Consumer Payment Industry Analysis

Visa and Master Card

Ramberto Jr. Sosa Cueto

Submitted in Partial Fulfilment

Of the Course Requirements

For Applied Microeconomic Theory

ECO 507

Master of Arts in Applied Economics

Spring 2016

0
Table of Contents

Introduction ............................................................................................................. 2

Literature Review ................................................................................................... 3

Defining the Market ................................................................................................ 5

Competition ............................................................................................................. 8

Pricing .................................................................................................................... 10

Oligopoly ................................................................................................................ 11

Profit....................................................................................................................... 14

Conclusion ............................................................................................................. 15

Bibliography .......................................................................................................... 17

Appendix I ............................................................................................................. 19

Appendix II ............................................................................................................ 21

Appendix III .......................................................................................................... 23

1
Introduction
The main focus of the paper is to understand consumer payment industry. In order to, the

research focuses mainly on the following aspects: the market participants, competition, price,

profit, and oligopoly. Accordingly, the theoretical framework used in this work utilizes both the

heterodox theory and neoclassical theory. As I prefer to use the economic explanation that best fits

regardless of the line of thought. However, what I consider objective other may consider

subjective, given the nature of the social sciences.

For a start, the consumer payment industry consists of card network (Visa, MasterCard,

American Express, Discover, etc.) that facilitate transactions between merchants and consumers,

using a complex mechanism. Particularly, what makes payment networks, confusing is the two-

sided market structure. Armstrong (forthcoming) calls them markets or institutions involving

two or more groups of participants who interact via intermediaries (Rysman 6). Payment

networks are two-sided because they provide services to both the issuer (banks that issue payment

cards) and the merchant, the one accepting the method of payment (Hesse and Soven 711).

Moreover, why is the consumer payment industry relevant? Overall, the consumer payment

market worldwide has more than doubled in the last decade, to reach US$47 trillion in payment

volume in 2014 (Euro monitor international). Further, U.S. region cards carrying Visa,

MasterCard, American express, and Discover brands generated $4.442 trillion in spending at

merchants in 2014, up 8.9% over 2013 (Nilson Report).

Nonetheless, its interesting to see how card networks may affect consumer prices and

merchants profits. And the economic conditions that contribute to the card networks growth. Not

to mention, the ups and down in adopting the method of payment, who are the winners and losers

in the industry.

2
Literature Review
The main issue under consideration is the consumer payment industry. Much of the

literature mentioned in this paper takes a space to explain the dynamics of the industry. In view of,

the studies focus on cooperation among competitors (oligopoly model), pricing, market

participants (merchants, consumers, banks and card networks), and in less extent substitute

products and entry barriers in the industry. The purpose of this review is to analyze what others

have written on the subject and use it to elaborate this work. Under those circumstances, this paper

analyzes the following investigations cited below:

To begin with, Rochet and Tirole (Cooperation Among Competitors), they explain the Visa

and Master Card not-for-profit joint ventures. This joint venture consists, in a set of rules designed

to govern the interconnection between their members. The key component in this market control

is the interchange fee, Fees paid by the acquirer to the issuer to compensate for transaction-related

costs. Visa and MasterCard establish interchange fee rates (First Data, Payments Industry

Glossary). In other words, there is a form of collusion controlling the industry or market power.

Further, Hesse and Soven (Defining Relevant Product in Electronic Payment Antitrust

Cases) address the Visa and MasterCard joint venture issue with an emphasis on antitrust

measures. It goes after the key components that reduce competition in the market. Specifically, it

uses the hypothetical monopolist test for analysis. In antitrust law, under the Horizontal Merger

Guidelines, the hypothetical monopolist test is used as a framework to determine if a relevant

product market is properly defined as a first step before it is determined whether a company has

monopoly power in that market violating antitrust law (Ryan 55).

3
 Other papers, such as An Empirical Analysis of Payment Card Usage (Hesse and Soven

73) approaches the consumer payment industry analysis from the card usage perspective. That is,

the interaction of consumer usage and merchant acceptance of payment cards, as a result of card

networks. It explains the incentives that consumers and merchants receive to sign up with networks

(Visa, MasterCard, American Express, Discover, etc.) and how it leads to major network growth.

Overall, the paper explains that consumer choice of a network is positively correlated with the

amount of local merchant acceptance of that network.

In addition, latest papers such as Competition Policy Issues in the Consumer Payments

Industry (Economides) and Pricing Payment Cards (Bedre-Defolie and Calvano), they focus

on competition and pricing. Economides states that intermediation fees impose by card

associations (Visa and MasterCard) are considerably higher than cost. At the same time, This is

facilitated by rules imposed by the card networks on the merchants that do not allow merchants to

steer competition to cards that have lower fees (Economides). In other words, there is market

dominance and control. On the other hand, Bedre-Defolie and Calvano discuss the inefficient price

structure imposed by networks. Due to, over subsidizing car usage and overtaxing merchants. In

the model, consumers make two decisions (membership and usage), while merchants make only

one (membership) (Pricing Payment Cards).

In summary, most of the available literature agree to similar points. Such as, the definition

of the market and how it works, the collusion on the market, market dominance, pricing, barriers,

etc. The contributions from a paper to another do not diverge much from these lines. Even though

they might use a different approach, the conclusions converge to the same point. I hope to

contribute to further understanding of the payment consumer industry by approaching the issue

from heterodox and neoclassical theory.

4
Defining the Market
The four major purchase transactions worldwide in the consumer payment industry are

done by Visa, MasterCard, UnionPay, and Amex. In 2014, together Visa and MasterCard

represented about 84% of the market share worldwide (Visa with about 58% and MasterCard about

26% of the market share) (see appendix I). Notably, Visa and MasterCard are set up as

cooperatives of banks. Many authors refer to the association as a collusion. According to

mainstream economics, when firms instead of competing decide to collude, they may jointly agree

to set prices and maximizes the sum of their profit (Varian 498). On other words, monopolistic

market power.

For instance, the Visa and Card association have member banks, the issuing banks and

the acquirer banks (see top member banks in U.S., appendix II). The acquirer banks deal with

the merchants payment method, and intermediate transactions for issuer banks, who issue cards

to consumers. In fact, every exchange between a consumer and a merchant handled through Visa

or MasterCard is intermediated by both the acquiring and the issuing bank. When the acquirer

bank is the same as the issuer bank the transaction is a three party. Otherwise, the transaction is a

four party. In other words, it is a two-sided market. (Economides 5)

5
Source: Bedre-Defolie, zlem, and Emilio Calvano. Pricing Payment Cards American Economic Journal:
Microeconomics 5.3 (2013): 206231. Web. 22 Mar. 2016.


To illustrate, In any given exchange, a good or service goes from merchant to a consumer.

The price the consumer pays is transferred to the acquiring bank and then to the merchant. The

merchant pays a merchant discount to the acquiring bank and the acquiring bank pays an

interchange fee to the issuing bank. The card association (Visa and MasterCard) serve as a

clearinghouse for each of these transactions and extract a small transaction fee from both sides

(Issuing and acquiring bank). The card associations set the interchange fee, the others card business

enterprises rarely deviate from set interchange fee. Member banks set the terms they charge to

consumers and the merchant discount, as well as a contract for the extra benefit such as reward

programs. (Rysman 4)

Due to, the four party network. Three markets can be identified. First, the market between

the merchant and the acquirer; second, the market between the issuer and consumer; and last, the

market between the issuer and the acquirers (Economides 5). Business enterprises such as Visa

and MasterCard made their profit from the market between the issuer and the acquirers, through

the interchange fee set by the card association. The interchange is a fee paid by the acquirer to the

issuer to compensate for transaction-related costs (FirstData).

However, why there is even a market for the transactions between a consumer and a

merchant? What are the incentives? Overall, the incentive is subject to Card usage and Card

membership.

the Consumers tradeoff in part is the easy access to cash. Foregoing the costs of

windrowing, converting currency cash. And of course, it may also allow the consumer to sacrifice

future consumption in order to increase present consumption. Likewise, the seller basic tradeoff in

accepting a payment card is that acceptance may attract more consumers. Even more, the benefits

6
from lower cash holding, faster payment, easy accounting, saved trips to the bank. All these

characteristics fall under card usage and both merchant and consumer pay a fee in exchange for

the service. (Hesse and Soven 553) (Bedre-Defolie and Calvano 211)

Further, the rest of the incentives are subject to card membership. Upon joining the card

network, buyers and sellers pay transaction insensitive (fixed) fees to their banks and receive fixed

benefits. For instance, cardholders enjoy the security of not carrying large amounts of cash,

membership privileges, travel insurance, ATM services (such as account balance sheets, money

transfers, etc.), social prestige (club effects); and merchants benefit from safe transactions.

(Bedre-Defolie and Calvano 211).

Further, aside from the incentives just mention. More consumers using a particular

network should lead more retailers to accept the network, making the network more valuable

(Rysman 7). Similarly, it is possible the correlation is both ways. As the number of merchants

utilizing a paying method increases, equally, consumers utilizing the method of payment increases.

7
Competition
For instance, the market analysis in the consumer payment industry is subject to two

assumptions. In the first place, issuers bank has market power and acquirers bank are competitive.

The acquiring banks market does not have much product differentiations, additionally, the search

costs are low. Conversely, the issuing side is considered as an exhibiting market. For the reason

that, it has search costs, reputation involves, innovation, etc. Additionally, the interchange fee pay

to issuers by acquirer banks is fixed by the card association and is not subject to competition. Later,

the interchange fee is discussed. (Rochet and Tirole 552)

The mainstream economics consider perfect competition the norm and the most desirable

state of the economy. Otherwise, the market is inefficient. As mention above, one of the reasons

acquiring bank are competitive is the lack of production differentiation. the condition is directly

related to competition. The less differentiated a product is, the more willing the consumer is to

substitute a product for another given a rise in price (M, M, and Tarzijan 13). Put in another way,

it is a service relatively easy to substitute given its homogenous nature in the market. Further, the

low search cost allows until a certain point symmetric information. Whereas, asymmetric

information leads to market fails in the perfect competition theoretical framework.

On the other hand, the issuers bank has market power. The possible explanations include

search cost, which can be translated in asymmetric information. Further, firms may alter the

structure of a market undertaking conducts, such as research and development, advertising,

innovation and product differentiation The innovation, in theory, allows greater product

differentiation, increasing product heterogeneity. (M, M, and Tarzijan 67)

Furthermore, observing the relation of the issuer bank and acquirer bank (card association

members). In fact, member banks cooperate to set the interchange but compete to set the terms

8
received by consumers and merchants. The cooperative determination of the interchange fee has

been the subject of the antitrust scrutiny, with the card association arguing that the importance of

the consumer and merchant interaction creates a two-sided market in which the interchange fee is

an important instrument for achieving the efficient level of pricing to pricing to both sides.

(Rysman. 4)

The networks (such as Visa and MasterCard) use a strategy to achieve an equilibrium with

less competition. For a start, it must be ensuring that a card holder does not face directly the cost

of using a particular card payment. This may be subject to two conditions: first, the consumer do

not pay more to the issuer bank for using a card that has higher costs; and second, the consumer

do not pay more to the merchant for using a card that has higher costs. (Economides 9)

To illustrate, due to the two-sidedness of the network, the card holder does not need to

venture in transaction cost. However, the network collects the transaction cost from the merchant,

even more, the network can subsidize the card holders (see scheme below). Second, by imposing

contractual obligations on the sellers, the sellers cannot charge different prices to reflect the

different card fees. The paper discusses how card associations achieve this control on later sections.

(Economides 9)

Source: Economides, Nicholas. Competition Policy Issues in the Consumer Payments Industry by Nicholas
Economides: SSRN. Social Science Research Network. 9 Nov. 2008. Web. 21 Mar. 2016.

Incidentally, the same situation is described by one of the Heterodox microeconomics

fundamental features. The control of the markets or industries by a small number of large

9
corporations (Visa and MasterCard in this discussion). It states that even if an industry is relatively

competitive, there exists an organization within an industry (in this case a card association) that

manages profits, price, quantity, etc. (Jo).

Pricing
An available mechanism for firms to incentive cooperation among them is the use of

contracts. Even though the pricing contracts are usually illegal, it is not a fantasy (M, M, and

Tarzijan 239). According to Kaleckis mark-up pricing, prices are determined by firms over the

production costs. In the same line, Eichner (Chapter 1), state that prices are determined by mega

corps in the oligopolistic pricing model. In the framework, the price is the function of the growth

rate of investment relative to the growth of internal funds (Jo).

With this in mind, we discuss pricing in the consumer payment industry. According to

Bedre-Defolie and Calvano (Pricing Payment Cards), there are four stages of pricing in the

industry. And he divides the timing as follows:

Stage 1: The payment card network sets the interchange fee. Specifically, Visa and MasterCard

cooperation explicitly set the fee. And others card networks do not deviate.

Stage 2: Observing the interchange fee, the issuer sets its card fees and each acquirer sets its

merchant fees. In other words, once the interchange fee is set, issuing banks and acquiring bank

set their fees subject to this fee. That being the case, card associations have the industry control.

10
Stage 3: Merchants and consumers decide, simultaneously, whether to accept and hold payment

card (membership) and which bank they will choose for the service. On other words, prices are

administered, and economic agents choose whether to take it or not. Theoretically, both economic

agents observe the membership benefits as well as the fees.

Stage 4: Merchants set retail prices. And consumers decide whether to pay by card or cash.

Further, as stated in stage 2, both issuer and acquirer bank intermediates between the

consumer and merchant. However, the decisions affecting pricing on one side of the market will

have repercussions on the other side of the market. To illustrate, assume the card association, the

issuer banks, or regulators decide to reduce the fees, in a manner, merchants pay less.

Consequently, the consumers fee increases or the incentives the issuers bank offer are reduced, in

order for the card network to keep the mark-up profit. (Economides 7)

Oligopoly
Do oligopolies tend to collude to fix the market, to fight each other, or to oscillate between

those extremes? New-Chicagoans say that fixing always fails, yet there are exceptions. Tight

oligopolies under some circumstances may share monopoly outcomes. Based on the literature

studied, it appears that Visa and MasterCard have successfully colluded through the Card

Association. The oligopoly neoclassical model more likely to explain this interdependence is the

Bertrand model. In the Bertrand model, the price is the only decision variable. The theory fit the

most since the interchange fee is set by both Visa and Master Card. (Shepherd and Shepherd

chapter 11)

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 Further, Visa and MasterCard, have designed a set of rules to control the market and

interconnection between the members (Rochet and Tirole 549-550). It can be resume in the three

following:

1) Interchange fee: the acquirer pays a jointly set interchange fee to the issuer.

2) Honor-all-cards rule: Affiliated merchants must accept any card of any issuing member.

3) No-surcharge rule: affiliated merchants are not allowed to impose surcharges on consumers

paying with a particular card.

Two of these rules are viewed with suspicion by the economists. On one side, the no-

surcharge rule might be an attempt by payment card system to leverage their market power by

forcing more card transactions than is efficient. Since the consumer is not subject to direct cost

when using a particular card regardless of the merchant fees. On the other side, the collective

determination of the interchange fee, instead of determining it competitively. (Rochet and Tirole

550)

To illustrated, the No-surcharge rule permits the merchant to charge the same amount for

a Visa transaction as for cash, but if a merchant offers a discount for cash compared to Visa, he

may not offer the equal deduction to a comparable card. On other words, what the merchant offer

for one card he most offers for all other cards. The no surcharge rule does not allow the merchant

to offer better term to the customers, even though, the fees to the merchant are different from one

card to another. Further, this means a merchant cannot discourage the use of a particular network.

(Economides 10-11)

Also, in order to avoid loss of profits in credit cards, the networks imposed an honor-all-

cards rule. That is that merchant cannot choose to have one service, the sole option is to have both

the credit and the debit service, issued by the bank in the card network (Economides 11). The

12
condition can be defined as a tied sale. The tied sales refer generically to situations where company

forces or induces the purchase of a set of goods or services (M, M, and Tarzijan 129).

In Sum, all three of the rules some way or another gives industry control to card networks

(Visa and MasterCard). As explain above, issuer and acquirer banks fee are subject to the

interchange fee. And the affiliated merchants are subject to the honor-all-cards rule and no-

surcharge rule. These rules permit card networks to generate a significant amount of profits and

overall control of the industry. Similar to that established by Eichner (Jo),"The firm 's output is

sold under conditions of recognized interdependence, the members of the industry engaging in

what has been termed ' joint profit maximization.

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Profit
Overall, according to heterodox economics, the purpose of the Business enterprise is to

survive, expand, and reproduce itself. In doing so it gains power over time. Consequently, the

business enterprise focus in generating cash flow, in contrast to profit maximization. The

heterodox economics, approach to the business enterprise its very different from mainstream

economics. Since it focuses on the firm as a group of individuals (corporation) and the mainstream

approach it as an optimizing individual. With this in mind, we analyze the Visa and Master Card

Profits.

According to Economides (Competition Policy Issues in the Consumer Payments

Industry), Credit card networks despite their market share, have a high price-to-cost markup. There

is evidence of revenues increasing in a larger proportion than total cost over time (see appendix

III). For instance, Visa and Master Card profits have increased over a 300% in the past decade.

Even though, their world market shares have been decreasing over the same period of time (see

appendix I).

14
 Visa vs MasterCard
$16,000 MasterCard, Net Revenue (in millions) Visa, Net Revenue (in millions)
$14,000
$12,000
$10,000
$8,000
$6,000
$4,000
$2,000
$-
2005 2007 2009 2011 2013 2015

Soure: Visa And Mastercard, Sec fillings

Economides propose a simple explanation, it is due to the market power of the card association

(Visa and MasterCard). The market power allows the business enterprise to set a price subject to

it mark-up profit and cost. Also, this market power is enhanced over time as profit increases. As a

result of further investment and R&D.

Conclusion
On the whole, the consumer payment industry is the two-sided market. It involves Issuer banks,

Acquirer banks, consumer, and merchants. Within the industry we identify three markets:

the issuer bank and acquirer bank market, control in some form by Visa and MasterCard

by imposing the interchange fee (card association). For the reason that, other card

networks rarely deviate from fee set up by the card association.

The issuer bank and consumer market, which is considered as an exhibiting market. In

other words, information is asymmetric. Consequently, leading to market power.

15
 The acquirer bank and merchant market, which have little product differentiation and low

search cost. Consequently, it should be competitive. But, in some way they are controlled

by the card association and the incentive to have available the payment method which the

buyer utilizes.

Further, the cards networks present a form of collusion, by cooperating in setting rules to

control the industry. As has been mentioned, the industry control relies on the following rules:

Interchange fee: the acquirer pays a jointly set interchange fee to the issuer.

Honor-all-cards rule: Affiliated merchants must accept any card of any issuing member.

No-surcharge rule: affiliated merchants are not allowed to impose surcharges on

consumers who pay with a card.

Through the following rules, the card networks in a way on another manage profit and price

(for all three markets). More importantly, it accomplishes controlling the identified markets

without affecting the price of the good the consumer faces. Ultimately, it is presumed that this

leads to over subsidizing car usage and overtaxing merchants.

In view of, the card networks profit has increased significantly in the current decade. On

the other hand, operation expenses have remained relatively low; and the world market share for

Visa and Master Card have decreased when to compare to a decade ago. However, as we discussed

previously the loss in market share is compensate with market control. Put in another way, by

jointly maximizing profit by setting up interchange fee and the set of rules.

16
Bibliography
Economides, Nicholas. Competition Policy Issues in the Consumer Payments Industry by
Nicholas Economides: SSRN. Social Science Research Network. 9 Nov. 2008. Web. 21 Mar.
2016.

FirstData. Payments Industry Glossary. FirstData. n.d. Web. 21 Mar. 2016.

TSYS. 2014 Consumer Payments Study. TSYS. 2014. Web. 21 Mar. 2016.

Hesse, Renata B, and Joshua H Soven. DEFINING RELEVANT PRODUCT MARKETS IN

ELECTRONIC PAYMENT NETWORK ANTITRUST CASES. Antitrust Law Journal 73.3
(2006): 709738. Web. 22 Mar. 2016.

Rochet, Jean-Charles, and Jean Tirole. Cooperation Among Competitors: Some Economics of
Payment Card Associations. The RAND Journal of Economics 33.4 (2002): 549570. Web. 22
Mar. 2016.

Rysman, Marc. An Empirical Analysis of Payment Card Usage. The Journal of Industrial
Economics 55.1 (2007): 136. Web. 22 Mar. 2016.

Bedre-Defolie, zlem, and Emilio Calvano. Pricing Payment Cards. American Economic
Journal: Microeconomics 5.3 (2013): 206231. Web. 22 Mar. 2016.

Varian, Hal R. Intermediate Microeconomics: A Modern Approach. 8th ed. New York: Norton,
W. W. & Company, 2009. Print.

M, Jorge Tarzijn, Ricardo Paredes M, and Jorge Tarzijan. Organizacin Industrial Para la
Estrategia Empresarial. 2nd ed. United States: Pearson Educatin, 2006. Print.

Shepherd, William G, and Joanna M Shepherd. The Economics of Industrial Organization. 5th ed.
United States: Waveland Press, 2004. Print.
In-line Citation:

Eichner, Alfred S. The Megacorp & Oligopoly: Micro Foundations of Macro Dynamics. United
Kingdom: Cambridge University Press, 1976. Print.
In-line Citation:

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The Nilson Nilson. The Nilson report archive of charts & graphs. 2016. Web. 22 Mar. 2016.

Euromonitor International. Consumer payments 2015: Trends, developments and prospects.

Euromonitor International, Mar. 2015. Web. 23 Mar. 2016.

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 Appendix I

Source: The Nilson Nilson. The Nilson report archive of charts & graphs. 2015. Web. 22 Mar.
2016.

19
Source: The Nilson Nilson. The Nilson report archive of charts & graphs. 2011. Web. 22 Mar.
2016.

20
 Appendix II

Source: The Nilson Nilson. The Nilson report archive of charts & graphs. 2015. Web. 22 Mar.
2016.

21
Source: The Nilson Nilson. The Nilson report archive of charts & graphs. 2015. Web. 22 Mar.
2016.

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 Appendix III

Visa
Net Revenue vs Operating Expenses
$16,000
Visa, Net Revenue (in millions) Operating expenses
$14,000
$12,000
$10,000
$8,000
$6,000
$4,000
$2,000
$-
2005 2007 2009 2011 2013 2015

Soure: Visa And Mastercard, Sec fillings

MasterCard
Net Revenue vs Operating Expenses
$12,000
MasterCard, Net Revenue (in millions) Operating Expenses
$10,000

$8,000

$6,000

$4,000

$2,000

$-
2005 2007 2009 2011 2013 2015

Soure: Visa And Mastercard, Sec fillings

23
 Visa vs MasterCard
$16,000
MasterCard, Net Revenue (in millions) Visa, Net Revenue (in millions)
$14,000
$12,000
$10,000
$8,000
$6,000
$4,000
$2,000
$-
2005 2007 2009 2011 2013 2015

Soure: Visa And Mastercard, Sec fillings

24