[Warning: Lots of text. Will probably take 10 minutes to read and 10 minutes to digest.]
We recently had a ruling in Canada that found it illegal for credit card networks (Visa / Mastercard) to prevent merchants from applying a credit card surcharge. As of last week, merchants are now allowed to add a fee when a customer pays using a credit card.
There have been a lot of posts on the r/Canada and r/PersonalFinanceCanada subreddits and the consensus from most people (who are likely consumers) is that this is another way to fleece the customer. I think this is a misguided point of view so I wrote a post trying explain as carefully as I can why this will eventually benefit the customer. The vast majority of the comments to my post were negative so I'd like to get an actual economist to look at my argument to see if it is on the whole is sound.
Link to original post with better formatting (text also reproduced below)
# Why having credit card surcharges is the right thing to do. A long read on the history, economics, business and the prisoner's dilemma of the credit card industry.
There's been a lot of discussion and debate on r/Canada, r/PersonalFinanceCanada and r/Ontario about the new court decision that allows merchants to apply credit card surcharges which were previously not allowed or greatly restricted. A lot of the blame seems to be directed at the merchants (i.e., the retailers / stores), and perhaps rightly so, since one can make an argument that these "surcharges" have certainly already been factored into the price of goods and services.
This purpose of this post is not to discuss that any further. Instead, it's to shed light on how we got here in the first place, and how restricting credit card surcharges have led us down a rather pernicious path of excessive fees. The forces that have upheld the ban on credit card surcharges are both governments (which in some countries/states outright ban merchants from adding a credit card surcharge) and the credit card duopoly of Visa and Mastercard (who force merchants to not apply a surcharge in their terms and conditions where the law doesn't prohibit this).
Some of the downsides of not having credit card surcharges are:
1. Visa/Mastercard have created a market dynamic where a rational consumer has no choice but to pay using a credit card (since the perks make using a credit card make it on net cheaper than paying by cash)
2. As a consequence of this, the credit card fees (which are ultimately footed by the consumer) are almost certainly higher than you'd expect in a properly functioning market
3. This fact that credit card fees are paid by all customers, regardless of whether they pay by card or cash, mean that certain populations who are less likely to use credit cards (usually poorer) subsidise the credit card usage of populations who are more likely to use credit cards (usually richer).
Let me make my stance clear before we proceed. I am not justifying the new surcharges that some merchants (such as Telus) seem to want to apply. If a merchant is sincere about adding a credit card surcharge to cover credit card fees, it should go hand in hand with an equivalent decrease in price for anyone paying by cash.
What I am arguing for is that it is wrong that credit card surcharges have been restricted in the past. I'll show how the ideal outcome for the consumer is not only for credit card surcharges to be legal but for it to be mandatory for the consumer to pay as a surcharge the exact credit card fee caused by the use of card. This will benefit both cash users, who will no longer have to subsidize the fees of credit card users, and card users, since this will likely apply pressure to decrease credit card fees.
While I have idealized much, and for the most part ignored factors like the costs involved in using cash (for instance, added security), I believe much of my argument still stands even if you were to account for this.
# How Credit Cards Work #
Before we get into the details of why having credit card fees are the right thing to do, we need to understand the seemingly convoluted dynamics of how the credit card industry works.
When you purchase something with a credit card, the merchant has to pay the credit card network (Visa/Mastercard) and the bank issuing the credit card which transfers the funds. For simplicity's sake I'm going to refer to both of these fees as the 'credit card fee' or simply 'fee' but there's a more detailed break down in the appendix at the bottom of this post. The credit card networks such as Visa and Mastercard set the rules for how this fee is calculated but the issuing bank gets most of the money (since it is the bank that handles the money and takes on the risk in issuing you a line of credit). In a way this is backwards from how things usually are. Usually, if you take a loan out to purchase something, you pay the interest on the loan, not the merchant. However, in this case, it is the merchant that pays the bank for the credit used by the consumer.
The credit card fee can vary widely. In Canada it is usually between 1-3% of the amount of the total transaction. The bank gets about 80% of the total fee and the credit card network gets about 5-10% of the fee. The rest go to the payment processor whom I'm going to ignore for the most part since they neither set the rules for the bulk of the fees nor get the bulk of the fees.
Many credit cards also come with a range of "benefits" that I'll collectively refer to as "perks". This includes any feature of using a credit card that has nothing to do with facilitating a transaction. The more obvious ones are Air Miles, airport lounge privileges, extended warranties on electronics and any amount of "cashback" (in quotes since it's not really cashback if they take your money to give it back to you). As I'll explain below these "rewards" are probably the most brazen part of the market failure that the credit card networks have created.
There are a couple of points that are important to understand for the rest of the discussion:
1. The credit card fee varies greatly between 1-3% of the total transaction. The primary reason for this wide range of fees is the type of card you use. Premium cards (for Visa, this would be Visa Infinite and for Mastercard this would be World Elite) have a higher credit card fee rate for a merchant compared to the same transaction for a basic card. This is how you get more "perks" such as Air Miles or "cashback" when you use these premium cards.
2. The credit card networks (Visa/Mastercard) set the terms and conditions for the merchants that accept these networks. In jurisdictions where this is not illegal, this usually means that merchants are prohibited from passing on the credit card fee to the consumer in the form of a surcharge. For instance, if a store sells apples for $1 in cash, if it is to accept credit cards, the final price to a consumer using a credit card must be the same. This means that to cover the additional credit card charge, merchants have to inflate the price of the apple for everyone, including consumers who pay by cash. The same apple now perhaps costs $1.015 for everyone, including cash payers.
# Externalities, Market Failure and The Prisoner's Dilemma, or in other words, how credit card networks can never lose #
When you pay using a credit card and there is no credit card surcharge, all of the customers of that merchant indirectly pay higher prices to cover your card fees. This [often affects poorer people disproportionately](https://www.brookings.edu/opinions/americas-poor-subsidize-wealthier-con...) since it is harder for them to get a credit card. It's doubtless wrong to have someone else pay a part of your bill, worse when it's a poorer person paying a richer person's bill.
Externalities are bad in economics because when you don't have to pay full price, you often take actions that are bad for society as a whole. For instance, if you run a chemical factory and there were no government regulations on pollution, you would probably save on costs to minimize pollution so that you can increase your profits. This might mean than you save $100 on costs, but at the same time the cost to society as a result of disease caused by your polluting could be $1000. Thus, your actions are globally suboptimal and should probably be prohibited.
In many cases, government regulations reduce the extent of the externality, but with no regulations credit cards fees are a perfect externality with the card user paying 0% of the fee.
> The Prisoner's Dilemma of Using a Credit Card or why the credit card system is rigged against consumers
In a world without credit card surcharges, holding all other factors constant, as a rational consumer you can only make one choice; sign up for the most premium credit card your bank offers you and use it to pay for everything.
Let's go back to our example of the $1 apple and see how this works out. Let's also increase the credit card fee to 15% and have a perk of 5% cashback to better illustrate the problem (treat 5% cashback as 5 cents cashback for simplicity's sake).
There are four scenarios depending on who decides to pay using card or cash:
1. **You pay by: Cash, Others pay by: Cash**
The apple *costs $1.00 for everyone*. In this scenario, both you and everyone else is irrational to not use a credit card and get 5% cashback. However, go to the fourth scenario to see how this actually pans out.
2. **You pay by: Cash, Others pay by: Cash**
You pay $1.00 but you get 5% cashback making the *net price $0.95 for you*.Since you are the only person using a card, the credit card surcharge as a proportion of all sales is negligible to the merchant and the price of the apple remains at $1.00.*Everyone else pays $1.00*.In this scenario the other customers are irrational to use cash.
3. **You pay by: Cash, Others pay by: Card**
The sticker price of the apple has now gone up to $1.15 since the merchant has to cover the credit card fee for almost all customers.*You pay $1.15* for the apple.Everyone else pays $1.15 at the counter but then gets 5% cashback which leaves them with a *net price of $1.10*.In this scenario you are irrational to use cash.
4. **You pay by: Card, Others pay by: Card**
The sticker price of the apple is $1.15 since the merchant has to cover the credit card fee.You pay $1.15 but get 5% cashback so *your net price is $1.10*.Everyone else has a *net price of $1.10* as well for the same reason.
Notice how regardless of how the other customers pay, the optimal solution for you is to pay by credit card. Eventually all of the other customers pick up on this trick as well and what ends up happening is that everyone pays by credit card regardless of how much the fees are. Even in this example with massively inflated credit card fees, **you have no choice but to use a credit card**.
> Market Failure
See the problem here? You may or may not have a preference to pay using a credit card, but the only rational choice you can make is to pay using credit card. You may well prefer to pay by card for convenience’s sake but that's irrelevant here. What this shows is that you have no choice. This compounded with the fact that governments do not regulate credit card fees means that there really is nothing stopping the credit card networks from charging 50% or even 100% of the transaction amount as a fee.
In reality this doesn't happen because such a move will almost certainly elicit a severe regulatory crackdown from governments. At the same time, this makes it plain to see that whatever the credit card fees are now, they must be exorbitantly higher than what they ought to be. So even if you're comfortable with a 2% added fee, you should know that this might well be 5-10x what it ought to be).
This next sentence describes, perhaps, what I find most egregious about all of this.
**In credit cards, not only do you have a perfect externality where those who benefit from it's use pay $0 and offload all of the costs to all consumers, but when it comes to "perks" the externality is effectively used to pay for an additional product (Air Miles, cashback, etc.) that has nothing to do with facilitating a transaction.** These features are unnecessary and unnecessarily inflate the fees. In a sense even the line of credit that you have though the bank is an unnecessary perk if you pay you credit card bill on time. The only feature of value, then, is the ability to make an electronic cashless transaction. In many cases, not even those who receive these additional perks would want them if they knew that they are paying more as a result of it.
# Why Credit card fees should not only be allowed but also be mandatory #
Regardless of whether a merchant decides to apply a credit card surcharge or not, the fees will eventually be passed on to the consumer. Therefore, it is in the consumer's interest that credit card fees are lowered, not in the merchant's interest.
The only way consumers can apply pressure on the credit card networks to reduce their fees and to stop bundling pointless "perks" is if consumers are given a legitimate option on whether to use a credit card or not. The only way to have this option is if you aren't forced to indirectly pay credit card fees if you pay by cash. In other words, if a consumer uses a credit card, they ought to be obligated (with no exceptions even if the merchant is against it) to pay as a surcharge the exact credit card fee. Not a penny less, not a penny more. At the same time, merchants should be obligated to reduce the current prices for consumers paying by cash. Note that the current ruling that allows merchants to apply a credit card surcharge is still suboptimal since merchants are still free to not apply a surcharge.
**Having a mandatory credit card surcharge means that if consumers feel they are being unfairly charged high card fees, they will switch to cash which would incentivize the credit card networks to lower their fees. Similarly if they feel that the additional fees incurred by using a premium card are not worth it, they will switch to using a basic credit card.**
Other options to lower fees are to have government intervention to set limits on credit card fees or to outlaw bundling "perks". Intervention like this is difficult to do correctly and might lead to further problems that increase costs on the consumer.
# Conclusion #
In conclusion, the prisoner's dilemma of using a credit card means that we have no legitimate choice on whether or not to use a credit card. Credit card networks have intentionally further exploited the consumers inability to (indirectly) not pay these fees by bundling unwanted "perks" that further increase credit card fees, making it even more suboptimal to not use a credit card. This market failure leads to considerably higher credit card fees which eventually make us all, collectively, worse off.
Hopefully you now have a better understanding of how credit cards work, and how the credit card networks have created a system that increases costs on the consumer.
# Appendix #
The major fees paid by the merchant are:
1. Interchange fee. Set by the credit card network but paid to the issuing bank. Covers the risk to the bank for issuing you a line of credit. Between 1-3% of the transaction amount. For debit transactions, this drops to about 0.3%.
2. Assessment fee. Set by the credit card network and paid to the credit card network. Covers the cost to use a credit card network such as Visa or Mastercard. Usually around 0.1% of the transaction amount in the U.S. and probably similar in Canada.
3. Payment processing fees (set by the payment processor and paid to the payment processor). In Canada, these are companies like Moneris, Global Payments, and Square. These companies facilitate the transaction, handle the fees when a transaction occurs and pays the various fees out to the bank and the credit card network. Fees vary but the numbers online seem to suggest this is either under 0.15% of the transaction amount or a flat fee around $0.15 in the U.S. Some payment processors charge one flat overarching fee that includes the interchange fee, assessment fee and the processing fee which makes it hard to tell how much of a cut they're actually getting. Unlike the interchange and Assessment fee, the retailer is free to choose their payment processor, so you'd expect market dynamics to push this fee down.
I appreciate your sharing your view on a specific policy issue based on the systematic application of economic concepts.
My understanding of the suggestion is that the mandatory surcharging rule on credit card payments would be better for consumers for the following reasons.
First, paying with credit cards incurs costs eventually passed on to consumers.
Second, no surcharge rule (uniform pricing across payment methods) burdens even cash-payers with a part of such costs.
Third, such a distribution of the burden may be regressive because lower-income consumers may subsidize higher-income consumers through this.
I believe the argument's reasoning is consistent and well-developed from the assumptions. Still, it is always worth considering how widely applicable such assumptions would be. In this regard, I introduce additional dimensions we may further consider, trying to relax such assumptions. Thinking about how the conclusion would be with relaxed assumptions can make discussions even more fruitful.
Three points are made in the following:
First, when we discuss a ‘better’ policy, we may take additional factors into account.
Second, the quantity demanded by consumers can be adjusted according to the change in price.
Third, merchants may have market power.
1. Additional factors when considering a better policy
The argument in the question suggests a policy about how we can improve the economy. When we evaluate an economic policy, it should be discussed in terms of what perspective it can improve the economy. That is, we need some criteria. The mandatory surcharging rule in the question seems to employ consumers’ benefits as the criterion in the argument.
Two things worth mentioning about consumers’ benefits as the criterion.
First, I suggest that the concept of consumers’ benefit may extend to even non-monetary value beyond just the monetary incentive (“perks”). One of such non-monetary values of using a credit card is that it enables us to have a more flexible budget by allowing a negative saving (that is, making a loan). In other words, consumers can purchase a product at the right time without worrying too much about a temporarily negative balance in their account. Then consumers are better off by having broader options in their hands (It is worth noting that this discussion should be based on the assumption that consumers are ‘rational’ in the sense that they do not excessively spend their money beyond the budget in the end. Whether consumers are rational or not is another interesting issue we can consider).
On top of that, we may aim at improving ‘social welfare’ when we examine which policy would be the best. Social welfare is a wider concept than just consumers’ interests in that it incorporates firms’ profits as well as consumers’ surpluses. Note that a firm's profits are also someone else’s income, who is eventually a consumer in the other markets (distributional implications are not considered here but would be worth examining). Suppose we adopt social welfare as our objective to improve. In that case, the mentioned high profits of credit card networks might have some different implications, which can be interpreted as a good thing.
2. Possibly variable demand
Regarding social welfare, it is useful to think about how the policy would affect the quantity of products demanded by consumers.
Suppose a policymaker cares about social welfare as a whole. Then an important issue in the market should be the total volume of the transaction itself because when a transaction is made, both buyer and seller are better off unless they are ‘irrational’. Then the natural question we should be asking is how the existence of surcharges would affect the quantity of transactions. This is important because one of the implicit assumptions made when the concept of the prisoner’s dilemma is applied seems to be that the demand is fixed (constant demand). In the provided game between cash and credit card payers, consumers consider only payment methods, not how many units they would purchase (or even whether they would be willing to purchase any). This implies that consumers do not adjust their quantity demanded according to the change in prices that are highly correlated with payment methods. Hence, with the given assumption, the amount of transactions is always fixed regardless of payment methods, and therefore social welfare is also constant accordingly. This is why the only distribution of burdens (expressed as the externality) can be considered in the argument. But the constant demand assumption may not necessarily be the case.
It is generally believed that in most cases, higher price induces lower quantity demanded (Similarly, from the credit card networks’ perspective, one of the reasons why they do not raise credit card fee even higher is that they expect their customers to be not willing to pay for such high fees, reducing their using credit cards, which is not good even for credit card networks as well). Also, a merchant's surcharge can impact the price of goods. Hence, putting these together, we can conclude that allowing surcharges or not can affect consumers’ quantity demanded. With this given, if we relax the constant demand assumption, then the mandatory surcharging policy may have different implications on the consumers’ purchasing decisions and the subsequent distributional impacts between credit card payers and cash payers.
3. Merchants’ market power
The economic outcomes can also depend on the assumption of how the merchants would set the prices. In the prisoner’s dilemma example again, the given price of apples is assumed to be determined by rational merchants under intense price competition, which is why it is assumed that exactly 100% of credit card accepting cost is passed on to consumers. In reality, however, this may not necessarily be the case.
Some merchants can have market power for numerous reasons. It may be because the nearest other retailer is located several miles away, consumers are locked in to the retailer due to its membership program, the merchant has a better quality of customer service and amenities, or many more. In other words, many merchants may have the ability to differentiate themselves from their competitors in different aspects, even if merchants sell technically the same products.
Having market power means they can set the price above its cost and therefore have a positive margin. Under such circumstances, the surcharge rule enables the merchants to set the surcharge higher than the corresponding costs. Ultimately, they can take it as an opportunity to make even higher profits by implementing price discrimination according to consumers’ payment methods. Such excessive surcharges would be socially undesirable in the sense that they induced consumers to use more cash than with fair surcharges, which sacrifices some potential utility of consumers’ using credit cards (which may directly affect the volume of transactions). Indeed, some merchants impose surcharges that exceed their credit card accepting costs in Australia and the U.K (Hayashi 2012).
To sum up, the evaluation of the potential effects of the surcharging rule may differ according to the policy's objective, how consumers would react, and how the competition structure of the market is organized. It may be effective in a certain market but may not be in another market, depending on its specific economic conditions (Economides and Henriques 2011).
Economides, N., & Henriques, D. (2011). To surcharge or not to surcharge? A two-sided market perspective of the no-surcharge rule.
Hayashi, F. (2012). Discounts and surcharges: Implications for consumer payment choice. Federal Reserve Bank of Kansas City, Payments System Research Briefing, June.