Visa and those Fees, I: Market Malfunction

You really need to read this article about Visa and fees. Ever read something and think “I should have tried writing that”? That’s how I feel. Interchange fees are a bit of a topic I love writing about here, and it’s great to see a well-researched and written New York Times article on the topic. Do read it.

Kevin Drum, Felix Salmon and Yves Smith have more.

I’m going to write some additional points for this article in the next entry, but first I do want to focus on Tyler’s Cowen’s response (my numbered points):

[1] As Natasha forced me to internalize years ago, when I use my Visa credit card, and sign for payment, I receive frequent flyer miles. When I use my Visa BB&T debit card (yes, my two main payment cards are both Visa), I don’t get anything back. By using the credit card, resources are redistributed away from the store and to both Visa and me. On net that’s a better deal for me and that’s why I end up signing so often. [2] This could be efficient too, in a constrained second best sense. For one thing, it indicates the supermarket was earning ex ante monopoly profit; is it so tragic for some of that profit to be split by Visa and me? One way to understand Visa is that it is supplying countervailing power by “organizing” consumers against the retail monopoly and distributing the gains from the new bilateral monopoly arrangement.

For [1] it’s worth noting that this behavior is still optimal even if his frequent flyer miles are a net loss to him because prices are higher than what he is recouping; otherwise he’s taking an even bigger loss and subsidizing everyone else, a dynamic we saw in this diagram about interchange fees with credit card transactions:

The [2] argument would need more. As Yves points out, this is more like a Tobin Tax on retail businesses, rather than evidence of monopoly profits. The government charges a corporate tax; is the fact that corporations pay it evidence of a monopolist profit?

I do like this from Cowen:

Addendum: When issues of this sort arise, there is a common pattern in blogospheric discussion: Blogger A criticizes a market practice with tones of absolute condemnation. Blogger C (in this case, me!) responds with a plausible scenario, and a microeconomics-consistent first-order explanation, that things aren’t so bad after all. Blogger D tries to defend Blogger A by shifting the burden of proof to Blogger C to demonstrate that markets are efficient in such a case and by leveling charges of market fundamentalism and by citing some second or third best arguments that the market can fail after all. Don’t be fooled by that polemic slide in emphasis; the burden of proof is on the critics here — those asserting the existence of an evil and asking us to move beyond a loose agnosticism — not on me.

Heh. I’ll take the bait, and give you the very best of the arguments that markets can easily fail here – but we’ll need to leave Economics 101 and go to Economics 302 – Network Theory and Two-Sided Market Microstructure. It sounds complicated, but it’s interesting with an easy example. More under the fold.

Blogger D, standing by!

If you are reading this then you probably already know the perfect example of what a two-sided market looks like – pdf files. You know pdf files, right? You have read them on your desktop or in a webbrowser through the adobe reader, and perhaps you’ve even created one through a version of an adobe pdf file creator. True story: when adobe first tried its product, it charged for both; it tried to recoup half the cost through the reader, and half the cost through the file creator, and it was a disaster. Nobody was willing to pay to read a file nobody would be producing, and nobody was willing to pay to produce a file nobody would necessarily be reading. As opposed to most markets, the markets of oranges and pizzas of Economics 101, two types of people needed to simultaneously move into this third party’s product for any pricing structure to work.

Someone smart at adobe realized the best way to win this market, and you now know what it is: give it away free to one side, and charge the full price to the other side. So you can get the adobe reader for free (click here!), however if you want to produce a pdf document you have to pay.

Two-sided markets have network effects (they are often called two-sided networks); increasing scale to one side creates increasing scale to the other side. Think video games looking at it from the point of view of the console, your xbox or your playstation: the more games for a console, the more players will buy the console; the more players buy the console, the more profitable it is to make games for the console. Here’s a wikipedia article on this, here’s an excellent paper by Rochet and Tirole.

(stay on target)

So the credit card industry has a similar dynamic and solution to the adobe problem above. It charges the retailer the full price of the transaction and “gives away” the transaction part of the card. This encourages more people to cluster around, say, Visa, which then creates an incentive for more businesses to carry the card, which encourages more people to cluster around a card….

Now don’t believe economists when they say they have a perfect handle on efficiency in so-called “corner solutions” like these that show up in real life markets. They have ideas, but we are far away from the Economics 101. This is a situation where the platform user can pick one side and squeeze it. Now if Adobe got out of line with the price it charges to produce pdfs, demanding too much money, it’s somewhat easy to see the internet moving to a new reading format. It’s easy to download stuff, and reconvert texts. Adobe knows competitors are out there looking to grab its market share, and that keeps it disciplined.

It’s much harder to see this happening for credit cards, where there are massive scale costs in the technology, and, much, much more important and a thing that doubles down the network problems, another agent that needs to cooperate on the platform end of the transaction – the banks. The banks have these fees negotiated up through competition, and these fees disperse into the real economy.

There’s a lot of two-sided markets out there. The problem with the credit card industry is that if there is price squeezing going on, it is at the expense of, and the scale at, the entire real economy. And the people teamed with them on this, the people profiting and using their scale to negotiate these fees up, are our largest banks using their political influence and scale. More on this in the next entry.

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10 Responses to Visa and those Fees, I: Market Malfunction

  1. pushmedia1 says:

    I wonder about “It’s much harder to see this happening for credit cards”. Wasn’t American Express ubiquitous before Visa and didn’t Discover nudge its way into the market.

  2. K. Williams says:

    Yeah, pushmedia’s right: there isn’t one player in this market, the way there is for PDFs. That is, there isn’t a single “platform user.” You have MasterCard, Amex, Discover, not to mention debit cards and good old cash, all of which are perfectly acceptable — and easy to use — alternatives to credit cards. You need to explain how Visa attained its supposed “monopoly” and how it maintains it in the face of competition — and how that attainment and maintenance are anti-competitive — in order to make a convincing case here. Simple hand-waving about network effects won’t do it.

  3. skeptic says:

    I may be wrong, but I do not recall that Acrobat Reader (now known as Adobe Reader) was ever anything but free, and I have been making and using PDF files since about 1996.

    In response to K. Williams, there is not “one player” in the market for PDF creation software, and Adobe has always published the PDF file format specification specifically so that would not be so. There is in fact, and has been for a long time, alternatives to Adobe’s products for creating PDF files, some of which (ghostscript) has always been free.

  4. Porkins says:

    You do know that Porkins crashed and burned, right?

  5. Sam says:

    skeptic: According to Wikipedia, Acrobat Reader ( was originally priced at $50 a copy. The IRS licensed Reader for unlimited distribution and then anyone could get a free copy. I’d guess this is when Adobe realized that giving away the reader was actually a good idea.

  6. skeptic says:

    Sam: I stand corrected re: Acrobat Reader. Thanks.

  7. Linus says:

    See how things change in other economies, in my case – India when cash was King and the preferred means of paying. In 1988, while shopping for our wedding, my father-in-law-to-be played (what he thought was) a neat trick on shopkeepers. After the mandatory bargaining and finalizing the purchase, he would flash out his credit card to pay; the cashier would be (obviously) disappointed because this meant no cash for at least a week (and also it meant that Sales Tax HAD to be given to the government :() My FILTB would then ask for a 3% discount and offer to pay by cash and the retailer would gladly oblige. And as they say here – Retailer bhi khush, FILTB bhi khush (Retailer happy, FILTB happy).

  8. Mike says:

    Pushmedia and K:

    There’s a lot of ways to think of concentration, but on most metrics, both cards and volume of transactions, visa is about half the market, master card about 25-30%, everyone else 25-20%.

    If that was the market for pizza, it would send your Herfindahl index and other IO tools into the red zone. But double that with this network effect, and then we have serious issues.

    Next is that the banks are also highly concentrated, and there’s a platform negotiation there, where you get the perverse situation that these fees are negotiated UP by market forces, instead of down.

    2008 worldwide purchase volume by card type:
    Visa credit – 31.7 percent
    Visa debit – 28.6 percent
    MC credit – 22.0 percent
    Amex credit – 10.0 percent
    MC debit – 6.3 percent
    JCB credit – 0.9 percent
    Diners credit 0.4 percent
    (Source: Nilson Report, May 2009)

    Porkins, watch out behind you! They come from behind!! (I know, wrong guy. Still good advice.)

  9. Pingback: An Interview About Interchange Fees with The Credit Card Con « Rortybomb

  10. Ron Stone says:

    My belief may go against the maintream view but I believe that credit card usage is going to drop consistently over the coming years in favor of debit cards and dare I say it, Cash. This will occur due to 1) More and more people’s credit is used up or dried up due to the current recession and the hit to people’s credit, 2) Growing fears of identity and other financial thefts and 3) Many people going back to basics in their lives. Debit cards will pick up some of this to maybe stay flat to a slight increase. Time will tell if I’m right.

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