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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”,

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slide1

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
slide2

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.
slide3

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).
slide4

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.
slide5

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

slide6

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.

slide7

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,…)

slide9

OTHERS…

LOOKING FORWARD: KEEP POSTED ON

slide10

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)

slide11

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 

slide12

Card usage with homogenous sellers and a too low

interchange fee

efficient card usage

effective card usage

slide13

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).

slide14

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).
slide15

Member banks

Issuers:

      • Cost per transaction
      • Charge fee:
      • Symmetric equilibrium
      • Issuer profit proportional to transaction volume.

Acquirers:

      • Cost per transaction
      • Competitive  charge merchant discount:
slide16

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.

slide17

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).

slide18

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)

slide19

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

slide20

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)

slide21

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).

slide22

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

slide23

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.

slide24

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.

slide25

surpluses

Social

welfare

Users

surplus

IF

monopoly = excessive IF

competition = too low IF

slide26

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

slide27

Assume constant margins for banks:

TOTAL USERS SURPLUS:

SOCIAL WELFARE:

slide28

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
slide29

With the HAC rule, merchants accept:

  • debit card 1 alone iff
  • Merchants accept both cards of network 2 iff:
slide30

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.

slide31

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

slide32

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.

slide33

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.

slide34

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).