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Interpreting Australian Interchange Regulation's Consumer Impact

posted by Adam Levitin

A lot of the interchange debate in the United States now is about interpreting the results of the longest-standing interchange regulation experience, that of Australia.  There's a lot of ridiculous claims made about Australia.  So let's clear the deck.  There isn't any conclusive empirical evidence about the effects of interchange regulation on consumers.  I don't know of any study that even purports to study the effect of interchange regulation on consumer prices.  There's a MasterCard-funded study which found (surprise, surprise) that interchange regulation hurt consumers.  But the study reaches this conclusion by looking at annual fees and levels of rewards, which are just two pieces of a much larger picture.  Selective metrics can't tell us about overall consumer welfare (or the distribution thereof).  To do so would require a detailed analysis of, at the very least, Australian consumer prices (including rate of inflation) and Australian credit card products (including interest rates and other fees, not just annual fees and rewards).  The data for such a study doesn't exist. No one can take an empirically-founded stance one way or another.  What this means is that statements from MC/Visa and their defenders that consumers in Australia haven't benefited from interchange regulation are simply nonsense. 

This doesn't mean that we can't make any assumptions about Australia.  Below the break, I explain why contending there isn't a pass-thru to consumers requires arguing against basic principles of economics.  Economics 101 tells us that we can expect a pass-thru, the percentage of which will vary by the competitiveness of the merchant's industry. 

As a general matter, it is axiomatic that if a merchant's costs decline, the merchant will pass-thru the savings to consumers only to the extent required by competitive pressures in the merchant's industry.  Unless the basic laws of economics are suspended when it comes to interchange, there will be pass-thru if there is competition in the merchant's industry.  Strangely, many of the opponents of interchange regulation assume that interchange savings would not be passed-thru, as if they were different from any other cost for merchants. 

Presumably the part of merchant savings get passed on to consumers (if any) depends on how competitive the merchant's industry is.  If the merchant is in a competitive line of business, like groceries or gasoline, the consumer pass-thru will probably be significant.  If the merchant is in a less-competitive line of business, like airlines or telecom, then the pass-thru will probably be small.  This isn't a reason not to regulate interchange, but simply to improve the competitiveness of other markets. 

What this means is that the only way that interchange regulation would not result in a net benefit to consumers is if the credit card market (with unregulated interchange) is more competitive than other industries.  While that might be true for specific industries, I have trouble believing that it is generally true for the majority of consumer transactions by dollar amount.   (I am ignoring distributional issues, which probably argue for extra-weighting to small dollar transactions, which are probably more competitive industries, as they are volume, not margin business models.)  What this means is that unless the card industry overall (not just issuance!) is much competitive than most merchant's industries, there is almost assuredly a pass-thru benefit to consumers from interchange regulation, even if the data and econometrics are insufficient to prove it empirically. 


The current credit card market is more efficient for me. I pay 100% for stuff whether I pay cash or credit. I get 2% back, so I pay 98% of the cost. I have no annual fee and no balance.

If things would cost less with cash, I would pay cash. But they don't, cause the credit card companies don't allow it.

for most, it is a triple whammy: higher costs (the automatic 2%), higher interest (cash means no interest), and spending more money.

This bill is best for the economy, although it would be bad for me personally.

“What this means is that statements from MC/Visa and their defenders that consumers in Australia haven't benefited from interchange regulation are simply nonsense.”

Who has the burden of proof Adam? Should not the person who changes the system have the burden of proof to prove what they did has actual benefit? All we have at this point is concrete negatives with injured parties juxtaposed with a series of nebulous, unknown, and possibly non-existent positives. As you have said no one has been able to prove interchange regulation has been a good thing for anyone but we can point to the negative side effects as they have hit consumers. I’m not asking to prove a negative; I’m asking for any evidence that this regulation has had any benefit to consumers. This legislation was put into place seven years ago. Do you not think it’s odd that no one has come forward neither the RBA, retailers, nor interchange regulation advocates to counter any study done by the payments industry? Perhaps it goes back to your point when you mentioned the CRA study. Perhaps no one wants to sponsor that study because they may not like the results. Regardless, the burden of proof lies with the experimenter to prove or disprove their hypothesis and to this point the only thing that’s been forward is that no one can prove it didn’t work.

“As a general matter, it is axiomatic that if a merchant's costs decline, the merchant will pass-thru the savings to consumers only to the extent required by competitive pressures in the merchant's industry. Unless the basic laws of economics are suspended when it comes to interchange, there will be pass-thru if there is competition in the merchant's industry.

Presumably the part of merchant savings get passed on to consumers (if any) depends on how competitive the merchant's industry is. If the merchant is in a competitive line of business, like groceries or gasoline, the consumer pass-thru will probably be significant. If the merchant is in a less-competitive line of business, like airlines or telecom, then the pass-thru will probably be small. This isn't a reason not to regulate interchange, but simply to improve the competitiveness of other markets.”

Instead of thinking in simple Economics 101, let’s interject some Behavioral Economics, Game Theory, and Price Elasticity into the examples. I’ll talk about one I am intimately familiar with, Convenience Store Gas Sales.

Convenience Stores:
Two stores, Adam’s Gas and Grant’s Fuel:
12 gallon fill-up at $3.00 per gallon = $36 ticket.
Mastercard rate: 1.9% - 68 cent interchange on the ticket

If Adam’s Gas receives a break of 3 cents per gallon off the rack rate from his supplier, he has two options.

1. Drop the price and pass this along to the consumer to generate more volume
2. Hold on to the three cents and expand the margin

Adam’s Gas knows that if he lowers his price, Grant’s Fuel will see it immediately. In this case, perfect price transparency exists between competitors and to consumers. Also, convenience stores have one of the highest price elasticity’s of any business. There is a phrase in the industry, “the consumer will jump the curb for a nickel” …because they will. This is why you find stores near each other pricing the same because volume drops substantially when even priced 1 cent a gallon higher (high price elasticity). In many ways this would look like collusion, but in fact is normal, rational behavior in the industry.

Back to our story, let’s say Adam’s Gas and Grant’s Fuel instead of receiving 3 cents off the rack rate both receive a 36 cent break off their interchange, but both are aware the other received the interchange break. Adam’s Gas and Grant’s Fuel both know if they lower their price and pass the savings they will be immediately matched (again perfect transparency and high price elasticity of demand) thus achieving equilibrium once again or they can hold on to the margin. In this case, the rational decision for both Adam’s Gas and Grant’s Fuel is to hold prices steady.

When savings funnel through an industry, I would agree they typically will flow to the consumer. However, when everyone receives the same savings and there is no ongoing benefit to reducing price its actually more rational for the players to not move forward with price cuts. This simple example shows that in effect what occurs when interchange is cut is prices remain the same.

In thinking about your argument, the only time I believe interchange would be passed along to consumers would be in an industry where price elasticity of demand is high but price transparency is low. Offhand, the only sorts of items this applies to would be high ticket purchases with little price feedback such as automobiles or real estate sales.

Examining the players gives us a much better understanding of when and why someone would drop their price. In this case, when everyone receives the same interchange savings benefit there is little to no reason to drop the price of goods.

Hangtime79: The one place we actually have pricing data on interchange discounts is gas stations. Some gas stations offer cash discounts, while others don't. The discounting stations have a cash price and a credit price; the others have just a unitary price. At matched stations, the cash price is lower than the unitary price is lower than the credit price. This means that when interchange costs are lowered (to zero via cash payments), there are savings passed through to the consumer. You can get the details in my Harvard Journal on Legislation article from 2007.

Your game example is nice. I think it's correct within the rational actors/full information conditions you posit. But that's not reality. Retailers do get into price wars, as they aim for volume, rather than margin. And if you go five blocks from my house, you'll find a drag with some five gas stations on it in very close proximity. Some consistently price their gas a few cents higher than the others (Citgo is cheaper than Shell, e.g.). Clearly there is more going on in this market than can be captured by a reductive game theory model.

Finally, remember that interchange regulation does not necessarily benefit all merchants within an industry equally. Regulation would either address the pricing of the indirect interchange fee or the merchant restraint rules. That means that there is less than perfect transparency in pricing to competitors and competitors might not have equal ability to pass on savings.

You tell me that you're intimately familiar with convenience store gas sales. I'll believe you. Are you also intimately familiar with Cournot models? They say that you are somewhat correct for a duopoly, but as the number of competitors expands, the price reaches equilibrium.

When in doubt, follow the money. If they intend to pass the savings on to the consumer, then why is the National Retail Federation spending millions on lobbying activities. They're speaking out of both sides of their mouth, telling you in one sentence how interchange is hurting the small business owner and in the next, tell you how its hurting consumers. Which one is the money going to, the small business owner or the consumer? Truth is, not much is going to either. The real money is going to the companies with the most to gain. I'm talking about the big box retailers. All this legislation does is move profits from Bank of America to Walmart. BofA will then need to make up the revenue stream somewhere and you'll get higher interest rates on your card balance as a result. So instead of saving money, you'll end up paying more.

I'm confused.

First, let me start by saying that I generally agree with Adam that declines in interchange fees will be passed through to final prices (assuming that merchants continue to price the same across payment methods - if they don't, it's not clear why you need the interchange intervention anyway). While hangtime79's suggestion that the pre-legislation prices will serve as a collusive focal point for firms has some support in the empirical literature (think of gasoline prices rising like a rocket and falling like a feather in response to fluctuations in crude oil prices), I think that we generally believe that prices of individual firms will adjust in response to an overall cost decline. Of course, that's a bit vacuous as some price decline is, indeed, axiomatic, but I'd go further to argue that most of the firms who are pushing for this - WalMart, Target, Home Depot, etc. - will lower their prices in response to lower payment costs in a way that largely reflects those cost declines. Moreover, it seems a bit perverse to suggest that interchange fees serve a role of reigning in merchant market power or preventing collusive behavior by merchants. Last I heard, that's the role of the DOJ and FTC - for better or worse - not the responsibility of Visa and MasterCard.

But this is the first point where I'm confused. Their costs are lower. But their prices are also lower. So to a first-order approximation, their profits are unchanged. What gives? Why are these guys wailing to high heaven about their payment costs when it's not immediately clear how those payment costs influence the profitability of their operations? I can think of three reasons. (A fourth, more nefarious, reason has to do with hangtime79's posts.)

First, they really care about "cash users." After all, by raising their prices due to high card fees, they're really funneling those fees through to people who pay with other payment methods. I find this a bit hard to swallow. While they use "cash payers subsidizing card user rewards" as a standard complaint, I'm not sure why WalMart suddenly cares about cash payers over other customers.

Second, they stare at the "card fees" line on their income statement and just cannot stand how that line grows. Partly due to higher card fees, but also due to higher rates of card use. They don't recognize that a cut in card fees, unless it's differential in a way that advantages them over their competitors, won't really change the competitive landscape that they face so that other parts of their income statement will change in a way that offsets the decline in interchange fees. I can just see a senior exec at WalMart yelling at his payments folks, "Why is this card fee line so darn big??? Let's get this darn card fee down! So that we can lower our prices!" (N.B. This applies both to price declines and hiring more workers, I believe.) I think that there's something to this, but these guys aren't stupid (I think), so it's hard to believe that they don't recognize this fact.

Third, if they can lower their card fees and lower their prices, they'll move down their demand curves and sell more. Most importantly, from an aggregate point of view, the overall amount sold will increase rather than simply shifting sales among retailers (or yielding no net change if everything cancels out).

I suspect that this last effect is what the merchants really have in mind. They have some margin on each item sold, and if they can decrease their payment costs, they can decrease their overall price, keeping that margin more or less intact, can sell more, and can up their profits.

Note, however, that this is more subtle than simply the "pass-through" issue that Adam discusses - it requires info that is much more complex than simply measuring the effect of interchange decreases on prices. The welfare effect here has to do with aggregate elasticities, not just redistributions associated with the same level of sales.

The second thing that I'm confused about has to do with Adam's statement that "the only way that interchange regulation would not result in a net benefit to consumers is if the credit card market (with unregulated interchange) is more competitive than other industries." Competition in retail industries concerns how much it costs to buy something. Competition in a payments market concerns how much it costs to use a payment method to buy something. These are not the same things. In the former, the issue is how much distortion is created in the amount of final goods and services that individuals consume. In the latter, the issue is how much distortion is created in the way that people pay for things.

The thing about interchange fees is that they primarily affect how people pay for things by altering the effective price of different payment methods relative to the costs and benefits of those payment methods. As other commenters have noted, interchange fees fund rewards, or at least better terms, for cardusers that encourage them to use cards. A cut in interchange fees will remove the source of those rewards or, more generally, will make card use relatively less attractive compared to cash, at least on the margin. (Note that the "on the margin" statement is notable because we don't care about the inframarginal people who will "still use their debit cards," rather we care about the person who is right on the edge of using or not using her debit card.) So people may shift away from cards, in this case debit cards, which every policymaker seems to love otherwise relative to credit, in favor of cash. Is this a good thing?

The merchants have a beef and the banks have turf to defend, both of which suggest some rents to be gained that almost certainly don't reflect the interests of consumers. The battle between big banks and big retailers can leave one with a dirty taste in one's mouth - who of these two is really reflecting the interest of the "consumer."

But the core policy issue comes down to how we want people to pay for things and how we encourage or discourage certain types of payment behavior. In the end, I'm fundamentally confused about the exact inefficiency that this amendment is supposed to address. Too much debit card use? Too little? And then how is the language in the amendment supposed to achieve that policy goal? Interchange fees that are "reasonable and proportional to actual cost"? I propose that any multiple of cost would satisfy the second requirement. That, I would argue, is axiomatic (what idiot wrote that language?). However, what does the first mean?

Chabot: Neither the merchants nor the banks act altrusitically for consumers. They have their own profit motivations. But that doesn't mean that there isn't a real consumer protection issue at stake, or that there isn't a convergence of the consumer interest with the merchant interest.

Merchants are motivated by a combination of points three and two. More money in consumers hands means more ability to purchase goods and services from merchants (rather than payment services). And for merchants who are seeing their margins squeezed by growth of card fees, limited fees brings them some relief. (To the extent this means more merchants are in business, it benefits consumers in terms of greater choice, but that's a side point).

I think a movement from debit to cash is unlikely. First, from the consumer perspective, cards have lots of advantages over cash, even without rewards. Convenience, safety, record-keeping, social norms, etc. Second, from the merchant perspective, cards are usually preferable over cash, for many of the same reasons. Merchants that don't want cards don't take them. Third, debit rewards programs are very stingy; it's doubtful that they have a big effect on the cards vs. cash choice. They do have an effect on the signature vs. PIN choice among debit transactions. Finally, I'm not sure that cash is necessarily such a terrible thing socially, from an efficiency standpoint. (See Australia's experience with polymer banknotes, which have been adopted by a number of other countries.)

“Reasonable and proportionate to actual cost” actually makes a lot of sense. “Proportionate to actual cost” means that debit interchange fees must relate to cost, not to transaction amount. Currently fees are a combination of a small flat fee and a percentage fee. The percentage fee is proportionate to the transaction amount, not cost. The cost of processing a $20 debit is the same as a $200 debit. The Durbin amendment says that the fees should therefore be the same. (More broadly, proportionate is meant to contrast with disproportionate, which is basically the same as saying "reasonable." Lawyers like cease-and-desist replication...).

“Proportionate” is actually the easy part of the directive; it’s “reasonable” that raises the hard questions of what sort of profit margin is acceptable. I take "reasonable” to mean that the fees should be fairly close to cost; the margins should be those that would attain in a competitive market (the Fed has experience with this from regulation of its own ACH operations). Of course, the question is how competitive of a market. In a perfect market, there'd be virtually no profit. Note that this isn’t the first time Congress has punted the "reasonable" fees issue to the Fed. It did so too for certain consumer card fees under the Credit CARD Act.

As an Australian, subject to this mess, you're minimising some points and totally missing some others.

a) I've seen zero evidence that merchants have passed on any of their reduced interchange fee in their prices.

b) Yes, competitive industries are less likely to surcharge for credit card use. So, your grocery prices might drop a little (in theory -- see (a)), but airlines charge about 10% extra for credit cards. It only takes a small number of high-surcharging market sectors to totally outweigh any possible gains. (... that aren't, in my experience, actual anyhow.)

c) Taking cash, protecting it, depositing it, etc, has a cost. A surcharge for accepting plastic is a con, because it assumes the cost of accepting cash is zero.

d) Complexity is a huge cost. If everyone is charged the same way, it's quick and convenient. At least one major hotel chain charges a credit card surcharge in Australia if you book directly with the hotel, but not if you book online. However, this means that customers such as myself then ask them why I'm being charged more than someone else and they end up refunding me anyhow! What a shambles. The annoying thing is that all of this is unproductive. If a company charges us a 2% surcharge and then wastes 90% of it in implementing and maintaining the systems that make the surcharge possible, it would be vastly more efficient for consumers overall if such surcharges didn't exist. The overall effect is to simply push up prices.

Craig hit the nail in the head, many Australians are calling for reform of the system including consumer protection agencies. Adam is a bit wrong on the debit to cash, small businesses love cash more than large because they may not have to deal with many of the issues such as employee theft, and can easily do tax evasion versus a multi national corporation or chain that isn't like a corner deli in an ethnic neighboorhood with one or two employees who are friends.

Looking back at many articles in the 70s and 80s, it is clear that discounts would be common if somebody asked or if a large percentage of people were paying cash and a few people paid credit. Adam is also wrong on the debit card rewards, many debit rewards are increasing but much to the chargin of merchants because debit is less risky to the credit card company and merchants feel that they shouldn't pay a high fee. Much has not been talked about the pin v. signature debit and many folks are confused as to how it works is it like an in store atm or a by a network?

Speaking as a small business owner that does most of their business with credit cards. This will help no one, Visa and MC are businesses with a responsibility to their shareholders to make money. The market assures that this is done in the most efficient way with the least effect on the consumer. Mess with that system and you might get artificial savings, but they will be more than offset by other costs.

The reason Wal-Mart doesn't like this is probably because it will artificially level the playing field. Surely, they already negotiate the lowest fees in the world, why should small companies pay the same? And that's a good question, we should not, they do a lot more volume they should get it cheaper.

I'll update, debit rewards programs are not stingy as per what Adam said. It is true that initially the average debit reward is low, however this is changing or was changing depending on how the durbin amendment takes effect.

Take perkstreet financial , they are giving 2% back every purchase, the source of funding? Interchange fees, many companies like chase are rolling at debit rewards such as 2-3% cash back and promotions. Chase real cash is superior to almost all credit card rewards and so is perk street financial.

There is a antitrust point and getting back to Adam's regulated utility argument, if society still a long way from being cashless even though its declined becomes way, and banks take most of the fees from the debit cards whether pin or signature and in this recession debit card use has risen much faster than credit card usage, and banks don't give rewards (they do due to competition and to gain market share and attract consumers), then it may have a "economic rent", but we are a long way from that. Large retailers who pay taxes and stand the most to benefit from card usage such as check and cash costs are the ones who often file lawsuits against visa and mastercard such as walmart and signature debit.

Great read and informative, thanks. You’re right we don’t hear very much at all about the Greens Policies. I had no idea they didn’t recieve big biz political donations – good on them. This will be something I’ll be keeping strongly in mind when I head to the ballot box.
Very awesome of you to share these - thanks! :)

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