TWO SIDED MARKETS AND TYING IN PAYMENT SYSTEMS Jean-Charles ROCHET (Institut d’Economie Industrielle, Toulouse University, France) March 2004 • This presentation was prepared for the conference “The Economics of Payments”, • organized by the Federal Reserve Bank of Atlanta (March 31 and April 1, 2004). • It builds on two papers with Jean Tirole: • “Tying in Two-Sided Markets and the Impact of the Honor All Cards Rule” (2003), • “Two-Sided Markets: An Overview” (2004). http://www.idei.asso.fr
TYING IN THE PAYMENT CARD INDUSTRY: • Oct.1996: Wal-Mart and other US retailers charged • VISA and MasterCard (violation of antitrust law) • HAC rule “tied” credit cards with off-line debit cards, more expensive than ATM cards (on line). • lawsuit certified as a class action with > 5 million merchants. Damages evaluated over $7 billion. • June 5, 2003: VISA and MasterCard settled for over • $3billion, and accepted to abandon HAC.
The traditional view on tying is that it is often anticompetitive: • Leverage theory: tying can be used by a firm that is • a monopoly on one market to extend its monopoly • power to another market (by preventing entry or forcing • exit of other firms on that market) Whinston (1990). • Price discrimination: tying allows firms with market power • to extract more surplus form consumers (but mixed • bundling is not necessarily welfare decreasing).
However, the payment card industry is a two-sided market, • where networks compete to get both sides (i.e. merchants • and consumers) “on board”. The logic of these industries • is different. • Moreover there are other important examples of tying in • two-sided markets: • Windows and Internet Explorer (US, 1998-2000) • Windows and Media Player (EU, 2003), • TV Channels and Advertisement… • My presentation will try to analyze the impact of tying on • two-sided markets and show the difference with the one-sided • case.
PRESENTATION OUTLINE 1- TWO SIDED MARKETS: AN OVERVIEW 2- THE FUNDAMENTAL EXTERNALITY IN PAYMENT SYSTEMS 3- A FULL MODEL OF THE PAYMENT CARD INDUSTRY 4- COMPETITION BETWEEN NETWORKS 5- APPLICATION TO TYING 6- EXTENSION TO OTHER TWO-SIDED MARKETS
TWO-SIDED MARKETS: AN OVERVIEW • Examples of two-sided markets: platform buyers sellers gamers users “eyeballs” cardholders videogame platform operating system portals, newspapers, TV debit & credit cards game developers application developers advertizers merchants • Chicken and egg problem. Must get both sides on board/court each side while making money overall.
Two-sided markets raise new questions: • Price structure: receives attention from • managers: • impact of elasticities and externalities, • impact of platform competition, • impact of multi-homing (examples: payment cards, software, real estate,…). • public policymakers (termination charges, Ifs): • antitrust implications (legitimacy of cross-subsidies, impact of tying,…)
OTHERS… LOOKING FORWARD: KEEP POSTED ON
2- THE FUNDAMENTAL EXTERNALITY IN PAYMENT SYSTEMS: Consider the costs and benefits associated with a payment by card: Acquirer Issuer Merchant Customer sells good at price p (costs and benefits are net i.e. w.r.t. a cash payment)
Baxter (Journal of Law and Economics, 1983) Social welfare maximized if: card payment competition on downstream markets leads to: under-efficient usage. Efficiency restored with appropriate interchange fee customers use card
Card usage with homogenous sellers and a too low interchange fee efficient card usage effective card usage
Card usage is efficient when (Baxter’s interchange fee) efficient card usage effective card usage However Baxter’s model does not model the strategic behavior of banks (they make no profit) nor merchants (cards acceptance allows them to attract more customers).
3- A FULL MODEL OF THE PAYMENT CARD INDUSTRY • Rochet-Tirole (2002) • Consumers/buyers: • Net benefit distributed according to c.d.f. . To simplify: • is transaction specific • but consumers ex-ante identical. • Merchants/sellers: • Net benefit same for all merchants (or heterogeneity is observable). Assumption relaxed in Rochet-Tirole (2003) • Merchants compete as in Hotelling model. • For the moment: unique network (monopoly).
Member banks Issuers: • Cost per transaction • Charge fee: • Symmetric equilibrium • Issuer profit proportional to transaction volume. Acquirers: • Cost per transaction • Competitive charge merchant discount:
Timing • Consumers observe retail prices / card acceptance and pick merchant. • Then observe their type and choose payment means. • Issuers set fees f, acquirers set merchant discounts m. • Consumers take card? • Merchants accept card? • Merchants set retail prices. Cooperative sets interchange fee a.
Merchant acceptance Proposition 1: At equilibrium, merchants accept card iff merchant discount strategic benefit of merchant direct benefit of merchant (average convenience benefit of cardholder) Equivalent to: Baxter: Strategic benefit lowers merchant resistance (i.e. they accept higher IFs).
Intuition • Accepting the card has 2 consequences for the merchant: • increases net cost (per transaction) by • increases average convenience benefit of consumer Increases profit margin by (decreases in a)
Welfare analysis Issuers’ profit proportional to volume and thus increases with a. Then network chooses the maximum IF that merchants accept Social welfare: where Social welfare is maximum for
1st case: Low issuers’ margins Network’s choice leads to overprovision of cards (f too low, a too large) Social welfare Interchange fee a (1st best)
2rd case: Large issuers margins Network’s choice leads to socially optimal provision of cards Social welfare Interchange fee a (second best) (1st best) Proposition 2: The socially optimal IF equals the minimum of a* (1st best) and (maximum IF accepted by merchants).
4- COMPETITION BETWEEN NETWORKS • Recall the main features of the model: • homogenous sellers: benefit from card payments, sell differentiated products (Hotelling) • competitive acquirers Two networks i = 1,2, offering identical cards Merchants choose which cards to accept Merchants set prices; Consumers choose stores Networks set Ifs Banks compete
FUNDAMENTAL LEMMA: At the equilibrium of the Hotelling game, merchants accept the subset of cards that maximizes total users surplus. Bertrand competition between card networks leads to some special form of “undercutting”: if a network does net select , no merchant accepts its card.
Proposition 3: At the competitive equilibrium, networks set identical fees This is the value of a that maximizes total users surplus Social welfare (users surplus plus banks’ profit) is maximum for Inter-network competition leads to too low interchange fees.
surpluses Social welfare Users surplus IF monopoly = excessive IF competition = too low IF
5- APPLICATION TO TYING • Extend our model: • two types of cards: k = d (debit), k = c (credit) • two networks (associations) i = 1 (ATM) offers only d; i = 2 (VISA) offers both d and c. Two debit cards = perfect substitutes. Cardholders credit (credit) Merchants (debit) VISA Cardholders off-line debit Cardholders on-line debit ATM Network
Assume constant margins for banks: TOTAL USERS SURPLUS: SOCIAL WELFARE:
FUNDAMENTAL LEMMA: At the equilibrium of the Hotelling • game, merchants accept the subset of cards that maximizes total • users surplus. • Thus without the HAC rule, merchants accept: • credit card iff • debit card 1 alone iff • debit card 2 alone iff
With the HAC rule, merchants accept: • debit card 1 alone iff • Merchants accept both cards of network 2 iff:
OUTCOME OF NETWORK COMPETITION: • Without HAC: identical fees for debit (those who maximise users surplus) monopolistic fee for credit. • With HAC: network 1 charges same fee as before network 2 chooses combination of fees for debit and credit that maximizes its members’ profit under the constraint that total users surplus (for debit and credit) equals at least the user surplus created by network 1.
ANALYZING THE IMPACT OF HAC RULE: • fees for ATM cards unchanged • total users surplus unchanged • total volume increased • total profit increased • social surplus increased. surpluses Social welfare Users surplus Cardholder fees f
ROBUSTNESS: • In the monopoly case social surplus is also increased by HAC rule. • If credit and debit are partial substitutes: HAC rule can decrease welfare if banks’ margins are large. • If merchants are heterogenous (supermarkets vs specialized stores), those with few credit transactions lose from HAC rule, while those with many gain. But if heterogeneity small average gain.
6- EXTENSION TO OTHER TWO-SIDED MARKETS Example of advertisement on free TV channels Viewers TV Channel Advertisers Most viewers would like to view TV programs without advertisement (tying). But without using specific technology (decoders) TV Channel cannot charge viewers. Tying is the only way free TV channels can survive.
A lot remains to be done: • competition between free TV (with ads) and pay TV • exclusivity of premium programs (NBA, NFL,…) ~ killer apps for software • technological innovation to “un-tie” advertisements (TIVO).