Action on payment cards (a few) Insights from theory Emilio Calvano Brussels, 15 June 2011

Why theory? Increased demand for Econ theory Dodd-Frank Wall Street Reform and Consumer Protection Act. Aftermath of the financial crisis Banking regulation (e.g. capital adequacy and liquidity regulation) Role of central banks (e.g. “flexible” inflation targeting) [...] Increased demand/supply for simple solutions (causality both ways) Do they exist? (at least in a controlled environment) Do they work? (arguably yes...)

Two sets of theories (with non empty intersection, sorted by claimed distortion) Set 1: Focus on distortions on the extensive margin (acceptance by merchant and consumer). Common ingredient: elastic participation on both sides (different institutional details) Common theme: Spence distortion: average vs marginal user. Set 2: Focus on distortions on the intensive margin (use by consumer and merchant) Common ingredient: “observable heterogeneity” Common theme: “must take cards” issue induces over-provision Role of price structure and hence of IFs different One instrument / many issues: interchange fees are not and in fact can’t be a panacea for solving all externality-induced distortions Set 1: not obvious distortion (signing the “gap” not trivial even when participation on one side is relatively inelastic) Set 2: “fully captive” merchants imply equilibrium over-provision of card services.

The tourist test benchmark Internal Validity (Rochet and Tirole 2011 framework) Merchants are homogeneous. ([or] observable heterogeneity) A “must take cards” issue is there. (for some reason merchants accept cost increasing cards) All consumers and merchants are “on board.” Consumers are charged shop-contingent usage fees. (slice up the mkt definition to the “retailer type” level) No externalities on other markets. (consumers purchase anyway) We all agree on definitions of costs and benefits

three shortcuts Only 1 choice here: cash vs plastic Interchange fee is an (imperfect) control for end-user prices. Only 1 (simple) goal: efficient usage pay with plastic whenever social benefit > social costs Only 1 reason to price beyond “avoided cost”

The tourist test int. fee (TTIF) and its logic Fact: whenever there is an epsilon markup somewhere the TTIF fails. (e.g. markup on issuer side: under-provision) Claim: the TTIF is still a “reasonable” fee (i.e. performs reasonably “well”) one can always find conditions on market structure under which TTIF is “reasonable.” Consider now the following alternative: E(milio’s)IF = TTIF + 1% one can always find conditions on market structure under which EIF is “reasonable.” Point: The information you would need to assess whether one is more reasonable than the other is the same information you would need to set the First Best fee. So if you have it go for first best. If you don’t any fee is “reasonable.” def: TTIF induces a merchant discount equal to the “ avoided cost ”

The Zenger (2011) “critique” Fact: “perfect surcharging” and TTIF implement the same allocation. Fact: that allocation is inefficient. Observation: Frictions (or no-surcharge provisions) give you a shot at first best. Alternative read: good illustration of why “one-sided” platforms may choose to go “two-sided” to increase welfare of end-users Example: 99 cents Apple’s ITunes pricing policy. [...]

The tourist test benchmark External Validity (Beyond Rochet and Tirole 2011) Let’s relax these assumptions now (no more shortcut!).... Merchants are homogeneous. (or observable heterogeneity) A “must take cards” issue is there. (for some reason merchants accept cost increasing cards) All consumers and merchants are “on board.” Consumers are charged shop-contingent usage fees. (slice up the mkt definition to the “retailer type” level) No externalities on other markets. (consumers purchase anyway) We all agree on definitions of costs and benefits

Punchline Simple is good. Unfortunately there is no simple rule here, nor reason to believe that “simple rule” is better than “no rule.”