Price Differentiation and Menu Costs in Credit Card Payments Marcos - PowerPoint PPT Presentation

VIII Annual Seminar on Risk, Financial Stability and Banking São Paulo August 8, 2013 Price Differentiation and Menu Costs in Credit Card Payments Marcos Valli Jorge Banco Central do Brasil W ilfredo Leiva Maldonado Catholic University of Brasilia

Market structure ( four-party schem e) ( four party schem e) market sides p Merchant h Consumer price m f merchant fee consumer fee a Acquirer Issuer interchange fee g Credit card scheme set rules and act as switch and router 2

Main reference • Rochet&Wright (JBF 2010) : “Credit card interchange fees” Rochet&Wright (J F 0 0) : Credit card interchange fees – “General tendency for merchants to adhere to the setting of a single price regardless of the form of payment ” single price regardless of the form of payment. – “Part of the reason for this is the no ‐ surcharge rules adopted by the credit card systems.” – “If retailers were able and willing to discriminate based on the If retailers were able and willing to discriminate based on the use of store credit, they maybe able to induce consumers to use credit cards and store credit efficiently.” – “One important direction for future research: to extend our model to allow retailers to offer different prices when model to allow retailers to offer different prices when consumers make use of store credit.” 3

Main aspects of R&W ’s approach Main aspects of R&W s approach • Model the credit functionality of a credit card: much of the • Model the credit functionality of a credit card: much of the existing literature treats payment card as debit card; • Consider the store credit as a competitor of the credit card (in addition to cash); • Cardholders can not internalize retailers’ net avoided costs from credit card usage (merchant fee minus cost of store credit); credit card usage (merchant fee minus cost of store credit); • Model the excessive usage of credit cards: increase interchange fee can reduce consumers aggregated welfare; 4

Results under non surcharge rule g Rochet&W right ( JBF 2 0 1 0 ) • Single price equilibrium; • Interchange fee is not neutral: • Interchange fee is not neutral: – It affects card usage (real allocations); – There is an endogenous cap: • The monopoly card network raise it to increase credit card The monopoly card network raise it to increase credit card usage and maximize profit; • If sufficiently high, merchants do not adhere to the credit y g , card system; • The cap value exceeds the level that maximizes consumer The cap value exceeds the level that maximizes consumer surplus; 5

Results under non surcharge rule g Rochet&W right ( JBF 2 0 1 0 ) • If regulators only care about consumer surplus: – A conservative regulatory approach is to cap interchange fees A conservative regulatory approach is to cap interchange fees based on retailers’ net avoided costs from not having to provide credit themselves. – This always raises consumer surplus compared to the unregulated outcome sometimes to the point of maximizing unregulated outcome, sometimes to the point of maximizing consumer surplus. 6

Consum er’s w elfare under single price equilibrium d i l i ilib i 7

Methodology • Three payment instruments: credit card, store credit and cash; • Two types of purchases: – ordinary purchases (deterministic, using any of the three instruments) ordinary purchases (deterministic, using any of the three instruments) – extraordinary credit purchases (random, can not use cash); • T o retailers disp te the market • Two retailers dispute the market where consumers incur in here cons mers inc r in transportation costs (Hotelling competition); • Compute: – Consumers utilities; – Merchants market shares; – Merchants margins; – Merchants profits (margin x market share); Merchants profits (margin x market share); • Apply first order conditions to obtain equilibrium prices; 8

Model structure w ith price differentiation ith i diff ti ti store credit costs product cost random with c.d.f . H  c S c B p r x = proportion of Merchant h Consumer p c = p r + Δ c credit card owners m = c A + a f = c I + π - a merchant fee consumer fee a profit margin Acquirer Issuer interchange fee c I c A credit card costs Store credit Credit card 9

Hotelling com petition w ith transportation costs T Transportation costs t ti t s . t s . t 1 2 Consumer Retailer 2 Retailer 2 R t il Retailer 1 1 s s 1 2 Distances 10

Store credit random cost faced by consum ers faced by consum ers ( ordinary purchases) When credit card is an option When credit card is not an option with a cost with a cost with a benefit with a benefit C B C B C B H probability cash cash distribution f+ Δ c credit card 0 0 0 store store f+ Δ c credit credit store credit credit 11

Store credit random cost faced by consum ers faced by consum ers ( extraordinary purchases) When credit card is an option When credit card is not an option with a cost with a cost with a benefit with a benefit C B C B C B credit dit H probability card distribution f+ Δ c credit card store 0 0 0 credit store store credit f+ Δ c store credit credit 12

I ndicators of acceptance I ndicators of acceptance • Does the consumer use of credit cards instead of cash at the retailers i ?     c f 1 if credit card (or 0 )  c i L   i i   0 if if cash h • Does the retailer i adhere to the credit card system? i dh D th t il t th dit d t ?   1 1 if if adhere dh system  r L  i   0 otherwise 13

Consum er’s expected utility   0                    r r c U U u u u u p p c c dH dH c c E E c c x x L L S S a a . 1 ( ( 1 1 ) ). . ( ( ) ) . ( ( ) ) . . ( ( , ) ) i i B B B i i 0 c B Cost of all Cost of all Utility of an Utility of an purchases ordinary purchases. Benefit from credit card transactions Utility of extraordinary Utilit f t di C Cost of the store f h (credit) purchase credit transactions with probability θ . (if x=0 ) where       c c           c c B c c B S a L c f dH c L c dH c   ( , ) : ( ). ( ). . . ( ) i i B i B i B B   c   f 0 i Cost savings from substituting store credit for credit card 14

I ndifferent consum er and retailers’ m arket shares  t  2  U s t U s . . 2 2 2 1 1 1 1 Indifferent Consumer Consumer Retailer 2 Retailer 1 s    s s s 1 s 1 s 2 1 1 15

Retailer’s m arket share Retailer s m arket share          U s t U s t . ( 1 ). 0 i i j i                   r r r c r c p p x L S a L S a t t s ( 1 ). . . ( , ) . ( , ) 2 . . 0 j i i i j j i         r r r c r c p p L S a L S a . ( , ) . ( , ) 1         j i  i i j j s x ( 1 ). .         i i t t t t 2 2 2 2 . 2 2 .       zero when in equilibrium 16

Retailer s expected m argin Retailer’s expected m argin                r r c M p H c x L a 1 .( ) ( 0 ) . . . ( , ) i i S i i Revenue Cost of store credit Cost of credit card net of product cost. transactions transactions (if x=0 ) where where                      c c c a H f m c H c ( , ) : ( 1 ). 1 . 1 ( 0 ) . i i i S S Cost of credit card transactions 17

18 Retailers’ profits Retailers profits i M M s . i s    i

Equilibrium prices under price differentiation              1                r p p t t H H c c x x H H c c ( ( 0 0 ) ) . . 1 1 ( ( 0 0 ) ) . .  S S   1 Use the credit card Use store credit when instead of cash. instead of cash there is no cardholders. Subsidy to credit card users    c r p p m c S retailers avoided cost  c c 19

Rochet&W right s single price Rochet&W right’s single price         1           p t H c x H H f c x H f m ( 0 ) . . ( 0 ) ( ) . . 1 ( ) . . S S     1 1 Use store credit if Abandon the store credit Use credit cards there is not cardholders. to use the credit card. 20

Cross subsidies under price differentiation under price differentiation 21