Why credit-card rules are anticompetitive

Alex Verkhivker | Sep 06, 2018

Sections Economics

Suppose that paying for your morning coffee with an American Express card cost more than using Visa or Mastercard, which in turn cost more than cash. That would reflect merchants’ true expenses for the competing payment systems, according to Chicago Booth’s Dennis W. Carlton and University of British Columbia’s Ralph A. Winter.

But under US rules, merchants aren’t allowed to add surcharges to reflect their costs for taking credit cards. They can’t even try to steer customers by disclosing which cards carry lower expenses (although discounts for cash are legal). The judicial decisions behind this include the Supreme Court’s five-votes-to-four ruling in June that sided with American Express on its policy barring merchants from encouraging consumers to use lower-cost cards—but are, according to Carlton and Winter, based on faulty economic reasoning. 

These decisions allow credit-card companies to engage in what would otherwise be considered anticompetitive behavior, the researchers write. In 2015, buyers used credit cards for roughly $11 trillion of transactions, or more than 10 percent of global GDP. Carlton and Winter use an estimate of US merchants’ costs of accepting Visa and Mastercard of 2.15 percent, and say AmEx’s fees are higher. Credit card merchant fees in the US are estimated to be in the billions. 

The no-surcharge and no-steering rulings eliminate competition among credit-card companies because a low-cost credit-card company will not see its low fees reflected in lower surcharges and a higher market share, Carlton and Winter explain.   

To make their case, the researchers present a theory for “vertical most-favored nation clauses,” restraints that prevent “a multiproduct retailer from charging more for one supplier’s product than for the products of rival suppliers.” Carlton and Winter then apply the theory to the credit-card industry’s no-surcharge and no-steering rules. These practices, they find, can jack up costs for all consumers—regardless of whether people pay with plastic or cash—because they eliminate competition among card companies, deter card companies from entering markets they’re not in, and raise prices for consumers, including those who do not use credit cards since merchants have to price goods to cover payment-system costs.

Why have US courts found this to be legal? It boils down to the technical economic issue of whether the credit-card market is “one-sided” or “two-sided” and to the technical legal issue of who has the burden of proof—whether it is the defendant or plaintiff who has to prove certain facts. Economists have generally analyzed the credit-card market as two-sided, with merchants paying credit-card companies for services on one side and consumers receiving rewards and other benefits from the card companies on the other side. Carlton and Winter demonstrate that despite this, the fees merchants pay and the benefits card users receive correspond exactly to prices and promotion costs in the conventional economic framework for analyzing one-sided markets. In such a conventional market, the legal rules place the burden on the defendant to explain why the restrictions on competition ultimately serve to promote competition overall. 

Carlton and Winter applied their analysis to the appeals court finding that the Supreme Court essentially upheld. American Express argued that because credit cards are a two-sided market, it is inappropriate to apply the same rules to evaluate vertical restrictions (restraints between companies at different levels of a production or distribution process, in this case between credit-card companies and merchants) as are applied to evaluate vertical restrictions in conventional markets. A five-to-four majority of the court agreed. In a deviation from how courts evaluate vertical restrictions in conventional markets, the court said that in such two-sided markets, the burden was on the plaintiff to prove that the restrictions on merchants failed to promote overall competition. (In fact, the Supreme Court ignored the findings of the district court, which had determined that the defendant had presented no such justifications.) The court said that consumers must have benefited from the restrictions because the number of transactions had risen over time. 

“The idea that the higher retail prices resulting from the no-steering restraints harmed only merchants and, through the funding of greater cardholder benefits, helped only cardholders is fallacious,” the researchers write. “Higher retail prices clearly harm customers who do not use an AmEx card at the merchant and, as we showed, can also harm even the customers who do use an AmEx card” because of the lack of competition on fees among card companies and the hidden markups to cover merchants’ credit-card costs.

Moreover, the reasoning used by the appellate court in the AmEx case—which the Supreme Court later accepted—“lacks economic foundation,” the researchers find. “Creating different legal rules for the same economic conduct depending on whether the market can be described as one-sided or two-sided is a mistake.”