Interchange Fees: A Review of the Literature
Massachusetts Institute of Technology (MIT) - Sloan School of Management
Payment Card Economics Review, Vol. 1, pp. 25-44, Winter 2003
This paper summarizes the key contributions to the literature on the economics of interchange fees. The older literature tries to address the issue without rigorous modeling. Thus, it was possible even after Baxter's seminal contribution to suggest, as did Carlton and Frankel, that society might be better off mandating a zero interchange fee. The more recent literature still leaves many theoretical and empirical questions unanswered. However, several conclusions can be drawn from the efforts to model interchange fees formally by Rochet and Tirole, Schmalensee, and Wright.
The cost and demand factors driving private fee-setting are closely related to those that determine socially optimal fees. Moreover, any deviation from social optimality will be the result of subtle differences between the two sides of the market - not from market power leading to excess profits for association members. No rigorous analysis supports the idea that a zero interchange fee or a fee set by regulators based on cost would generally raise welfare. Furthermore, while there is no guarantee that interchange fees set by associations will maximize social welfare, this does not imply that collective rate-setting is appropriate grist for antitrust scrutiny. The hallmark of anticompetitive pricing is excess profits and less-than-optimal output. Yet, there is no reason to believe that private setting of interchange fees generates excess profits for the colluding parties since competition in acquiring and issuing activities can be expected to dissipate any surplus revenue. The interchange fee has the effect of lowering costs on one side of the market and raising them on the other. Nor will interchange fees set above the socially optimal level generally restrict output.
Number of Pages in PDF File: 20
Keywords: interchange fees, payment cards
Date posted: January 25, 2005