The Neutrality of Interchange Fees in Payment Systems

Melbourne Business School Working Paper No. 2001-03

47 Pages Posted: 30 Jul 2001

See all articles by Joshua S. Gans

Joshua S. Gans

University of Toronto - Rotman School of Management; NBER

Stephen P. King

Monash University - Department of Economics; Productivity Commission

Date Written: July 2001

Abstract

There has been considerable public debate over the effect of interchange fees on credit card transactions. Regulators in Australia and Europe have argued that these fees can be set by banks to have an anticompetitive effect. In the US, it has been argued that these fees, together with a rule that prevents a surcharge for credit purchases, might create a cross subsidy between cash and credit customers. Academics have noted that, in particular circumstances, interchange fees have no real effects in the absence of such a no-surcharge rule.

This paper considers two aspects of credit card interchange fees. First, it provides a general neutrality result. We show that in the absence of a no surcharge rule, interchange fees can never have any real effects. This result does not depend on the degree or nature of competition at either the bank or the merchant level. Second, we consider the potential for a bank with market power to manipulate interchange fees in the presence of a no-surcharge rule in order to raise bank profits. We show that such cross subsidisation is not profitable if there is adequate competition from 'cash only' merchants. We then consider the interaction between imperfectly competitive merchants that accept credit cards. For the special case of a single merchant, we provide both necessary and sufficient conditions on demand and the merchant's profit function for fee manipulation to be feasible. We then examine what occurs when there are multiple imperfectly competitive merchants; demonstrating that the profitability of any cross subsidisation depends critically on the nature of merchants' competitive interactions.

Keywords: Credit card associations, payment systems, interchange fee, neutrality, no surcharge rule

JEL Classification: G21, L31, L42

Suggested Citation

Gans, Joshua S. and King, Stephen Peter, The Neutrality of Interchange Fees in Payment Systems (July 2001). Melbourne Business School Working Paper No. 2001-03, Available at SSRN: https://ssrn.com/abstract=276228 or http://dx.doi.org/10.2139/ssrn.276228

Joshua S. Gans (Contact Author)

University of Toronto - Rotman School of Management ( email )

Canada

HOME PAGE: http://www.joshuagans.com

NBER ( email )

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Stephen Peter King

Monash University - Department of Economics ( email )

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Australia

Productivity Commission ( email )

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Melbourne, Victoria, Victoria 3000
Australia

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