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Interchange Theory: Simultaneous Rent-Extraction from Both Merchants and Consumers

posted by Adam Levitin

Todd Zywicki and I have been having a back and forth on interchange in several forums.  Todd and Joshua Wright had an op-ed in the Washington Times, I responded with a letter to the editor, and then Todd came back with a blog post. I posted a detailed response to Todd in the comments to his post, but I will repost the core of the response here.  

In his blog post, Todd says that he can't understand my argument that in the credit card world there are economic rents (supracompetitive prices) being extracted from both merchants and consumers.  Todd thinks the only possible economic rents story is one of merchants being charged too much and consumers too little.  (Todd does not endorse this story, but he at least gives it theoretical credence.)  Therefore, Todd believes that any reduction in interchange income must be offset by an increase in consumer charges.

What follows is a brief outline of my argument that the current credit (and debit) card system simultaneously extracts economic rents from both merchants and consumers.  The corollary to my argument is that interchange regulation actually produces reductions in the economic rents paid by both merchants and consumers; it does not result in costs being shifted form merchant to consumer, but instead results in reduce profits for card issuers and card networks.  To this end, I present a rough sketch of the net impact of interchange reform in Australia; as surprising as it is, I do not believe this has been done before.  

The issue is not whether consumers or merchants benefit from cards; of course they do, or they wouldn't use them.  Instead, the question is whether they are paying supracompetitive prices.  Let's take this one piece at a time.  

1.  The Merchants.  Merchants need to accept cards to be competitive with each other.  This means that merchants face a prisoner's dilemma of sorts; once enough merchants take cards, everyone has to take cards to stay competitive.  This problem is most severe in e-Commerce; I don't know of a successful Internet business of any scale without taking cards.  PayPal alone won't do it.   Some business lines, like university tuition, are still relatively immune, but for most merchants card acceptance is a requirement of doing business.  This means that merchant demand for plastic is highly inelastic, which allows the networks to raise prices significantly without much of a loss in business volume.  

The networks raise prices in two ways.  They raise their own fees and they raise the interchange fee, which is paid to the issuer.  The networks raise the interchange fees because they compete with each other for issuers.  The networks make their own money off of fees that depend on transaction volume, and the way they ensure higher transaction volume is to get as many cards issued on their network as possible.  The networks are able to attract issuers by offering higher interchange fees (one-size-fits-all issuers) and higher additional bespoke payments to the big issuers.  So that gets us to the first half of the problem--rents being extracted from merchants.       

2.  The Consumers.  Although there is robust competition in some areas of consumer finance, there is rarely competition on total cost; instead, total costs are shrouded from the consumer.  This isn't the place for me to lay out my whole argument about lack of price transparency in consumer finance (wait for the article), but in short it is done through splitting the cost up into multiple components that are often contingent on the consumer's hard-to-accurately-anticipate future behavior and by bundling products (e.g., frequent flier miles and credit) to make valuations harder for consumers.  

In short, there is very little transparency of total cost for the non-payment functions of financial products.  There's no way to tell ex ante what it will cost to revolve a balance of $1000 on any particular credit card for a year when we apply for the card, which means that there's no price competition.  There's lots of competition on image and rewards and teaser rates (and competition has almost eliminated annual fees), but that's not total price competition.  

Consider credit card advertisements.  How often do you see claims about low rates or fees other than teaser rates and no annual fees.  No mention of other fees or even of APRs.  Instead, adds are about "No Hassle Rewards" and getting to put a picture of your kittens on the card.  The lack of price competition in the bundled non-payment functions of payment cards sets the stage for rent-extraction from consumers. Consumers don't realize the extent of the rent-extraction until its too late.  That's the genius of the system. 

The role of interchange in consumer rent extraction.  Interchange plays a role in this in two ways.  First, the current interchange fee system equalizes the cost of all payment systems to consumers.  Therefore consumer choose their payment system based on benefits, not benefits net of cost.  Cards have lots of inherent benefits, but to this interchange fees finance rewards programs that only enhance the relative attractiveness of cards.  Greater usage of cards (credit or debit) results, by law of large numbers, in more consumers using the consumer lending functions of payment cards (credit and overdraft).  

Now what about the ultra-savvy consumer (let's call him "Z").  Z isn't fooled by pricing complexity and product bundling in financial services.  And because Z's no fool, Z is a dedicated transactor who never revolves a balance.  Z isn't going to switch to cash, however, because he faces a prisoner's dilemma.  As long as everyone is using plastic, why should he be a sucker and go to cash and subsidize the plastic users?  This dilemma holds regardless of whether everyone is a savvy like Z or whether Z is a stand-out and everyone else falls for the card pricing tricks.  

Will costs be shifted from merchants to consumers?  If I am correct, and there is rent extraction from both merchants and consumers (I'm not going to delve into the evidence here--just take it on faith in this post), then it does not follow that if the networks and issuers together can extract $48 billion less from merchants that issuers will just make it up with $48 billion more in rent extraction from consumers.  The ability to extract economic rents does not mean that consumer demand is completely inelastic.   

Indeed, if card issuers are profit-maximizing, they should be close to maxing out consumer demand inelasticity, meaning that they can't raise price much more on consumers; price shrouding can only go so far in disguising costs.  As long as there is sufficient price elasticity from consumers, the net rent extraction from merchants and consumers will be necessarily reduced, which means that reduced rents from the merchants will come primarily out of the networks' and issuers'  profits, not out of consumers'.  

Some very informal evidence:  in 2003 Australia regulated interchange rates.  Total merchants fees have fallen from 145bps to 86bps.  We don't have as good of data as one could wish for, but what we have strongly suggests that interchange reform in Australia did not result in a dollar-for-dollar transfer of reduced merchant costs to increased consumer costs, as Todd fears will occur.  

Heres the rough math:  

  • Australia had $226B in card transactions last year.  With interchange reduced by 58bps, that's an annual reduction in interchange revenue of some $1.3B.  Reserve Bank of Australia (RBA) estimates that $1.1B gets passed along to consumers in lower prices.  
  • The banks say annual fees rose $480M per year.   So we have a net gain there of $620M for consumers.  
  • Now we have to account for reduced rewards programs.  I don't know of any figures there, but I can't imagine that eats up $620M.  
  • And we also have to factor in the drop in interest rates that resulted after interchange regulation as banks were forced to compete more on price and less on hard-to-value rewards.  RBA estimates that card rates fell by 3-7%.  Let's take the conservative estimate of 3%.  We know the monthly credit card balances accruing interest in Australia.  The sum of those balances multiplied by .0025 (=.03/12) is $980M.  
So we're looking at a net consumer welfare gain of about $1.6B minus the value of reduced rewards.  (And maybe we need to figure in the extent to which card usage rose because of lower rates, but it won't eat up that much of our current net figure; I welcome anyone who wants to refine this rough analysis to do so.)  Now AUS $1.6B in savings doesn't sound like a big deal, but let's convert Aussie to American.  We can do that by putting the savings in household terms--$1.6B in annual savings would translate to $200 annual savings per household!!!  That's really significant.  And considering that US interchange rates are higher (and would presumably fall more) the likely consumer welfare benefit are larger.  

Now this is all very back of the envelope and the data isn't as good as we'd like, but I think it's pretty clear that (1) the reduction of interchange revenue in Australia was largely passed on from merchants to consumers, (2) that the reduction in interchange income was not offset by an equally large increase in consumer fees, (3) that the next social welfare benefit therefore sizable.  What seems particularly impressive (even taking these numbers with a grain of salt) is how interchange regulation actually reduced rent extraction on both the merchant and consumer sides of the card market.  Interchange reform forced greater price competition on the consumer side of the market. 

This suggests that in the US reducing interchange rates (and the method for doing this is not the critical issue) would benefit merchants (as they will not pass along 100% of savings to consumers), but it will also benefit consumers both through lower retail prices and through greater price competition on credit cards.  In other words, interchange regulation results in a reduction in economic rents charged to both merchants and consumers, and merchants and, especially consumers, will benefit. 


I pretty much agree with this post, with one caveat. Although Adam mentions ultra-savvy consumer "Z", his calculations treat consumers as homogeneous. This is fine for his price theory, but misleading in the political economics of credit cards.

Adam's Consumer Z, I believe, actually benefits from a shrouded system. Consumer Z is not only a dedicated transactor, but is also an ace at de-shrouding rewards and actively using all good features associated with cards. Such consumers exist, and tend to be wealthier and politically more influential than other consumers.

So what happens? Net-net, the credit cards rip off the merchants and weaker consumers, and share a bit of the swag with the stronger consumers. The stronger consumers are aware of this (that's why they are strong), and are a potent political bloc in favor of the status quo.

This explains two otherwise-puzzling features of the credit card system: why transactors aren't actively discouraged, and why the credit card industry so meekly backed off when the Fed prevented them from shortening the billing cycle.

I've already explained how Adam's consumer Z is misleading, there are non rewards cards that have lower interest rates which may subsidize higher interest cards with rewards, there may be cards that charge fees for special features such as entertainment and discounts unrelated to interchange for the most parts.

The wealthy have more assets and cash then the middle class and the poor who are more likely to finance things. Many studies have shown the Australian system as benefiting retailers and not consumers, I would like to see a more detailed post and also in Australia I believe the fraud costs are more shifted as the merchant's responsibility.

Should people with excellent credit subsidize those with poor credit who pay late or maybe lost money in the stock and real estate market such as with the housing bubble, should they pay the same interest rate? Should

large businesses who want the benefits of credit cards more so than a local food store who may or may not be consumer friendly and may do tax evasion who subsidize that business. Large businesses don't really care so much as to the cash v. credit but want credit without reduced interchange as credit reduces employee theft, increases consumer spending if they don't have the cash, generates increased sales with financing, makes accounting and tax compliance easier and is easier to manage electronically as well as reducing cashier costs and fraud liability.

The consumer Z is also misleading in which a person who is financing a large project may wish to use a lower or zero interest credit card. Australia merchants such as qantas and taxis are surcharging users more than the actual cost of the transaction , thus the middle class and the poor pay not the cash rich wealthy.

"Factchecker"--what are the "Many studies" you refer to? The only study that makes such a claim that I know of is the Charles River Associates study that MasterCard paid for. I'd be very appreciative if in your "factchecking" role you could produce _any_ other studies with such a finding.

As far as low rate nonrewards cards subsidizing high rate rewards cards, this depends on how the cards are used. If consumers behave rationally, then revolvers will get nonrewards cards with low rates, while the Z's of the world--pure transactors--will get the rewards cards because they don't care about the high rate, so long as they think the rewards are worth the annual fee. Otherwise, they'll go with the low-rate, nonrewards cards too.

The tax evasion point is a red herring. Most merchants really don't want cash. They want nonrewards credit and nonrewards debit. Small, family-owned businesses (restaurants, e.g.) might want cash for tax evasion purposes, but a unique case, not the rule.

Merchants with market power--like Qantas--will extract rents from consumers by over-surcharging. But that's not a credit card problem. It's a problem of lack of competition in those merchants' industries. Does Qantas accept payment other than by credit card? If not, then this is just a matter of Qantas gouging consumers in general, rather than a card problem. They would gouge on the ticket price if they couldn't over-surcharge on the card. If Qantas takes non-card payments, then the explanation might be that Qantas figures that consumers using cards are more price inelastic than other consumers because they are purchasing on credit, so they won't walk away because of the additional fee (and the limited alternatives for air travel). In any case, this is a problem of lack of air travel competition in Australia; it's not a credit card problem.

That's not entirely accurate, a person who is financing a large project may get zero or low percentage credit cards, many businesses use credit also. You are correct, large businesses don't really want cash they want lower interchange credit because they want the benefits of credit without paying a market rate so they lobby Washington.

The Z's of the world might be misleading, sure there are a few but its not monotonous, a high volume rewards spending could via interchange fees, support a company businesses looking to credit cards with a zero or low interest card and no rewards. Paying interest may or may not rational but in a free market people take business and risk decisions all the time, if somebody loses on the real estate bust and has bad credit, the credit card company may or may not offer him the best credit card irrespective of rewards.

Tax evasion is probably more common than you think, the studies I refer to are ones published by the federal reserve and its professors and members who have worked for them, not a mastercard study , even so a mastercard study is no better or worse than a retailer study. The conclusion was that it is too complex and there is no one sided solution that would benefit consumers.

Taxi companies are also surcharging in Australia, if you look at many aussie newspapers many consumers are mad, sure some aren't mad particular ones who are wealthier and have cash.

With the reduction in Australian interchange rates, Visa and Mastercard rewards from major banks fell almost uniformly from one Qantas frequent flyer point per dollar to 1/2. (Some cards which used to give bonuses on many transactions removed those bonuses, so it's actually slightly worse.) Valuations vary, but you can redeem for 1-5c/point, depending on your purpose. I'd value rewards at around 2-3c/pt (i.e. reward credit cards give you about 1-1.5% back now, but used to return 2-3%, a loss of 1-1.5%)

Over 60% of card spending is on credit cards ($17.8B/month vs $11.3B/month in 2009, according to creditcardfinder.com.au), so the loss to consumers was around 1-1.5% of 60% of $226B. That's $1.35B-2B. You say we gained $1.6B.

Well, isn't that great. A huge amount of bureaucrats' time and taxpayers' money spent, along with the time of many employees of banks and other institutions, and the net result is roughly zilch. Zero gain for a huge bureaucratic paper-shuffle.

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