Thank you very much. I thank the committee for inviting me here today. I should tell you, and I'm sure it exists with my colleagues, that professors are used to speaking in fifty-minute segments, not five. So it's going to be a little difficult.
I have a paper that should be handed out. The things I leave out are in the paper. It's not a long paper. And I should also tell you that my research has primarily been financed by Visa.
Let me get to it, given the time I have. The key feature of the credit card system is that it's a two-sided market, and a two-sided market is somewhat different from the markets economists generally deal with. A two-sided market is a market where there's an interrelationship between the two sides, and in the credit card business the two sides are the merchants and the cardholders. You can't run the system without cardholders. You can't run the system without merchants. The more cardholders there are, the better it is for merchants. The more merchants there are, the better it is for cardholders. It's like a network and there are these interdependents on both sides.
Cardholder demand for system services depends on other things: the level of cardholder fees, the value the cardholder places on the convenience of using the cards over other means of payments, and the number and quality of merchants participating in the system. Essentially merchants' demand is very similar. They depend on merchants' fees, the efficiency of accepting cards over other means of payments, and on the number and quality of cardholders.
The point I want to emphasize from the beginning is that this two-sided nature of the market makes the economics somewhat different from what it normally is.
There are three important points about the payment system. First, it's important to remember that the issuing and acquiring identities are through the payment system organization jointly engaged in the production and supply of services. It's joint production. Second, it's important to understand the two-sided nature of this market.
Evans and Schmalensee give a real-world example. In Asia, particularly, there are dating clubs, and in dating clubs men and women can go and meet one another and see if they are suiting each other's needs. It seems to be that men value these clubs more than women, and what generally happens in these clubs.... It's just as costly for the owner of the club to service the women and the men in the club, and to bring them in, but it's generally the case that women are not charged; they're even given free drinks sometimes, and men pay all the costs. Seems fair. And it's done to operate an efficient system. It's done because men won't come if there are no women. Women won't come if there are no men. You have to balance the system, and the way you balance the system is through an interchange fee. You have men pay this fee, not related at all to cost.
The third economically important feature of two-sided markets is that both sides of the market benefit from the growth and demand of the other side. Recently there have been challenges to four-party systems, particularly in Australia and a number of other countries, and in this country too. There are two important points to understand. First, people who criticize the system argue that merchants should not be required to cover any of the costs borne by the issuers who are providing the services to cardholders, since retailers argue they don't receive any benefits from them. It's claimed that a collectively set interchange fee imposes such costs on merchants. Accordingly, retailers urge that the interchange fee should be calculated on the basis of an objective cost standard, which excludes costs not related to payment networks. Second, it's argued that rules such as honour all card rules and no surcharge rules effectively force retailers to accept Visa and MasterCard.
I'm going to argue that there are flaws in these arguments, and particularly I argue there are about five flaws.
The first flaw is that merchants do receive benefits from payment card systems. They get increased sales and increased convenience. Increased merchant sales rise because when people use credit cards to make purchases, and larger purchases, they bring in new types of purchases, and you get increased sales because there are lower transaction costs. When I go and fill up my car with gas, they don't need as many employees because I pay myself. I put my card into the machine. If everybody paid cash, you would have huge lineups. Also, the merchants don't have to hold cash balances, which generally are costly.
The second flaw is there's no economic justification for cost-based regulation. You don't want to just look at cost. Cost is one factor, but it's not the only factor. It's a more complex system, and by limiting the justification of interchange fees only to cost, the argument fails to account for the respective benefits that merchants and cardholders derive from interchange fees.
The third flaw is that retailers are not forced to accept credit cards as payment methods. They do so because there are benefits. It's less costly for them to use it, when you measure all costs. And merchants can refuse to accept them. There's a large number that do. Costco, a huge merchant, doesn't accept MasterCard and doesn't accept Visa. My wife and I both love Costco.
Four, there's another flaw. There is no subsidization of credit card users by cash users. There's this argument that people who use cash are subsidizing credit card users. Yes, there is a no-surcharge rule, but there's no rule prohibiting merchants from giving a discount for cash. There's no difference, from an economic point of view, between surcharging for credit cards or discounting for cash. Merchants do discount for cash, but it's very rare. A lot of times, I would argue, they do discount for cash in order to avoid paying all sorts of taxes. Cash is a method to get around paying taxes.
Flaw number five is that there's no rational economic basis to distinguish between three- and four-party systems. There's no difference to distinguish between the Amex system and Visa and MasterCard.
Let me conclude with the lessons from Australia, and let me read you a quote from a study by Robert Stillman et al. They concluded that:
Regulations should only be employed if there is clear evidence of a market failure and only if there is reason to believe that regulation is likely to benefit consumers.
The RBA's regulations have clearly harmed consumers in Australia by causing higher cardholder fees and less valuable reward programs and by reducing the incentives of issuers of four-party cards to invest and innovate. At the same time, there is no evidence that these losses to consumers have been offset by reduction in retail prices or improvements in the quality of retail service.
The empirical evidence does not support the view that consumers have derived any net benefits from the intervention. Generally, economists think of regulating an industry where there's some monopoly power and there's too little output produced and too high a price is charged. Regulation in Australia and regulating interchange fees causes a reduction in output and a higher price to consumers—it goes against what economists generally believe are the necessary conditions for regulation.
Let me conclude. Before analyzing two-sided markets such as the payment system industry, it's critically important to understand the unique economic considerations that drive this efficiency and its competitiveness. Foremost among these is the interdependence of demand among the acquiring and issuing sides. One must consider the cost and benefits provided to both sides of the market rather than focusing on one aspect of the market in isolation.
Thank you very much.