Study: Fee caps can boost rewards, cross-subsidies in payment networks
A new Federal Reserve Bank of Philadelphia working paper reveals that capping interchange fees can increase cardholder rewards and intensify cross-subsidization in payment networks, particularly when consumer demand is inelastic. The research develops a two-sided model to analyze the implications for prices, profits, and welfare.
The hidden tax of payment networks
The paper develops a comprehensive two-sided model of the payment card market, incorporating elastic consumer demand, merchant and network market power, ad valorem interchange fees, cardholder rewards, and cash as an alternative.
A central contribution is the identification of two endogenous 'credit card taxes,' defined as the wedge between the price paid by the consumer and the price received by the merchant.
These wedges arise from the interaction of interchange fees, rewards, consumer payment choices, and merchant pricing.
The tax on cash users depends positively on the interchange fee and the fraction of consumers using credit cards, as higher card usage raises merchants' average payment costs under a common retail price.
For credit card users, this tax is reduced by rewards.
In equilibrium, both taxes are jointly determined by the network's pricing, merchant decisions, and consumer card adoption, clarifying how the payment system redistributes surplus across consumer groups.
Regulation's surprising ripple effects
Interchange fees, typically 2-3 percent of transaction value in the U.S., are a subject of intense policy debate.
Merchants argue these fees are excessive, while card networks maintain they fund cardholder rewards.
Regulations like the Durbin Amendment and the proposed Credit Card Competition Act of 2023 aim to address these concerns.
The paper's analysis yields a novel result: capping interchange fees can increase equilibrium rewards when consumer demand is relatively inelastic.
This outcome, contrary to conventional wisdom, raises credit card adoption and intensifies cross-subsidization, potentially benefiting card users at the expense of cash users.
When demand is more elastic, however, fee caps reduce rewards and card usage, improving outcomes for both groups.
The study also characterizes conditions under which fee caps enhance allocative efficiency.
A nuanced view for regulators
This research provides crucial theoretical insights for policymakers grappling with the complexities of two-sided payment markets.
It effectively challenges simplistic industry arguments by demonstrating the demand-dependent and often counter-intuitive outcomes of interchange fee regulation.
A nuanced understanding of these dynamics is essential for designing effective policies that genuinely improve consumer welfare and allocative efficiency.