Antitrust Issues in Networks: Can They Do That? Should We Let Them?

BY ROBERT HUNT

n the United States, payment card networks antitrust law — which regulate how firms may exercise market power — coordinate the activities of thousands should be applied to this . This is I of financial institutions that issue cards, not just an academic question: In the U.S. there are currently two important millions of locations that accept them, antitrust cases involving payment cards. and several hundred million consumers that use them. Australia recently introduced new regulations for the payment card This coordination may include the collective setting industry in that country while the U.K. of certain prices and other controversial network rules. and the European Union have contem- plated similar measures. Such practices have recently come under the scrutiny Payment cards have two of antitrust authorities in the U.S. and abroad. In this distinguishing features that lead us to think differently about this market. article, Bob Hunt describes the economics of the First, payment cards exhibit what payment card industry and explains how it differs economists call network — for example, payment cards are more from the textbook model of competitive markets. He valuable to consumers when more argues that these differences should be reflected in the merchants accept them. Second, in the U.S. at least, thousands of and antitrust analysis of payment card networks. other firms provide payment card services to millions of cardholders and millions of merchants who accept cards. In the United States, general- check at the — the number In an environment with network purpose payment cards — Visa or of consumer checks written peaked externalities and so many participants, MasterCard, ATM cards, or debit cards during the 1990s and is now in decline.1 economic theory suggests that some — are ubiquitous and easy to use. In In this article, I explore how form of coordination is beneficial, 2000, there were about 900 million payment cards and explain why possibly essential. In the U.S., this is general-purpose payment cards in the we need to think a little differently usually done by a payment card U.S., or about four for every adult. about the market for consumer payment network. These cards were used in 28 billion methods than we do for most other Payment networks coordinate transactions worth $1.9 trillion. Indeed, markets. This has implications for the behavior of banks, merchants, and payment cards are displacing the paper when, why, and how the rules of consumers by setting certain prices and rules. In many other contexts, such practices might be considered anti- competitive. It is also possible they can have anti-competitive effects in the 1 These statistics are from the for market for consumer payments. Yet a Bob Hunt is an International Settlements’ Statistics on Payment Systems in Selected Countries (2002), careful examination of economic theory economist in the Table 6. They exclude store cards. The tells us this is not always the case. Research Department decline in checks’ share of consumer of the Philadelphia transactions — relative to and debit The challenge to policymakers Fed. card transactions — is documented in the is to decide, based on the available article by Geoffrey Gerdes and Jack Walton. information, whether a network’s

14 Q2 2003 Business Review www.phil.frb.org pricing strategy and rules are likely to transfer (EFT) networks, allows many in the form of interchange fees — about advance or retard economic efficiency. banks to participate. The association $23 billion a year.6 Such conclusions are complicated by builds and maintains much of the An is one way dynamic considerations — a network infrastructure: the lines and switches to ensure that network participants are that exercises market power may spur required to route transaction informa- the development of competing networks tion between different acquiring and with superior . issuing banks. The associations specify 5 In a closed network, the card issuer also acts that, for each transaction, an interchange as the acquirer. Such networks carry a merchant discount but not an interchange THE AND fee be paid to the bank issuing a card by fee. Examples include and ECONOMICS OF PAYMENT the bank acting as the acquirer for the Discover. CARD NETWORKS merchant.5 In the U.S., about 1.5 6 This estimate is from The Nilson Report, The U.S. payment card percent of the value of all general- February 2002 (No. 758). industry involves thousands of banks purpose-card transactions flows to issuers participating in a number of networks, millions of consumers who find it FIGURE 1 valuable to use a payment card, and millions of merchants who find it valuable to accept those cards.2 Flow of Payments in a Stylized Card Network* Pricing and Rulemaking in Payment Card Networks. Banks engage in two types of activities within a payment card network.3 Card issuers are banks that offer cards to consumers and determine the level of any fees or finance charges their customers see on their regular statements. Merchants also have banks, called acquirers, that process card payments on their behalf.4 Merchants pay their acquirer for these services by accepting a merchant discount — when a consumer makes a $1 purchase using a payment card, the acquiring bank pays the merchant slightly less than $1 for that transaction (Figure 1). An open payment network, like the bankcard associations Visa and MasterCard and most electronic funds

2 The organization and development of the U.S. payment card industry is described in the by David Evans and Richard Schmalensee and the book by Lewis Mandell. * This figure is an illustration; it is not a precise description of any actual network. 3 In this article, I will focus on general- In particular, it does not reflect the timing of actions required to authorize or settle a purpose credit cards, such as Visa or transaction. MasterCard, and debit cards. I will not discuss cards, oil company In the figure, the card issuer makes a payment directly to the merchant’s bank. In some cards, or bank cards when they are used at networks, this is not done directly, but instead is done via payments to and from the ATMs. network itself. The merchant discount and interchange fee are simply illustrative. Other fees (e.g., switch 4 They are called acquirers because they fees) are not included in the figure. acquire transactions for the network. www.phil.frb.org Business Review Q2 2003 15 able to recover their costs. But, as we The New Kid on the Block: example, Star, NYCE, and Pulse.10 But will see, it can also be used to coordinate The . Debit cards allow in order to accept PIN debit transac- the activities of banks that issue customers to pay for and services tions, the merchant must first install a payment cards and acquiring banks that at the point of sale by authorizing a PIN pad and have a contract with one process transactions on behalf of withdrawal from their checking or or more EFT networks. Today, about 1.3 merchants. Even though consumers do savings account. In the U.S., debit million different store locations can not directly pay the interchange fee, it transactions at the point of sale only accept a PIN debit transaction. often affects the cost and benefits of became common in the 1990s, but they Visa and MasterCard offer using a payment card. For example, have increased extremely rapidly. In the their own brand of debit card, but they issuing banks that receive higher 20 years ending in 2000, consumer function differently. These cards can interchange fees will have an incentive purchases made via debit cards rose typically be used for PIN debit transac- to reduce fees that cardholders pay from essentially zero to account for tions, but they can also authorize (annual fees, transaction fees, or interest transactions with just the signature of rates). Or they may offer incentives In the U.S., debit the cardholder. A purchase paid for in such as cash back or frequent flyer this manner is often called a signature miles. The interchange fee also affects transactions at the debit transaction. Unlike a PIN debit the acquiring bank because the bank point of sale only transaction, a signature debit transaction must cover that fee through the does not immediately remove funds discount it charges merchants. That, in became common in from the cardholder’s account; it turn, influences merchants’ willingness the 1990s, but they typically takes a day or two for the to accept cards. have increased transaction to clear. This delay creates The bankcard association also some credit risk for the issuing bank acts as the rule-making body for the extremely rapidly. because the cardholder may have network. In recent years, two of these insufficient funds in her account at the rules have received a great deal of nearly 12 percent of all noncash time the transaction clears. So, unlike attention. First, the honor-all-cards rule consumer transactions. During this same with ATM cards, banks offer signature says that merchants wishing to accept a period, the share of these transactions debit cards only to account holders that card brand must accept all cards issued paid via increased from 14 to meet minimum credit standards. under that brand. For example, a 21 percent; the share paid by check fell Another important difference merchant who accepts a Visa card from 86 to 59 percent.8 between the two types of debit transac- issued by ABC Bank must also accept Most ATM cards can be used tions is that a signature debit transaction Visa cards issued by XYZ Bank. In at the point of sale as debit cards. Such can be carried out with the same addition, merchants must accept all transactions are called PIN debit equipment used to authorize credit card types of a particular brand — from transactions because the cardholder transactions. In fact, under the honor- to plain vanilla cards.7 must enter her four-digit PIN to all-cards rule, stores that accept Visa or Second, the no-surcharge rule authorize the transaction.9 Funds are MasterCard must also accept the says that merchants may not charge then immediately withdrawn from the comparable brand of debit card. customers more for a transaction using associated bank account. The transac- Currently, 4.9 million store locations in one brand of card than for a transaction tion itself is routed through an electronic the U.S. accept one or both of these involving any other brand. Taken funds transfer (EFT) network, for cards, offering a huge merchant base for together, these rules require that signature debit cards.11 Signature debit merchants treat all cards issued under a transactions are routed over the card 8 See the article by Gerdes and Walton. given brand equally and must not favor These statistics refer to the number of associations’ network, and the card another card brand by offering its users transactions, not the value of those transactions. better prices. 9 A PIN, or personal identification number, is a 10 These networks are also the backbone of four-digit number entered on a keypad at an the 350,000 ATM machines around the ATM machine or point-of-sale terminal. country. Many networks require a PIN because, as 7 Bankcard association rules require long as it remains confidential, a PIN can 11 Information is from The Nilson Report, June merchants to accept their brands of debit verify that the card is being used by the 2002 (No. 765), in a column entitled cards as well. authorized cardholder. “Retailer/Bank Card Lawsuit.”

16 Q2 2003 Business Review www.phil.frb.org issuer receives an interchange fee merchants have little incentive to join. cost of fraudulent transactions only if comparable to the interchange fee on a Since such a network would clearly be the network’s antifraud technology is credit card transaction.12 unprofitable, it would never be sufficiently effective.17 Network Effects and Fixed launched. But if a network is launched Network effects and fixed Costs in Payment Card Networks. on a large scale, it’s possible that many costs at the network level may explain Payment networks function differently consumers will carry the card and many why bankcard associations and EFT from most markets, in part because of stores will accept it. If that happens, networks use many of the strategies network effects.13 A payment card is even more stores are likely to accept the described earlier. Setting an appropriate more valuable to consumers when more card, which may induce even more interchange fee is one way to ensure merchants accept the card. At the people to carry the card and so on. that network members take into same time, merchants are more willing Third, network effects suggest account network effects, presumably to accept a card if they know many that there could be significant barriers to increasing card usage. This in turn consumers use it. Every consumer who obtains a card and every retailer who accepts a card increase the value of the Modern payment card networks require large network to all other cardholders and all investments in communications and computing other merchants who accept it. Such facilities in order to make card transactions decisions create externalities that have a number of implications for the evolution convenient to customers and merchants and to and efficiency of payment networks.14 minimize fraud. First, consumers and mer- chants are unlikely to take network effects into account unless such effects entry, and those barriers may permit reduces the unit cost of card transac- are reflected in the prices they pay or established payment networks to tions, making payment cards more the benefits they receive.15 If these maintain prices above costs for some attractive to use or accept. effects are ignored, the payment time. The reason is that in order to Setting the fee at the network network is likely to be too small or successfully enter the market, a rival level eliminates costs associated with underutilized. network must do so on a large scale. But bargaining between individual card Second, payment networks the market may not be large enough to issuers and acquirers and uncertainty exhibit increasing returns to scale. If a support more than a few networks at about the actual costs of a card transac- network is introduced on a small scale, such a scale. tion.18 Consumers are more likely to use there is inertia — consumers and A second factor that distin- guishes payment cards from many, but certainly not all, industries is the large 16 An exception to this rule for credit cards is fixed cost associated with establishing a card-not-present transactions, such as 12 A $40 signature debit transaction generates viable payment network. Modern or telephone orders, where network an interchange fee of about 60 cents (1.5 payment card networks require large rules stipulate that fraud losses are borne by percent) while a comparable PIN debit the merchant. transaction generates an interchange fee of investments in communications and about 18 cents (0.5 percent). See the August computing facilities in order to make 17 As with network effects, large fixed costs 8, 2002 edition of ATM and Debit News. imply economies of scale. This could explain card transactions convenient to why we did not observe an increase in the 13 A nontechnical discussion of this subject customers and merchants and to number of payment networks in the 1990s (in can be found in the “Symposium on Network minimize fraud. The latter is especially fact, there was a significant decline), even Externalities.” For applications of the theory though technological advances significantly to financial networks, see the article by important to card issuers because reduced the merchant’s cost of accepting a Nicholas Economides and the one by James network rules typically promise to pay new payment card. McAndrews. merchants for fraudulent transactions as 18 Why doesn’t the collective setting of the 14 An exists when the decisions or long as the network’s procedures are interchange fee — an obvious example of activities of one entity affect, positively or followed. If networks did not make this price fixing among competitors — violate U.S. negatively, the environment of another. antitrust law? Federal courts have recognized promise to merchants, fewer merchants there are situations where such arrangements 15 For example, consumers are sometimes would be willing to accept payment may promote rather than retard competition. offered cash back or frequent flyer miles as an 16 See the Broadcast Music, Inc. and NaBANCO incentive to use their cards. cards. But card issuers will accept the cases.

www.phil.frb.org Business Review Q2 2003 17 a payment card if they know where it was especially important in the late mechanisms remain essential after a will be accepted and on what terms. 1960s and 1970s, when the card payment card network becomes well The honor-all-cards rule and the no- associations were trying to build nation- established? surcharge rule reduce the uncertainty wide acceptance of credit cards issued There could be a dark side to consumers would otherwise face. This primarily by small banks. But do these all this coordination: These rules might

Legal and Regulatory Challenges to Payment Card Networks

United States. In October 1996, Wal-Mart and the next five years and to keep them below a cap that will other retailers filed an antitrust suit against Visa and be calculated each year on the basis of card issuers’ costs. MasterCard.a This suit later became a class action, Allowable costs include transaction processing, financing representing several million retail locations. In April 2003, the interest-free period enjoyed by cardholders, and certain the district court ruled on the pre-trial motions, reaching a payment guarantees provided to merchants. Visa also number of conclusions favorable to the plaintiffs’ tying agreed to amend its rules so that its interchange fee can be claim.b The case was settled shortly thereafter. The disclosed to merchants. bankcard associations agreed to revise their honor-all-cards In a separate decision published in November rules so that merchants can separately decide whether to 2001, the Commission concluded that Visa’s honor-all-cards accept their brands of credit and debit cards, to reduce rule did not restrict competition even when applied to interchange fees charged on signature debit transactions, different types of cards (for example, credit and debit) and to pay $3 billion in damages over a 10-year period. The within the same brand (for example, Visa).f reduction in interchange fees in 2003 alone is expected to Australia. In August 2002, the Reserve Bank of save merchants $1 billion.c Australia (RBA) announced regulations that apply to In 1998 the U.S. Department of Justice (DOJ) domestic credit card transactions using Visa, MasterCard, or filed a separate antitrust suit against Visa and MasterCard. Bankcard credit cards.g As of January 2003, merchants are Among other things, DOJ objected to the associations’ permitted to surcharge transactions using these cards. In exclusivity rules, which prevent banks that issue Visa or October 2003, credit card interchange fees will be capped MasterCard credit cards from simultaneously issuing a according to a cost-based formula that will be revised every Discover or American Express card. In October 2001, the three years.h Allowable costs include authorizing and trial court invalidated these rules.d The case is currently processing transactions, financing the interest-free grace under appeal. period enjoyed by cardholders, and costs resulting from Europe. In July 2002, the Competition Director- card fraud and its prevention. The card associations must ate of the European Commission announced a settlement provide RBA with audited data on these costs each year. with Visa that addresses multilateral interchange fees levied RBA also invalidated certain card association rules that it on certain credit and debit transactions that involve banks concluded were inhibiting entry by monoline credit card in more than one member state.e Under the terms of the banks and merchant acquirers. agreement, Visa pledges to reduce those fees gradually over

a In re Visa Check/MasterMoney Antitrust Litigation, N0. 00-7699 (2d Cir 2001). b In re Visa Check/MasterMoney Antitrust Litigation, 96-CV-5238 (E.D.N.Y. 2003). c “MasterCard, Visa to Pay $3 Billion to Resolve Card Suit; Will Modify Debit Card Policy, Fees,” BNA Banking Report, Vol. 80 (May 5, 2003), pp. 739-40. d U.S. v. Visa U.S.A., Inc. 163 F. Supp. 2d. 322 (S.D. NY 2001). e Case No. COMP/29.373 — Visa International-Multilateral Interchange Fees. Official Journal of the European Community (July 24, 002). f Case No. COMP/29.373 — Visa International. Official Journal of the European Community (November 10, 2001). g Reserve Bank of Australia. “Reform of Credit Card Schemes in Australia IV: Final Reforms and Regulation Impact Statement,” August 2002. h RBA is imposing the cap against the volume weighted average interchange fee levied on card transactions rather than specifying caps for different kinds of transactions. RBA expects that once implemented, the caps will reduce average interchange fees about 40 percent.

18 Q2 2003 Business Review www.phil.frb.org be used to enhance a dominant But open payment networks particular payment network need not be network’s market power. Such allega- do not actually control all the prices that the best from the standpoint of consum- tions form the basis of an important consumers and retailers pay for a trans- ers.20 The economic literature has antitrust case in the U.S., regulation of action. Instead, they influence those explored a variety of reasons a privately the payment card industry in Australia, prices by setting the interchange fee. determined interchange fee may not and far-reaching inquiries in Europe For example, suppose the network raises correspond to the fee that maximizes (see Legal and Regulatory Challenges to the interchange fee so that each card social welfare, but in this article, we’ll Payment Card Networks). In the transaction is more profitable for card focus on just one.21 following sections, I’ll examine in greater issuers. Card issuers will seek out more Suppose that a merchant detail the role of interchange fees, the cardholders either by offering them charges the same prices regardless of the no-surcharge rule, and the-honor-all- more benefits or by reducing cardholder manner in which consumers pay. For cards rule in consumer payment fees. Merchants will observe more example, customers who pay with a networks. cardholders using the card. But there is credit card pay the same price as a trade-off to raising the interchange fee customers who pay with cash. While THE PROS AND CONS OF INTERCHANGE FEES An interchange fee can be An interchange fee can be used to solve a used to solve a seemingly intractable problem: how to maximize the value of a seemingly intractable problem: how to maximize payment network while ensuring that the value of a payment network while ensuring retailers and banks are able to cover their costs. Economic theory offers some that retailers and banks are able to cover their intuition about solving this problem. All costs. other things equal, prices should be set lower for customers who are more price because it raises costs for the acquiring different payment instruments mean sensitive, that is, more likely to switch to banks, and at least some of that cost is different costs for the merchant, those another form of payment in response to passed on to merchants. The higher costs are not reflected in the prices paid a small change in price. Conversely, cost of card transactions may cause by every customer. Users of the cheaper prices should be set higher for those some merchants to stop accepting the form of payment bear some of the costs customers who are not as sensitive to card. created by customers who use a more price differences. Economists refer to To summarize, economic expensive form of payment. In eco- this strategy as Ramsey pricing, in honor theory suggests two factors that are nomic terms, there is a cross-subsidy. of the mathematician and economist likely to influence the size of a privately Consumers tend to overuse the more Frank Ramsey.19 Intuitively, this rule optimal interchange fee, that is, one that expensive form of payment because they leaves consumers as close as possible to maximizes the value of a payment net- the consumption choices they would work. The first is the relative size of costs make if they were able to purchase borne by issuing and acquiring banks — goods and services at a price equal to banks will not willingly participate if 20 their marginal cost of production — the they cannot recover their costs. The A payment network that enjoys market power has some freedom to choose the competitive ideal. second is the degree of price sensitivity amount of resources to raise through some exhibited by cardholders on the one combination of fees and discounts to merchants and cardholders. When there is hand and merchants on the other. In more than one payment network, it is not 19 Ramsey solved the following problem: A order to maximize the value of a pay- necessarily efficient to encourage the growth fixed amount of revenues must be raised by ment card network, it is necessary to of a network if it is at the expense of a less charging prices for goods in excess of their costly one. marginal cost. But higher prices will reduce impose more of the costs on those par- consumption and therefore welfare. Under ticipants who are least likely to stop 21 See the articles by William Baxter; Dennis these circumstances, the best that can be Carlton and Alan Frankel; Sujit Chakravorti done is to charge higher markups on those using or accepting the card. and Ted To; Sujit Chakravorti and William goods with less elastic demand curves and Networks May Not Choose Emmons; Howard Chang and David Evans; lower markups on those goods with more the Interchange Fee Best for Society. Joshua Gans and Steven King; Jean-Charles elastic demand curves. See Ramsey’s 1927 Rochet and Jean Tirole; Richard article. But the best interchange fee for a Schmalensee; and Julian Wright.

www.phil.frb.org Business Review Q2 2003 19 enjoy all the benefits but do not bear all payment methods and encourage has permitted merchants to offer a the costs. At the economywide level, consumers to use the most efficient discount for cash purchases since 1975. this could mean a payment network will forms of payment. So if we think that a Yet, in 1983, less than 10 percent of grow too large because purchases costly payment instrument is being used retailers offered cash discounts. Most of outside the network are subsidizing too much, allowing merchants to this activity occurred at gas stations and purchases made within the network. surcharge may be a useful remedy. even this became less common once It’s possible a network can But permitting surcharges may these stores began to accept bank-issued exploit this cross-subsidy by raising have a second effect. If merchants are credit and debit cards.22 In Sweden interchange fees while reducing willing to pass on costs in this way, an and the Netherlands, two countries that cardholder fees. Merchants would pass open payment network cannot use an banned no-surcharge rules during the on these costs to all their customers, interchange fee to influence the prices 1990s, less than 10 percent of retailers increasing the subsidy noncard users pay paid by merchants and consumers. To report surcharging their customers and to card users. If some of the increased see this, imagine what would happen if there has been little change in the interchange revenues are passed on to the network raised the interchange fee merchant discount.23 In practice, then, cardholders (through lower fees or more permitting surcharging may have little perks), this would, in turn, increase the An important insight effect. number of cardholders. Merchants may not like this outcome, but they may be gleaned from theoreti- THE PROS AND CONS OF AN reluctant to stop accepting the card if cal models of payment HONOR-ALL-CARDS RULE they think cardholders will take their networks is that the The question regarding an business elsewhere. honor-all-cards rule is not whether The actual outcome depends effects of interchange networks should be permitted to have crucially on how consumers react to fees depend on the such a rule, but rather how broadly it changes in prices and the nature of can be applied. Suppose a network competition among merchants. If extent of market issues two types of cards — a credit card customers who do not use the card power enjoyed by and a debit card — under the same respond to small price increases by retailers. brand. Should a merchant be required switching to merchants that accept only to accept both types of cards even if it cheaper cards, or just cash, any cross- prefers to accept only one type? subsidy must be small. Thus, an and card issuers passed on the additional This was the central argument important insight gleaned from theoreti- revenue to cardholders via lower fees or in the Wal-Mart antitrust case: The cal models of payment networks is that additional perks. Suppose also that card plaintiffs argued that the bankcard the effects of interchange fees depend acquirers pass on the higher interchange associations were using the honor-all- on the extent of market power enjoyed fee to retailers by raising the merchant by retailers. discount. In turn, merchants could increase the surcharge on card transac- 22 Statistics on cash discounting are from THE PROS AND CONS OF tions, essentially negating the increased Credit Cards in the U.S. Economy. Evans and SURCHARGES benefits provided by card issuers. So Schmalensee document the subsequent So far, we’ve assumed that with surcharging, raising interchange decline in cash discounts in their 1999 book. Edmund Kitch argues that regulatory barriers merchants do not set different prices for fees in order to stimulate card use will made it relatively costly for merchants to different card transactions. What not be very effective. If network effects offer cash discounts. Alan Frankel argues that merchants believe any benefit of happens if payment networks permit are important and cannot be taken into charging different prices is not worth risking merchants to add a fee to transactions account by some other means, the result a negative reaction from customers. He also when consumers use a more expensive could be underutilization of payment wonders whether consumers react more strongly to fees charged at the point of sale payment method? In principle, mer- cards. than to fees that appear later on their bank chants could pass on any difference in But so far we have assumed statement. their cost of using different payment that given the opportunity, merchants 23 See the November 2001 European cards to the customers using those cards. actually would impose surcharges. Commission decision. In his 2001 report, This would eliminate any cross-subsidy There is reason to doubt much surcharg- Michael Katz notes that among retailers in the Netherlands who were aware of the legal between customers using different ing would occur. In the U.S., federal law change, 20 percent surcharged.

20 Q2 2003 Business Review www.phil.frb.org cards rule to impose an illegal tying arrangement, forcing merchants that FIGURE 2 accept a brand of credit card to accept PIN Debit vs. Signature Debit the same brand of signature debit card.24 Because card issuers receive Transaction Volume more interchange revenue from (billions per year) signature debit transactions, they have 9 an incentive to subsidize consumers’ use 8 PIN Signature of these cards. This, in turn, influences 7 6 consumers’ choices about signature vs. 5 PIN debit transactions. Merchants pay 4 these higher fees and pass at least some 3 of the cost on to consumers via higher 2 prices. During the 1990s, the use of both 1 types of debit cards grew immensely 0 (Figure 2). But the share of all debit 86 88 90 92 94 96 98 2000 2002 transactions using a PIN fell from about 60 percent in 1993 to about 38 percent Sources: EFT Network Data Book, Debit Card and POS Market Data Book, in 2002. and Card Industry Directory, various years. If we view credit and debit cards as distinct products, it seems reasonable that an honor-all-cards rule should be enforced separately for each presumably pay higher fees or enjoy cards and debit cards? There is at least fewer benefits, since the use of the cards some evidence that consumers do not type of card. In other words, merchants 25 could be allowed to refuse the debit could not be subsidized as heavily. use credit and debit cards in the same card but still be required to accept all Do Credit and Debit Cards way. For example, consumers are more credit cards issued under that brand. Compete in the Same Market? likely to use debit cards in drug and Similarly, merchants could separately Applying the honor-all-cards rule to grocery stores than they are at depart- decide whether to accept a debit card both credit and debit cards of the same ment stores (Table). In addition, brand but would then be required to brand seems more reasonable if these consumers can often initiate a PIN debit accept all debit cards issued under that products actually compete in the same transaction larger than their purchase brand. market. But do they? Economists and receive the difference in cash, a The likely result would be that typically define the boundaries of a feature not available in a credit card merchants would pay different fees for market based on how consumers transaction. While credit cards provide credit card and signature debit transac- respond to price changes. If a change in an explicit line of credit, debit cards do tions. If signature and PIN debit the price of one good induces consumers not. Such differences suggest that credit transactions offer merchants the same to switch to another good, we say these and debit cards are not pure substitutes benefits, the interchange fee for a goods are substitutes. If only a small as a means of payment. signature debit would have to fall in change in price is sufficient to cause In 2001, a federal court, in a order for these cards to remain competi- consumers to switch to the substitute separate antitrust case against the tive with a PIN debit, since the cost of product, we say they compete in the bankcard associations, reached just this 26 processing a PIN debit is less than the same market. conclusion. But in a number of cost of processing a signature debit. What can we say about previous antitrust decisions, the courts Users of signature debit cards would consumer substitution between credit

25 The Wal-Mart case was settled in April 26 This case was initiated by the U.S. 2003. (See Legal and Regulatory Challenges to Department of Justice in 1998. A similar 24 In a tying case, the plaintiff tries to prove Payment Card Networks.) Industry analysts conclusion was reached in a ruling on pretrial that the defendant is using the market power predict it will change the debit card market motions in the Wal-Mart case (see Legal and it enjoys in one market to extract profits from in precisely the way described in the Regulatory Challenges to Payment Card another, typically more competitive, market. preceding two paragraphs. Networks).

www.phil.frb.org Business Review Q2 2003 21 TABLE only after credit cards were commonly accepted in more price-sensitive retail Data on the Use of Debit segments, and virtually all merchants were using modern electronic terminals and Other Forms of Payment (for 1999) to authorize transactions.28 When network effects and Stores with dynamic issues are both important, as PIN Pads they appear to be in this industry, (percent) Percentage of Store Paid via policymakers face a difficult problem in Cash Check Credit Card Debit Card deciding what remedies, if any, will All Stores 50 35 21 25 8 benefit consumers in the long run. On Discount 43 47 17 27 3 the one hand, network rules and pricing Drug 73 41 17 26 14 strategies may be essential elements in the successful launch of a payment card Supermarket 100 44 32 11 12 network and its subsequent expansion. Department Store 20 29 15 26 2 On the other hand, once a payment Home Center 7 21 27 26 6 network is well established, it is possible Apparel 38 28 19 32 10 the same rules can lead to their overutilization and to pricing well in Source: “Survey of Retail Payment Systems,” Chain Store Age (December 1999) excess of costs. A further complication is Note: These statistics are derived from a survey of large retail chains. It is not a that the pricing strategy of existing representative sample of the retail sector. payment networks affects how and when newer and presumably better forms of payment emerge. New forms of payment must overcome any subsidies have defined the relevant market more or harm consumers? In antitrust cases, consumers receive when using today’s broadly to include cash, checks, judges are often forced to weigh the payment instruments, and this may 29 department store cards, and ATM static costs of certain conduct against require offering subsidies of their own. cards.27 Even in the 2001 decision, the any dynamic benefits it may offer. This Policymakers should take all of these judge recognized that the emergence of is not easy to do when it is not clear how factors into account when examining all-in-one cards — a single card that can a market would have developed in the competition among consumer payment B be used for credit, signature debit, or absence of the conduct under scrutiny. networks. R PIN debit transactions — may increase Suppose we return to the consumers’ willingness to substitute 1980s, before a thriving debit card between these different forms of market developed. How might such a payment. market be developed? The method 28 Both of these developments were promoted chosen by Visa and MasterCard was to by offering interchange fees below the YESTERDAY, TODAY, graft debit cards on to the existing credit standard rate. For a more detailed descrip- AND TOMORROW card networks. Using their honor-all- tion of the evolution of the debit card market in the U.S., see the book by Evans and At the end of the day, cards rule, the associations ensured that Schmalensee and the article by Steven policymakers need to know the answer millions of merchants would accept Felgran and the one by Felgran and R. Edward Ferguson. to the following question: Does the signature debit cards. Using their no- conduct of a payment network benefit surcharge rule, the associations ensured 29 John Caskey and Gordon Sellon argue that that these cards would be accepted on the adoption of debit cards in the U.S. was delayed in part by subsidies resulting from the terms equal to those of any other debit pricing of consumer check transactions. card. Even with these advantages, Today, higher interchange fees paid on debit transactions coincide with debit cards’ signature debit cards were not immedi- displacement of checks in many consumer 27 See the NaBANCO decisions. ately successful. Their success occurred transactions.

22 Q2 2003 Business Review www.phil.frb.org REFERENCES

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