Richard Epstein headshot

Laurence A. Tisch Professor of Law
NYU School of Law

Richard A. Epstein, the Peter and Kirsten Bedford Senior Fellow at the Hoover Institution, is the Laurence A. Tisch Professor of Law, New York University Law School, and a senior lecturer at the University of Chicago.

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Why Now? The Faulty Economics of Credit Card Reform

Richard A. Epstein is the James Parker Hall Distinguished Service Professor of Law at the University of Chicago, the Peter and Kirstin Bedford Senior Fellow at the Hoover Institution, and a visiting professor at New York University Law School.

About four years ago, I worked for Visa in opposing the opposed limitations on interchange fees that the Australian government was about to impose on the credit card industry. The situation there, like the situation in the United States, seemed hardly propitious for reform.  The use of credit cards was rapidly expanding, and the rate of interest was being brought down by competition, the number of cards in circulation had increased.  What is there not to like?

The fear of monopoly apparently.  Everyone knows that the credit card industry is highly concentrated.  That point in and of itself is not necessarily a bad thing.  The credit cards only work in what is called two-sided markets.  Consumers are prepared to sign up for credit cards only if they are aware that merchants will be prepared to accept them.  Merchants will be prepared to accept these cards only if consumers are prepared to use them.  The huge number of players on each side of the market cry out for the use of an intermediary to forge the connections.  The fewer the intermediate parties, the easier it is to organize the grid.  That task does not come without cost, and that cost in turn is incurred by the credit card companies that invest in the large infrastructure that keeps the entire system humming.

Breaking up these companies has real efficiency losses, so naturally the thought of the aspiring regulator is to turn to price controls as the next best solution. Someone of course has to pay companies to cover that expense, and to make a profit as well, but who should bear that burden? The great siren of all service users is to insist that they be charged at marginal cost.  After all, once costs are raised above marginal cost, some consumer who could have used the service will be excluded, which counts, after a fashion, as a type of inefficiency.   Needless to say, marginal cost pricing is a game that all users of inputs would like to play.  But it is not a game at which all can succeed.  Let the merchants on the one side, and the cardholders on the other, pay marginal cost, and no one is left to pick up the fixed costs of running the entire system.

Those costs amount to a tidy sum that someone has to pick up if the network is to remain viable. But which side and in which proportions?  The usual response is to see which side is more inelastic in the demand, on the simple (but nasty) ground that it has fewer options to escape the costs in question.  One nice consequence of this strategy is that the network will tend to shrink less on one side, which offers an added inducement to remain on the other side.

But, comes the response, just how much over marginal cost should the credit card companies be able to charge in a two-sided market.  Coming up with a precise answer to that question offers enormous descriptive and normative challenges.  And so the question is whether this game is worth the candle.  The Australian experience is not all that reassuring, as the shifts away from merchants imposed higher costs of card users which tended to thin their ranks, without any clear evidence that the merchants did their part by passing on the reduced interchange fees to their customers.

It is therefore no surprise that the title of the GAO’s report is not exactly a clarion call to action:  “Rising Interchange Fees Have Increased Costs for Merchants, But Options For Reducing Fees Pose Problems.”  My believe is that the title was chosen by the editors of the Onion. The first part of this title is of course a necessary truth, but it tells us nothing as to whether the increased fees help or hurt the  overall operation of the credit card system.  The words after the “but” remind us that there no evidence that two simple risks of price controls won’t go away.  The first of these is that the cuts are too deep so that the system will experience a financial shock from which it cannot recover. Lawyers might think that this could even raise the question of whether the rate reductions are confiscatory.  The second risk is a bit less ominous.  The increases of the costs to customers reduce the number of potential customers while making the service less attractive to those who remain.

Needless to say the GAO report gives no assurance that the interchange fee cure is not worse than the disease.  So why wade into such muddy waters?   With the real estate mortgage market under siege, this is hardly the time to open a second front in the credit card wars.  The administrative costs and political risks of initiative are not worth the candle.

Posted in antitrust, credit cards, economics, financial regulation, interchange and credit cards symposium, law and economics, markets