Frontline’s The Card Game

I wrote a quick review at The Atlantic Business of Frontline’s “The Card Game”, available for viewing online at this page.

If you’ve followed the debate closely, it’s probably a narrative you’ve heard before. What surprised me is how explicit CEOs of credit card companies were in stating things about the relationship between poor and rich borrowers. Former Providian CEO Shailesh Mehta, and pioneer of the new credit card marketing techniques, says directly that the most affluent consumers pay the least, while the poorest pay the most. It’s not exactly the same as when a risk quant reader of Felix’s said: “The industry is just a giant wealth transfer mechanism from poor people to wealthly people. The profits from below (subprime) serve to subsidize the interest rate and rewards cost of people in the ‘super prime’ category”, or some of the emails I got after I went digging into what is going on with credit card interest rates. But it also points in the same direction.

The review is titled “How Credit Cards Rob the Poor to Spoil the Rich” and the comments are worth reading. They include my new favorite comment ever: “Seems more a transfer from the ignorant and foolish to the informed and prudent – certainly something I feel should be incouraged [sic].” Indeed. As you can imagine, several readers thought this was grossly inaccurate. Well, Shailesh Mehta said it, not me, and that dude knows a hella ton more than me about hidden fees, so take it up with him. From supplemental pbs material:

Mehta: Now, if somebody pays their monthly bill in full, and zero interest income, and if you don’t charge annual fee, zero fee income. So you have to make up everything from the merchant side, which you cannot. So what banks ended up doing is therefore they were subsidizing this whole group, because still two-thirds of the people were not making full payment. And that interest income covered the losses of the people who were paying in full.

So overall, the business looked profitable. But … in a strange way, the banks were charging borrowers higher interest rates in order to give the wealthy people a break — in a strange way, if you look at it, because the people who have money were paying in full, and they were getting the break at the expense of the people who couldn’t pay in full.

PBS: So it was sort of an unintended transfer of wealth.

Mehta: It’s unintended, exactly. I don’t think anybody thought through that. But correct.

I see the transfer in two dimensions. First: Picture 100 consumers, and it costs a firm $1 to give them each a credit card. Now instead of charging $1 to each person, you give the card to everyone ‘free’, but charge 10 people $10 at random. That’s the movement that is made here. If you speak micro, there’s some fantastic theory work being done on why, even in perfect markets, “It is also not possible to profitably lure either myopes or sophisticates to non-exploitative firms. We show that informational shrouding flourishes even in highly competitive markets, even in markets with costless advertising, and even when the shrouding generates allocational inefficiencies.”

Now all I’m pointing out is that the 10 people here aren’t entirely randomly chosen. Some are chosen because they aren’t as sophisticated as others. Some are chosen because they have health problems, or were in an accident, or have had a spell of unexpected chronic unemployment. But no matter what the story of how they are chosen, they tend to be chosen from the bottom end of the distribution.

The other dimension, less interesting from a distributional point of view but interesting in the dynamics between payment types, is that there tends to be only one price charged regardless of whether or not you use a credit card. If your card gives you some sort of reward that is paid for by the merchant, which the merchant has to take from you in increased prices, even if you would rather pay cash it’s a nash equilibrium for you to have to use your credit card. We looked at this back here:

Let’s assume that the interchange fee is 2% to the business. If I buy a $100 stereo from a store, they only make ~$98 if you pay with a credit card, but they make $100 if you pay with cash. Now if I pay with a credit card, I get about 1/3rd of that interchange fee in some sort of credit card payment reward. Frequent flyer miles, an inflatable grill, whatever. Let’s say that I end up with a $1 if I use my credit card in this case.

Now I have to decide whether or not to use my credit card, and the business has to decide whether or not to charge $100 or $102, the $102 reflecting a break-even from a customer using their credit card. The stereo costs the business $100 and is worth $100 to me. What’s the payouts?

…This isn’t an academic exercise. A small business I was at had a sign noting that they get charged over 2% every time a customer used a credit card, so why don’t you pay cash or with a check? But as I was about to pay cash, I wondered: “Don’t the prices already reflect that I will use a credit card? I might as well get points towards my plane ticket or whatever comes with the card.”

Note that if you don’t have access to a credit card, you pay that price regardless.

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4 Responses to Frontline’s The Card Game

  1. Armin says:

    I really liked your analysis. The way it looks, there is no rational way to avoid credit or debit cards(the price paid stays the same even when paying cash). This differs a lot from the situation back in the late ´30s or even the 60´s, where all or at least a considerable proportion of people received their salary in cash. Effectively providing a free of charge payment sytem of going about normal life for consumers and small businesses.
    Since then transactions have moved increasingly in the direction of electronic transfers(i.e. credit- and debitcards, etc.). As you detailed in your post, there are strong disincentives to paying in cash. Effectively most people are bound to using creidt or debit cards.(The same holds true for many small businesses).
    In effect all surcharges on and cards are equivaltént to a sales tax. The revenues don´t go towards the federal budget, but in terms of the effect on conusmers and small businesses it is equivalent to a tax increase. Under the Roman Empire, Xing-Dynasty China and medival Europe this was called “tax farming” and executed by “Publicani”(, people who had bought the right to tax.
    Apart from the obvious questions in terms of fairness(excess Usury), the questions of democratic legimitation(“taxation without representation”), which I do not want to get into.
    The key question remains: If a mayority of US citizens use credit/debit cards, for most transactions the effect of an increase in fees will be equivalent to the imposition/increase of a federal value added/sales tax, and hereby has serious implications in terms of outcomes considering fiscal policy. (In effect it amounts to a Hoover-adminstration style tightening, administered by the financial sector). To argue that “taxes” are effectively,currently being reduced whilst unavoidable(banking) fees multiply seems more than cynical.

  2. Jon says:

    An interesting and well reasoned (as always) argument, but missing a key ingredient of the operational mix which, I suspect, is a product of your never having actually run a business. In my experience as a business owner (service retail, low pricepoint, repeat customers), the true benefit of credit cards, and the reason I tried like hell to get my clientele to be 100% card and 0% cash, was operational. Simply put, there are large costs (both explicit and implicit) to accepting cash for payment. Explicit costs are “slippage” and processing time (both at the till and in the back office during shiftly accounting). Implicit costs are those opportunities for business improvement which are lost when the owner has to spend time verifying cash counts, and, believe me, those costs are real. When you have only two or three hours to dream up new ideas, research them, plan out implementation and then convince staff to change their habits, you really resent spending the hours counting money. It’s dead time stolen by revenue that you’ve already collected and it means reducing the total of new revenue you’ll generate in the future. My estimate of slippage and managerial/ownership time for cash counting was in the neighborhood of 4-6% of revenues (just costing out management/owner time on an hourly basis, not making assumptions for lost income–the numbers got so big when I tried that I got depressed)–at that level, the 2.25% I was paying to Visa/MC was a no-brainer.

    Admittedly, the operational benefits shift as you move up the food chain. Amazon probably doesn’t worry about slippage at the till, but I can almost guarantee that they’d hate a world with 50-50 mix of cash and credit and would pay more than they do now to the credit card companies to prevent that from happening. A cash/check model could work for them, obviously, since the Sears catalog provided rural folk with more than corn cob substitutes for several generations, but I have to believe that the velocity of the transactions would drop precipitously (and hence retailer revenues and thus, assuming positive margins, profits).


  3. altereggo says:

    Really? I get 2% no-limit cash back on my card, so I’d be indifferent to the top-left and bottom-right outcomes if credit cards weren’t so convenient.

    The retailer also doesn’t have to deal with as much cash, which is a big advantage, especially with the potential for employee till-skimming.

  4. Pingback: Interchange, 1: GMU Conference, Debit or Credit? « Rortybomb

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