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

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. 

Full post as published by Credit Slips on June 23, 2010 (boomark / email).