Regulating Interchange Fees in Payment Systems

Melbourne Business School Working Paper No. 2001-17

26 Pages Posted: 10 Oct 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: October 9, 2001

Abstract

This paper provides a simple model of 'four party' payment systems designed to consider recent moves to regulate interchange fees and other rules of credit card associations. In contrast to recent formal analyses emphasising the role of network effects in the decisions of customer and merchants to use credit cards, we provide a model without such effects. In so doing, we identify the key role played by customers who determine the choice of payment instrument and hence, impose costs and benefits on other parties to a payment system. This model yields new insights regarding the role played by card association rules as well as confirming results derived elsewhere. In particular, we demonstrate that 'no surcharge' rules can encourage transaction efficiency by eliminating payment instrument choice as a means of price discrimination. We also demonstrate that, even in the absence of network effects, a desire for balance drives both the socially optimal and privately profit maximising choice of interchange fees. The role of the interchange fee is to ensure that the customer internalises the impact of its decisions on other participants to a payment system rather than from a need to account for network effects alone. Thus, the presence or otherwise of network effects should not be the focus of regulatory attention.

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

JEL Classification: G21, L31, L42

Suggested Citation

Gans, Joshua S. and King, Stephen Peter, Regulating Interchange Fees in Payment Systems (October 9, 2001). Melbourne Business School Working Paper No. 2001-17, Available at SSRN: https://ssrn.com/abstract=286535 or http://dx.doi.org/10.2139/ssrn.286535

Joshua S. Gans (Contact Author)

University of Toronto - Rotman School of Management ( email )

Canada

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

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Stephen Peter King

Monash University - Department of Economics ( email )

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Productivity Commission ( email )

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