Vertical Restraints in To-sided Markets: Credit Card No- Surcharge Rules Dennis W. Carlton Booth School of Business, University of Chicago Ralph A. Winter Sauder School of Business, UBC CRESSE July 5, 05
Are credit card companies alloed to adopt No-Surcharge Rules?: the La Australia Canada U.S. U.S. states In some jurisdictions, NSR s are illegal. In some, NSR s are legal. In some, NSR s are not only legal but mandatory
Ideas of this Paper I Vertical Theory:you and I are competing, selling differentiated products, through common retailers. Retailers are competitive, passing on prices. I impose a vertical MFN : retailers cannot charge a higher price for my product than for yours. So do you. impact reduces incentive to undercut collusive price. cost externalization effect. extend to monopolist /competitive fringe: a leverage theory II Apply this verticaltheory to credit card netorks the quintessential to-sided market. 3 3
Literature Andre Boikand Ken Corts, The Effects of Platform MFN s on Competition and Entry, Working Paper, Rotman, 04 Rochetand Tirole, Cooperation Among Competitors: Some Economics of Payment Card Associations, Rand Journal of Economics, 00 Justin Johnson, The Agency Model and MFN Clauses, SSRN, 03 Julian Wright, Why Payment Card Fees are Biased Against Retailers, Rand Journal of Economics 0 Benjamin Edelman and Julian Wright, Price Coherence and Excessive Volatility, forthcoming, QJE Steve Salop and Fiona Scott Morton, Developing an Administrable MFN Policy, Antitrust 03 Fiona Scott Morton, Contracts that Reference Rivals, DOJ Speech 0 4 4
I. Vertical MFN Restraint Duopoly Model. To suppliers of symmetric, differentiated products, cost c. Sell to consumers through a common set of retailers, charging holesale prices, 3. Retailers set prices p, p 4. Consumers: homogeneous prefs. Shop at only one store. But perfectly informed. Choose store on the basis of retail prices. -- if no restraints, retailers set p, p =, -- if bothsuppliers set vertical MFN, then retailers set p = p = + / -- retailers carry both products 5. Timing:. suppliers decide on MFN or not. Suppliers decide on, - label holesale pricing subgames 00, 0, 0, 3. Retailers set p, p 4. Consumers purchase: q i p, p, i=, 5 5
6 Impact of both firms adopting restraint 00 game: Bertrand game: 6 0,, = + q p q c 0,,, = + + q p q p q c,, q c + + = π
Impact of, both adopt MFN Evaluate first-order condition at Bertrand pricing outcome: cost-externalization effect diversion effect c q q + c > 0 p p Both effects higher prices under : an compe ve impact 7 7
8 In fact, prices higher than collusive level Repeat first-order condition characterizing, eqm price: Same as collusive first-order condition but for the / Interpret 8 0,,, = + + q p q p q c
Reaction Curves for 00and games linear demand case R R R R 0,0, Joint profit max IMPLICATIONS 9 9
Equilibrium of full game For linear demand: q p q p, p, p = p = p + dp + dp Given,0 and,, MFN is relevant only if > Think about s reaction curve, in 0 game ill jump So mixed strategy equilibrium. But very simple. Result of solving entire game: adopt MFN is a dominant strategy Prisoners Dilemma henever players are orse off in than 00: d < 0.5 Prohibiting vertical restraint is Pareto Improving in this case 0 0
Extension to Monopoly ith Competitive Fringe Still differentiated products, but second is supplied competitively q p, p monopoly [large] q p, p competitive [no choke price; c not too high] Will monopolist ant to impose MFN? Consider industry profits Π p, p these accrue entirely to monopolist, ho uses instruments. hich is higher? maxp Π p, c MFN maxpπ p, p **
Adding non-price competition DUOPOLY: Add a dimension x of promotion or quality, decided at same time as price. With suppression of price competition due to MFN, e ill get more non-price competition Stigler: Price versus non-price Competition, JPE 964 If non-price instrument perfect substitute for loer prices: agreement irrelevant Normative: enhanced non-price competition may benefit consumer but does not excuse collusion on prices nor should it excuse agreements that elicit collusive pricing or higher. MONOPOLY / FRINGE Price and a vertical MFN is a crude set of instruments. Suppose that monopolist ants to implement a higher price for competitive sector product than for its on product: it can set a very high price for both under the MFN, but refund some of the price to its on customers. If perfect non-price instrument is available, monopolist can implement a ider set of prices p, p
Points to take forard Duopoly: Vertical MFN is anticompetitive in duopoly, to effects. Monopoly ith fringe: anticompetitive via extension of monopoly poer Enhanced non-price competition ould not as a practical matter defend MFN in duopoly. Non-price competition increases anticompetitive effect in monop/fringe Perfect non-price competition renders impact of MFN irrelevant in duopoly, but stronger in monop/ fringe 3 3
Credit Cards 4 4
Credit card cash flos: 00 dollar transaction, no fees Credit Card Co. Issuer $00 Acquirer $00 $00 Cardholder Merchant 5 5
Credit card fees and surcharge: 00 dollar transaction $0.06 Netork Fee Credit Card Co. $0.06 Netork Fee Issuer $.50 Interchange Acquirer Benefits $.56 Merchant Service Fee Cardholder $.56 Surcharge Merchant Issuer Activities: promotion, benefits: air miles, insurance, interest rate, cash back 6 6
Credit card fees and surcharge: Vertical Interpretation netork fee Credit Card Co. netork fee credit card company sells right to access netork to consumer and merchant. Issuer Activities: x Interchange Acquirer charges a pricefor this service allocates much of this price to promotion and quality : I fee Benefits Cardholder Surcharge Merchant M fee merchant charges consumer for this service The interchange fee is the amount per 00 dollars allocated to promotion and quality. 7 7
Possible Objections to Interpretation credit card company does not in fact collect, then reallocate funds for promotion credit card company does not even engage in the promotion funded by the interchange issuers do much more than promote this interpretation forces credit card netork services into a vertical setting. But it is a to-sided market, ith: prices on both sides. need to attract agents on both sides cross-platform externalities 8 8
Interpretation is consistent ith principles of interchange economics Standard principles: p = issurer netork fee- interchange fee p = aquirer netork fee+ interchangefee q ~ p, p. optimal interchange fee maximizes volume of transactions. the interchange fee balances to sides of market 3. formula for optimal interchange rate Dorfman- Steiner Vertical Perspective A pq εa = ε p 9 9
NSR through the lens of the vertical interpretation An NSR results in higher, anti-competitive prices. Much most of the increased in price ill be allocated to a higher interchange rate. As Stigler predicted: suppression of price compe on greater non-price competition. Higher interchange fee, and positive impact on issuer/cardholder side of the market is not an adequate defense of restraint. A NSR also allos credit card company to leverage market poer, to extract surplus from cash and debit customers. 0 0
Economics of the Interchange Rate Surcharging basic neutrality result of credit card netorks: if: a surcharging is alloed, and can be implemented costlessly b % cashback % reduction in surcharge [ perfect cashback ] then: the interchange fee is irrelevant Given basic consumer demand for transactions q s, x and equilibrium actions on part of issuer, merchant and acquirer, a higher interchange fee is part of another equilibrium ith equivalent payoffs.
Interchange Irrelevance under Perfect Cashback Netork Fee Credit Card Co. Netork Fee Issuer $.50 + Δ Interchange Acquirer Benefits Merchant Service Fee Cardholder Surcharge Merchant Issuer Activities: promotion, benefits: air miles, insurance, interest rate, cash back
Economics of the Interchange and Surcharging surcharging plus perfect cashback irrelevance of interchange Perfect cashback irrelevance of a no-surcharge rule in duopoly 3 For monopoly credit card company, facing cash, debit as competitors: a No-surcharge rule allos extension of monopoly poer; b Perfect cashback strengthensthe poer of the no-surcharge rule to leverage monopoly poer through tax on cash, debit transactions. 3 3
Points. An NSR results in higher, anti-competitive prices, both ithin duopoly and through extraction of surplus from cash customers.. price ill largely be through interchange fee 3. Point carries little or no policy significance for alloing NSR s. 4. Vertical perspective: a valuable lens for econsof interchange 5. Perfect surcharging, cashback interchange irrelevant 6. Perfect cash back NSR restraints irrelevant in duopoly 7. Perfect cash back impact of NSR restraints strengthened in monopoly credit card market, facing cash. 4 4