of usage, but later. I call this the “confuse the user” tactic to make it hard for customers to know what charges relate to what days you might have used the Boingo service. She finally agreed to send me an invoice. Then we arrived at the heart of the matter, the Residence Inn charges. I explained to her that the Residence Inn provides free Internet, there would be no reason to need the Boingo service.

Here’s where we arrive at the automatic login feature that Boingo has. Once installed on your computer, Boingo is always looking for service for you. And, it saves your sign-in information conveniently for you. Since the customer signs up for the service which enables the “easy” re-login on other dates, you have used the service and the charge is valid. The customer must pay. At that point, I requested a supervisor, who told me the same story. When I raised issues about whether this results in truly “authorized” charges to credit/debit cards, whether Boingo was misusing customer credit cards, and fraudulent charging of cards, the supervisor immediately agreed to refund my money (and close my account). Not sure how good my claims were, but the Boingo supervisor had surely heard them before. Next time, my desperation for Internet service will have to give way to my fear of others automatically hitting any of my accounts. "Power tends to corrupt, and absolute power corrupts absolutely.” The morality of some vendors surely lessens once we give them our card data.

Commercial Law Welcomes Steven Semeraro as Guest Blogger

Steven Semeraro of Thomas Jefferson School of Law joins the blog as a Guest Blogger for the summer. Steven’s two recent papers, Credit Card Interchange Fees: Debunking Six Myths and Credit Card Interchange Fees: Three Decades of Antitrust Uncertainty argue that the current interchange-fee-setting system poses no substantial competitive threat. His work also takes on the issues of consumer welfare created by the effects of interchange fees. My favorite of the “Six Myths” is that the easiest solution to problems arising from the pricing of interchange fees is to permit merchants to surcharge credit card transactions. One of my complaints in the area of interchange fees is the lack of transparency in how much credit card use actually costs consumers even under the current system.

We look forward to hearing Steven’s thoughts on a variety of payment issues, including the Federal Reserve’s plans to alter Regulation Z (see What's in your wallet?).

Whither Economics?

In an interesting post on Critical Mass, Erin O'Connor confesses her ignorance about "how money works." She writes: "But I'm like most of us. . . . Everybody thinks he is an authority on how money ought to be managed and spent. But few of us really understand what money is, how it works, or what kinds of consequences can come from certain kinds of financial decisions."

It's no wonder, she says, so few of us have a clue about financial matters. Nobody studies economics. A study of leading universities' degree requirements (ACTA, The Hollow Core, 2004) showed universities don't require a course in basic economics as part of the core curriculum.

O'Connor attributes our nation's staggering financial ignorance to "academe's broadly socialist monoculture." Universities embrace "collectivism and cooperation, redistribution of wealth, government-run social programs, single-payer health care," but are hostile to capitalism and the infrastructure that makes markets work. "You don't have to look hard at all to find colleges and universities that press students, in course after course, to make moral determinations about how economies ought to be run--but you would be hard pressed to find a school that requires students to ground those determinations in actual economic knowledge."

The Treasury Department's Financial Literacy and Education Commission should take note. Instead of requiring disclosure of more information to consumers who cannot interpret it, Treasury should focus on introducing all Americans, inter alia, to the guns 'n butter tradeoff, the speed and time value of money, and the effect of marginal change in supply or demand on the price of widgets. I'm not expecting that any time soon.

What's in your wallet?

Not that any of this is a surprise to me, but Consumer Reports just came out with a new report about credit card reward programs. Not only does Consumer Reports conclude that we spend more with rewards cards, but also that complicated rules and restrictions makes most cards pretty troublesome. Consumer Reports also found that many of these cards also carry annual fees and higher interest rates. So why do consumers like them anyways? It must be the lure of getting something for free. Or, at least thinking it is free. Of course, one must ask whether the airline miles or charitable donation are worth the potential interest if you carry a balance. It might be easier just to make a donation and take the tax deduction!

While not tackling this particular problem, the Federal Reserve has announced plans to alter Regulation Z’s provisions regarding: (1) bank increases of rates on pre-existing balances; (2) bank practices of applying payments in ways to maximize interest charges; (3) certain practices that impose interest charges using the “two-cycle” method to increase the amount of interest due; and (4) the amount of time consumers have to make payments. Of course, the banks have not welcomed these changes by the Federal Reserve. While I give the Federal Reserve kudos for beginning to tackle the complex credit card fee issues, it would seem that this should only the beginning. In addition to fees associated with carrying a balance on a card, the fees associated with using credit cards are far from clear (see Good Results For Visa). I hate to be a cynic, but I would guess that the final result after wrangling with the credit card industry will be a watered down version of some modest consumer protections.