Discussion Paper No.

612

ELIMINATION OF COMPETITORS:SOME ECONOMICS OF PAYMENTCARD ASSOCIATIONS

Koki Arai

July 2004

The Institute of Social and Economic Research
Osaka University
6-1 Mihogaoka, Ibaraki, Osaka 567-0047, Japan

Elimination of competitors: some economics of payment
card associations
Koki Arai*
Abstract
This paper analyzes platforms and rejections in two-sided markets with network
externalities, using the specific context of a payment card association. We study thecooperative antitrust determination of the interchange fee by member banks. We use aframework in which banks and merchants may have market power and consumers andmerchants decide rationally on whether to buy or accept a payment card developed by
Rochet and Tirole (2002). After drawing the welfare implications of a cooperative
determination of the interchange fee and antitrust conducts, we describe in detail the factors
affecting merchant resistance, compare cooperative and for-profit business models, andmake a first cut in the analysis of system competition.
Keywords: competition; credit card; antitrust
JEL Classification: L41; G23; L80* Institute of Social and Economic Research, Osaka University; e-mail: arai@iser.osaka-u.ac.jp

telephone: +81-6-6879-8561, facsimile: +81-6-6878-2766
I would like to thank Aya Baba for helpful assistance.
01. Introduction
The rapid growth in the use of payment cards is a striking feature of modern economies.
It is characterized by the existence of strong network externalities: In a payment cardtransaction, the consumer’s bank, called the issuer, and the merchant’s bank, the acquire,must cooperate to enable the transaction. Two successful not-for-profit joint ventures,
Visa U.S.A., Inc. ("Visa U.S.A." or “Visa”) and MasterCard International, Inc.
("MasterCard"), have designed a set of rules to govern the “interconnection” between theirmembers: (i) Interchange fee, (ii) Honor-all-cards rule, and (iii) No-surcharge rule.
Further more, two successful for-profit firms, American Express and Discover, are the same
rules.
Some of these institutional features have gained wide acceptance and rationalized. To see
the benefits of a centrally determined interchange fee cum the honor-all-cards rule, itsuffices to envision the complexity of bilateral bargaining among thousands of banks aswell as the cost for issuers of informing consumers about the set of merchants with whom
an agreement has been reached.

The latter transactions costs could be avoided by keeping

the honor-all-cards rule while letting issuers and acquires set their pairwise interchange fees.
However, an individual issuer would then be able to impose an arbitrarily high interchange1fee, since the acquirer would then face the grim choice between accepting this fee on afraction of her payments and exiting the industry altogether. Individual issuers would
become bottlenecks, and their free riding would dissuade acquirers from entering theindustry.
Two features of these interconnection rules are viewed with suspicion by competition
authorities and by some economists. (See, e.g., Frankel (1998) and Carlton and Frankel(1995).)First, the no-surcharge rule is sometimes view as an attempt by payment card

systems to leverage their market power by forcing more card transactions than is efficient.
Second, the collective determination of the interchange fee is seen by some as a potential
instrument of collusion. Recently, after all, we obtained a court decision on an antitrust
law suit about the card systems’ exclusionary agreement.
The U.S. Department of Justice ("DOJ") brought a civil enforcement action challenging theorganizational structure of two of the nation's four major payment card systems. The
complaint charged that MasterCard and Visa U.S.A., which are organized as joint ventures
owned by their member banking institutions, conspired to restrain trade in two ways: (1) By
enacting rules permitting a member-owner of one to function as a director of the other (anarrangement the government described as "dual governance") (Count I); and (2) by2

enacting and enforcing "exclusionary rules," which prohibit their member banks fromissuing American Express ("Amex") or Discover cards (Count II).

After a 34-day trial, the court, in a commendably comprehensive and careful opinion, ruledin the defendants’ favor as to dual governance (Count I). As to Count II, however, thecourt held that Visa U.S.A. and MasterCard violated the antitrust act by enforcing theirrespective versions of the exclusionary rule, barring their member banks from issuing
Amex or Discover cards. The court further held that Visa International ("VisaInternational"), which owns the Visa brand, licenses it to Visa U.S.A., and exercises certain
governance powers over Visa U.S.A., was liable for participating in Visa U.S.A.'s violation.
The court ordered the exclusionary rules revoked and permanently enjoined all threedefendants from promulgating similar rules in the future. (See generally United States v.
Visa U.S.A., Inc., 163 F.Supp.2d 322 (S.D.N.Y.2001) (opinion and Proposed Final
Judgment); United States v. Visa U.S.A., Inc., 183 F.Supp.2d 613 (S.D.N.Y.2001)(modifications to Proposed Final Judgment).)
The defendants, MasterCard, Visa U.S.A., and Visa International, brought appeal. Visa
U.S.A. and MasterCard argue that the district court erred in its conclusion that their3

respective exclusionary rules violate the Sherman Act. Visa International contends there
was no adequate basis to hold it liable for Visa U.S.A.'s violation1.
The U. S. Court of appeals for the second circuit affirms the judgment (hereinafter, the“Judgment”).
This article analyzes the validity of the concern. To provide a policy analysis, it develops
a normative framework of the determination of an efficient interchange fee and of impact of
the antitrust agreement. The strength of this paper’s approach relative to the previous
literature (contrary to Rochet and Tirole (2002)) is that we build in antitrust effects and areable to show a proper welfare analysis. That literature focused on the payment systemstrategic mechanism based on the market power premises.

Namely, it assumes thatissuers have some market power, while acquires are in competitive (no market power)
alternatively. It seems to be a kind of general situation, but is not a good analogy. The
similar argument in the courtroom is not accepted with these mentioned:“Visa U.S.A. and MasterCard, however, are not single entities; they are
consortiums of competitors. They are owned and effectively operated by some
20,000 banks, which compete with one another in the issuance of payment cards
and the acquiring of merchants' transactions. These 20,000 banks set the policies

1This count is omitted in this paper.
4

of Visa U.S.A. and MasterCard. These competitors have agreed to abide by a
restrictive exclusivity provision to the effect that in order to share the benefits of
their association by having the right to issue Visa or MasterCard cards, they must
agree not to compete by issuing cards of Amex or Discover. The restrictive
provision is a horizontal restraint adopted by 20,000 competitors.2”
This article is organized as follows: Section 2 describes the working of the payment card
industry and antitrust conducts.

Section 3 develops the model. Section 4 re-interprets ofthe model under antitrust conducts. Section 5 compares the findings with those in theprior literatures.

Section 6 summarizes the main insights and discusses some topics for

future research.

2. Working of the payment card industry
A card payment is a service offered to two parties (the cardholder and the merchant) jointly
by two other parties (the issuer and the acquirer). The left side of Figure 1 shows the costs
and benefits attached to a card transaction.

The total cost of this service is the sum of theissuer’s cost CI and the acquirer’s cost CA. Suppose that the benefit accruing to the
cardholder (or buyer) for the marginal use of a payment card is equal to bB. Similarly, theSee the Judgment: III The Defendants' Arguments, A Harms to Competition, Paragraph
Five.
2

5

benefit to the merchant (or seller) of this marginal use of a payment card is bS. The
benefits bi and costs ci referred to above are net benefits and costs. The cardholder and themerchant must compare the utilities they get by using payment cards with those associatedwith alternative payment methods (cash, checks, etc.). At the social optimum, the total
benefit of the marginal transaction, bB+bS, is equal to its total cost, CI+CA≡c. The left
side of Figure 1 also features the payments from end users to intermediaries: cardholders
pay f to issuers and merchants pay merchant discount m to acquirers.
One of the features of payment systems is its two-sidedness. Whether the transactions
occur within a cooperative undertaking as studied here, or through a for-profit company
playing both roles of issuer and acquirer, the system must attract both sides of the market.
Any contemplated increase in the merchant discount must carefully consider the likely
merchant resistance, and similarly on the cardholder side.
The key feature of payment systems is antitrust conducts.

As above mentioned, theissuers and the acquirers are consolidated among the 20,000 banks and Visa U.S.A. and
MasterCard in order to optimal set maximal benefits of the consolidations through rejecting
business agreement with a for-profit company. The consolidated issuers and acquirers
have market power in the payment systems.
6

FIGURE 1
Net cost CI

Net cost CA
Pays p – a(a: interchange fee)

IssuerAcquirer

Antitrust conducts

Pays p+f(f: customer
fee)

Pays p – m(m: merchantdiscount)

Customer

Merchant
Sells good at price p

Marginalnet

Marginal net

benefit bB

benefit bS

3. A model of the payment card industry under the antitrust conductsSome models assume that issuers have some market power, while acquirers are perfectlycompetitive. (See Evans and Schmalensee (1999) and Rochet and Tirole (2002).)The

cause and the extent of market power is highly country-specific. In the model below, we
assume that issuers have some market power. Then we analyze the antitrust effect, also.
Our model is based on the model of Rochet and Tirole’s (2002). Accordingly, most of the7

assumptions such as a fixed volume of transactions, normalized to one transactions, etc. aretaken over. For example, CI and CA denote the per-transaction costs respectively, theinterchange fee is denoted a, and the merchant discount is denoted m (as following Section
2).

The customer’s yearly fee is f, and it is no variable fee.

Let bB and bS denote thecustomer’s and the merchant’s benefit.

Consumer side: Let E(bB |bB>=bB*) denote the expected benefit enjoyed by an average
cardholder, when consumers with type bB≧bB* purchase the card, and those with typebB<bB* do not.

Issuer side: Let D(f) denote the total demand for cards, and β(f) the average card holder
benefit.
Let f = f*(CI – a) denote the equilibrium customer fee.
Then the important assumption goes:

The oligopolistic equilibrium fee, f*(CI – a), is

defined for all values of the interchange fee a (even a >CI) and decreases with it. Eachmember bank’s profit increases with the interchange fee a.

8Acquirer side: Acquirers face per-transaction cost CA and are competitive.

For

interchange fee a, they offer merchant discount m given by m = a+CA.

Merchant side: Merchants I = 1, 2 set their retail prices (p1, p2) noncooperatively as inHotelling’s model.

Timing: The timing is as follows:Stage 1: The interchange fee is set (by collusively).
Stage2: Issuers set fees for their customers, who elect or not to have a card. Merchants
decide whether to accept payment cards, and then set their retail prices.
Stage 3: Customers observe the retail prices and whether cards are accepted, and pick astore. If the selected store does not accept payment cards or if the consumer does not own
a payment card, the consumer must incur his opportunity cost (bB) of using the alternative
payment method; similarly, the merchant incurs opportunity cost bS.

Then â is the level of the interchange fee at which the net cost to the merchants is equal tothe average cardholder benefit.
9Last, in order to analyze how merchant resistance is affected by the diffusion of cards in the
population, let us parameterize the oligopolistic equilibrium fee by a number τ that
increases when competition among issuers becomes more intense: f = f*(CI – a,τ), with f*decreasing inτ.

4. Re-interpretation of the model
After these preparations, Rochet and Tirole show and prove their Proposition 1, which is asfollows:
Proposition 1. (i) Under the no-surcharge rule, there exists an equilibrium in which all
merchants accept the card if and only if a≦â.
(ii) As competition among issuers intensifies, merchant resistance increases, i.e., themaximal interchange fee â decreases.

A little easy way to think is the other side of the meanings. We are supposed to think theissuer as the consolidation among the acquirers.

Once the issuer is thought of ascomposition of acquirers, then the cooperated price (customer fee; f) could be an optimallevel in the payment card consumer market.

There exist if and only if an optimal level of10the fee, which is the issuer=acquirer monopoly level against the consumer and the merchant.
The level is higher than the Cournot (or Bertrand) competition level of the acquirers. It iseasy to think that there exists the internal distributive level of the fee in the collusive
system.
And if competition rises among the banks in the collusive system, the total payoff of theconsolidation would decrease.

Rochet and Tirole’s Proposition 2 illustrates the externalities, which describes strategic
complementarity. This feature is a kind of credit card service’s character

The moreconvenient we use a credit card, the more merchants accept a credit card, and vice versa.
This finding is approved in the court (including even the equilibrium of card rejection, suchas “(1) Network-level costs are so high that banks and merchants cannot provide these
services for themselves.”3).

Rochet and Tirole’s Proposition 3 deals with interchange fee under the no-surcharge rule4.

The Judgment: I. Relevant Markets and Market Power.
Rochet and Tirole’s Proposition 3: Under the no-surcharge rule, the issueres’ preferredinterchange fee is equal to â .
3411The Proposition 3 means that there can be setting an optimal internal distribution level andthe effects on merchant side (overprovision). Rochet and Tirole’s Proposition 4 showsthat issuers’ perfect two-part tariffs implication.

It mentions that variable payments reduce

merchant resistance if and only if the interchange fee exceeds the issuer cost.

And bothassociations and a proprietary system enhance a positive externality by using some policies.
As for Rochet and Tirole’s Proposition 5, they introduce information incompleteness of
consumer, and show existence of social optimal interchange fee in general condition .

The other matter of interest is Rochet and Tirole’s Proposition 6, it states that:In the absence of transaction costs associated with the merchants’ charging different prices,(i) For a given interchange fee, allowing card surcharges raises the merchant price for
cardholders and lowers it for noncardholders.
(ii) When the no-surcharge rule is lifted, the interchange fee is neutral and there is anunderprovision of card services.
(iii) Lifting the no-surcharge rule reduces social welfare in case (i) of Provision 3. Lifting(i) If CI+CA-bS≦f*(CI - â ), then the socially optimal interchange fee is equal to the issuers’
preferred interchange fee.
(ii) If CI+CA-bS>f*(CI - â ), interchange fee set by a payment card association controlled byissuers leads to an overprovision of payment card services.
12the no-surcharge rule may increase or reduce social welfare in case (ii) of Provision 35.
In the antitrust conduct situation, the context means a problem of double marginalization6.
The no-surcharge rule prohibits a merchant from conducting price discrimination as amonopolist against a consumer. If the no-surcharge rule is lifted, then the merchant who
has a market power in the oligopoly situation can raise the price as long as the marginal
cost equal to marginal revenue (This is above (i) description.). It cause no effect on theinterchange fee which is like cost to the merchant ((ii)’s description).

Then if themerchant conduct marginalization of their action, social welfare’s direction depends on thesituation before and after7 ((iii)’s description).

Regarding system competition which is thought of two (or more) associations, Rochet andTirole deliberately note that system competition may reduce social welfare by lowering theinterchange fee.

And they express that they only want to warn against “naturalconclusions” and to stimulate further research on this very interesting topic.

See footnote four.
See Tirole (1998), p174.
7 If the limitation is constrain rigidly, the merchant’s marginalization cause dead weightloss under the merchant side monopoly. If not, the merchant’s perfect discrimination may
cause to raise social welfare through rising merchant’s benefit.
5
6

13

The last thing worth to be mentioned is Rochet and Tirole’s Proposition 7.

BeforeProposition 7, they note that a key difference between the for-profit and the cooperative
paradigms is that the former has two separate instruments and optimizes over the merchantdiscount and the customer fee, while in the latter the customer fee is determined by issuer
competition once the merchant discount/interchange fee is set. Then, Proposition 7 states
that: Let mP and mC denote, respectively, the merchant discount chosen (directly) by aproprietary system and (indirectly) by a cooperative banks.
(i) When issuer competition is described by Hotelling model, mC<mP, under the (weak)
assumption that the elasticity of merchant acceptance is small when m is outside thecompetitive region.
(ii) Linear demands, mC<mP.
(iii) When issuers compete a la Cournot and demands are linear, mC=mP.
In the antitrust context, including the for-profit entity into the model leads to leak profits tothe for-profit entity.

The conduct to obtain profits for for-profit entity cause to decrease

mC rather than mP in the oligopolistic situation.

It is important to consider that wecompare the welfare of the competition of a proprietary system with that of the cooperative
14

system.

5. Comparison with the literature
The theoretical and empirical analyses of the United States’ credit card market were
initiated by Baxter (1983) and Ausubel (1991), similarly. Then several articles have been
analyzed from the viewpoints of comparison of the ATM networks8.
Baxter (1983) is the standard reference.

Baxter assumed that perfectly competitive

paradigm then performed the normative analysis of finding the optimal interchange fee.
Schmalensee (2002) made analysis of market power issues.

Schmalensee considered thatthe interchange fee balances charges between cardholders and merchants under imperfectcompetition, and that economic basis for proprietary payment systems and cooperativebank card systems.
Then, Rochet and Tirole (2002) showed identification of the determinants of merchantresistance and analysis of the impact of the no-surcharge rule, as well as a comparison
between the privately optimal interchange fee and the socially optimal one. In a follow-up
article (Rochet and Tirole (2003)), they provide a general analysis of platform competition

8

These are mentioned in Rochet and Tirole (2002).
15and compare price structures under platform competition with those under a monopoly
platform.
We have pointed out the lack of the antitrust conducts in the framework of Rochet andTirole (2002), and show the simple re-interpretations of the credit card industry.
Another interesting topic is excess interest rates. Ausubel (1991) pointed out the interest
rate of credit card market in the 1980’s are sticky over the three times or five times of thefinancial market interest rates.

This indication leads to several similar studies. Calemand Mester (1995) considered that under the high interest rate of credit card, it is necessary
for consumers to take a search cost and a switching cost for the appropriate card. They
pointed out that credit card issuers offer high rate to keep away consumer’s adverse
selection, and provided that this situation made the high interest rate of credit card rulingout perfect competition in the market.

Stango (2000) confirmed that this high interest rateof credit card situation had been maintained by early 1990’s and that there was non pricecompetition between incumbents and new comers.

Knittel and Stango (2003) argued thatthe non bounded ceiling limitation of the interest rate of credit card functioned one of focal
point for the card issuers, and that the focal point made tacit collusion of the interest rate.
The situations mentioned by Ausubel and others are explained by some market power
16

caused by antitrust conducts of the cooperative bank card systems. Market power may bepresumed if the entity controls a large enough share of the relevant market. The court
stated that:“Indeed, despite recent increases in both networks' interchange fees, nomerchant had discontinued acceptance of their cards.

In addition, the court

inferred market power from the defendants' large shares of a highly concentrated
market: In 1999, Visa U.S.A. members accounted for approximately 47% of thedollar volume of credit and charge card transactions, while MasterCard members
accounted for approximately 26%.

(American Express accounted for 20%;

Discover, for 6 %.)9”
While competition among (and within) these networks is robust at the issuing level (where
20,000 separate issuers compete to provide products to consumers), at the network level(where four major networks seek to sell their technical, infrastructure, and financial
services to issuer banks) competition has been seriously damaged by the defendants'
exclusionary rules. The market power is regarded as one of the main reason of the highinterest rate of credit card in the 1980’s and early 1990’s.

9

The Judgment; I. Relevant Markets and Market Power, Paragraph Five.
17

6. Summary
This article has pointed out a leitmotif of economic effect of antitrust conducts in payment
card systems and studied Rochet and Tirole (2002). They state that in the absence ofunobserved heterogeneity among merchants, an increase in the interchange fee increases
the usage of payment cards, as long as the interchange fee does not exceed a threshold levelat which merchants no longer accept payment cards.

Indeed, there is this threshold in themodel, but this threshold is a kind of internal optimal re-distribution point in antitrust
collusion between many acquirers and association type issuers.
And Rochet and Tirole mentioned meaningful role played by merchant resistance.
Payment card systems can exploit each merchant’s eagerness to obtain a competitive edge
over other merchants, and this searching has two benefits for systems: it forces merchants
to internalize card holders’ convenience benefit, and it offsets the underprovision of cards
by issuers with market power.

From the viewpoint of antitrust context, merchantresistance means cost of buying for acquires and issuers collusion. Therefore, if the costis low (in the situation of a merchant has no market power and is on the competitive edge),
payment card systems obtain merits from the low cost and can pass through the benefits tothe consumer side.

Additionally, if system competition happens, merchant resistance18

(selling power10) would increase and the system’s benefit goes down.
If the no-surcharge rule is lifted and price discrimination is costless to merchants, theinterchange fee no longer affects the level of payment card services. The merchant pricefor cardholders is increased and that for noncardholders is decreased.
The payment card industry has received scant theoretical attention, and it will not come as asurprise to the reader that more research is warranted.

This article argued that theframework developed here can be used as a building block to analyze more generalsituations with acquirer market power and distorted competing means of payments,
including antitrust conducts in which is employed by Visa U.S.A. and MasterCard. The
payment card industry offers many other fascinating topics for theoretical and empiricalinvestigation, such as the competition between associations and proprietary, thedevelopment of e-commerce, and the comparison of world payment card systems.

The

respect thing is that we find out that who is decision-maker, jointly or a form of association,
and we are aware of including antitrust viewpoints.
This argument can expand a broader perspective.

Consider the pooling association

containing the music copyrights from each musician.

The association has two sided effect10

Using these words, contrary to “buying power.”19

similar to the payment card systems.

It is common to get in the licensing fee of music,

however if we can adopt this article’s framework then the association is suspect to be an
illegal under the antitrust law11. More generally, most markets with network externalities
and industrial association involve multiple sides and the choice of price structure andantitrust problems. It can think of internet operating and keeping the security association,international banking association, media advertisers and real estate agency assessment
association and so forth. What is important is real insights and recognition of positive
reality.

References:
Ausubel, L. M. (1991) “The Failure of Competition in the Credit Card Market,” American
Economic Review, 81; 50-81
Baxter, W. F. (1983) “Bank Interchange of Transactional Paper: Legal Perspectives,”
Journal of Law and Economics, 26; 541-588
Calem, P. S. and Mester, L. J. (1995) “Consumer Behavior and the Stickiness of Credit
Card Interest Rates,” American Economic Review, 85; 1327-1336

11

There is the situation in Japan.
20

Carlton, D. W. and Frankel, A. S. (1995) “The Antitrust Economics of Payment Card
Networks,” Antitrust Law Journal, 63; 643-668
Evans, D. S. and Schmalensee, R. L. (1995) “Economic Aspects of Payment Card Systems
and Antitrust Policy Toward Joint Ventures,” Antitrust Law Journal, 63; 861-901
Frankel, A. S. (1998) “Monopoly and Competition in the Supply and Exchange of Money,”
Antitrust Law Journal, 66; 313-361
Knittel, C. R. and Stango, V. (2003) “Price Ceilings as Focal Points for Tacit Collusion:
Evidence from Credit Cards,” American Economic Review, 93(5); 1703-1729
Rochet, J. C. and Tirole, J. (2003) “Platform Competition in Two-Sided Markets,” Journalof the European Economic Association, 1(4); 990-1029
Rochet, J. C. and Tirole, J. (2002) “Cooperation among Competitors: Some Economics ofPayment Card Associations,” RAND Journal of Economics, 33(4); 549-570
Schmalensee, R. (2002) “Payment Systems and Interchange Fees,” Journal of Industrial
Economics, 50; 103-122
Stango, V. (2000) “Competition and Pricing in the Credit Card Market,” Review of
Economics and Statistics, 82(3); 499-508
Tirole, J. (1998) The Theory of Industrial Organization, Cambridge, Ma. MIT Press
21

United States v. VISA U. S. A., Inc., 163 F. Supp. 2d 322 (S. D. N. Y. 2001)
United States v. VISA U. S. A., Inc., 163 F. Supp. 2d 613 (S. D. N. Y. 2001)
United States v. VISA U. S. A., Inc., et al. (2d Cir. Sept. 17, 2003)

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