Journal of Regulatory Economics

https://doi.org/10.1007/s11149-020-09406-z

ORIGINAL ARTICLE

The regulation of merchant fees in credit card markets

Hongru Tan1

© Springer Science+Business Media, LLC, part of Springer Nature 2020

Abstract
This paper provides a theory on how to regulate the level of merchant fees in credit card
markets. In particular, we discuss how to regulate the merchant fee in a closed payment
system with heterogeneous merchants. We find that tourist test is not a valid approach.
Our model suggests that the regulation should be based on costs of networks or banks
and market elasticity. Moreover, we provide an alternative understanding on how to
regulate the interchange fee in an open payment system. The initial public offerings of
Visa and MasterCard do not merely change themselves from not-for-profit associations
to for profit companies, but also change the mechanism in determining the fee level and
structure borne by end users. These changes in industry urge an updated understanding
of the optimality of interchange fees.

Keywords Merchant fees · Closed payment system · Regulation

JEL Classification G21 · G28 · L52

1 Introduction

This article presents a pricing theory of platform to discuss the regulatory issues in
credit card markets. The regulation of Interchange fees (IFs) or merchant fees has been
one of the critical issues in the credit card industry. Thus far, two regulatory methods
have been adopted in practice. The first is cost-based approach which implies that the
IF should be set according to the costs of banks or networks to provide credit card
transaction service. It has been put into regulatory practice in such jurisdictions as

We would like to thank Jeffrey Church, Julian Wright, Yang Sun, Zhongqi Deng and an anonymous referee
for helpful discussion and advises. Hongru Tan gratefully acknowledges the National Social Science
Foundation for Young Scholars of China, and funding from Institution of New Economic Development
(Chengdu) Fundamental Research Funds for the New Economy (No. H181220). All errors are ours.

B Hongru Tan
hongrutan@scu.edu.cn

1 School of Economics, No.24 South Section 1, Yihuan Road, Chengdu 610065, China

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 H. Tan

Fig. 1 Closed and open payment systems

Australia, the U.S. and etc. The second is tourist test, which has been adopted by the
European Union, suggests that the IF should be limited in line with merchant benefits
or cost saving of merchants in relation to card transaction service.
For explanatory purpose, we shall briefly introduce two typical payment systems in
the credit card industry, which are also demonstrated in Fig. 1. The first is the closed
payment system as for American Express (AmEx), in which a credit card company
provides transaction service directly to consumers and merchants, and charges mer-
chant fees and customer fees directly to merchants and consumers. The second is
called the open payment system as for Visa or MasterCard, in which each transaction
involves five interested parties, including the credit card company, the issuing banks or
issuers which issue credit cards to consumers, the acquiring banks or acquirers which
provides point of sale machinery to merchants, consumers, and merchants. In each
transaction, the payment for price of goods flows from consumers’ bank accounts to
merchants’ bank accounts by settlement among issuing banks, acquiring banks and
the card company. Transaction fees also occur within the payment. Merchants pay
merchant fees to acquiring banks, and in turn, more than 90% of merchant fees are
passed through by acquiring banks to issuing banks as IFs. The rest are retained by
acquiring banks to cover the cost. The issuing banks, which receive the IFs, charge a
customer fee to consumers.1 How to set a proper IFs (or merchant fees) in an open
system, and equivalently merchant fees in a closed system has received particular
concerns in regulatory practice.
Before tourist test was introduced in the Rochet and Tirole (2011), economists and
practitioners agreed unanimously to regulate the IF according to banking costs, despite
of the shortage in theoretical backup. To my knowledge, Baxter (1983) is the one of
few literature to provide theoretical support to cost-based regulatory approach. The
article finds that setting the IF according to banking could solve a problem of market
failure due to negative externality exerted by cardholders onto merchants. Consider the

1 Open systems have also experienced a structure change due to the Initial Public Offering (IPO) of Visa
and MasterCard in 2008 and 2006 respectively. Prior to IPOs, credit card companies were not-for-profit
associations of banks, especially issuing banks. The bank members within an association collectively select
an IF to maximize the transaction volume within the network. Post IPOs, credit card companies become
independent for-profit private entities, and charge two other network service fees to issuing and acquiring
banks in addition to IFs.

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simplest case where a credit card company provides transaction service to a consumer
and merchant, via an issuing bank and acquiring bank. If the benefit to consumer falls
short of the issuing cost, but the total benefits of consumer and merchant are greater
than the total costs of the issuing and acquiring bank, a transaction would not take
place without a monetary transfer from the acquiring bank to issuing bank. An IF equal
to benefit of merchants minus acquiring cost is social optimal for a payment system.
Tourist test was invented to tackle another inefficiency due to “must take” or mer-
chant internalization (MI) phenomenon. Vickers (2005) points that merchants “must
take” cards due to competition in attracting customers, and are unable to refuse the
excessive merchant fees. Alternatively, merchants take into account or internalize con-
sumer surplus of cardholders when decide to accept a card or not, so it is called MI.
These excessive fees are eventually borne by consumers when merchants cannot price
discriminately across payment methods.2 The consumers, who pay with cash, also pay
part of the fees without knowing it. In this case, the credit card transaction service is
over provided. The tourist test is to impose a cap on IF such that merchants do not have
to bear the excessive fees and curb the over provision due to MI. Rochet and Tirole
(2011) state that the logic is as the story when tourists visit a store. For a tourist, the
merchants have no concern to build up their reputation of accepting cards to attract
she or he to visit again. The merchants could claim that they accept cards up front to
attract consumers, but decline the cards once tourists come in the store. If the merchant
fees set at a reasonable level (i.e., less than merchant’s benefit from accepting cards),
merchants would not refuse to accept so as to avoid the cost due to business strategic
consideration. Therefore, an IF or a merchant fee passes the tourist test if merchants
are still willing to accept cards ex post.
This article is motivated by two aspects. First, we are aimed at filling a gap in theory
to understand the optimality of fee setting in a closed system. Currently, the regulatory
practices and economic theories mainly apply to the IFs on Visa or MasterCard net-
works – the open systems. No regulatory action has been conducted on merchant fees
of AmEx—the closed system. The current absence of regulation on AmEx’s merchant
fees does not imply this issue is not important. Conversely, the excessive merchant fees
are particularly at issue in a recent antitrust lawsuit— State of Ohio et al., v. American
Express, 585 U.S. [2018].3 This article builds a model tailored to the case of AmEx to
guide the potential regulation on its fee setting. To do so, we incorporate phenomenon
of MI into a general platform pricing model. We first show that capping the merchant
fee according to tourist test often decreases social welfare. A natural question to ask
is why by doing so, social welfare decreases in a closed system with heterogeneous
2 Credit card companies places such terms in contracts with merchants that forbid them from steering
away consumers to use other means of transactions. In case of Visa or MasterCard, the terms are called the
No-surcharge rule, which only limit the monetary method to steer away. The terms in AmEx case are called
Non-Discrimination Provisions, which are even stronger clause than the NSR and limit both monetary and
non-monetary methods to steer away consumers to use other means of transactions.
3 The case is mainly on AmEx’s Non-Discrimination Provisions (NDPs) which allows the companies to
inflate the price of goods by charging excessive merchant fees. NDPs basically forbids merchants from
encourage customers to use any other payment means by monetary and non-monetary methods. Although
AmEx won the lawsuit and retains the NDPs, it does not necessarily imply the merchant fee is immune
from regulatory inspection. The AmEx’ merchant fees should receive equivalent attention as for Visa and
MasterCard IFs.

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merchants. The test is supposed to be used to curb the usage externality due to MI, and
the social welfare should be improved afterwards. Why have we found an opposite
result compared to its application of an open system? This is because when the plat-
form maximizes profit, the card service is often under provided despite the presence of
MI. The elimination of MI often decreases the transaction volume further below social
optimal level and leads to a decline in total welfare. In comparison, the over provision
often occurs when a platform maximizes the transaction volume as for an open system,
and the elimination of MI curbs the over provision and lead to an increase in social
welfare. We further provide a model to optimally set the merchant fee and customers
fees, in which a platform maximizes the profit subject to an optimal price level –the
total fees borne by both consumers and merchants. The model shows that the merchant
fee should set according to costs of networks and market elasticity, which provides
theoretical backup to cost-based approach and turns the understanding back to Bax-
ter’s idea. Second, we reexamine the optimality of IF in an open system. The IPOs of
Visa and MasterCard turned the companies from not-for-profit associations into the
for-profit entities. Two additional networks service fees are charged afterwards. This
is to say, not only the objective of networks alters, but also the mechanism in setting
fees changes. We examine the optimality of fees in the updated setting and find that
the regulation should be based on cost of networks and banks as well.
Many literature discuss the regulatory issues in credit card markets. For clarity,
we lay out the key assumptions and applications of each literature in Table 2. Baxter
(1983) finds that an IF solves a problem of market failure due to negative externality
exerted by cardholders onto merchants. This cost-based IF internalizes the negative
externality effect and provides a justification for the cost-based regulatory approach.
Schmalensee (2002) suggests the collectively set IF is based on bank costs, but does not
support any straightforward policy toward the IF. He shows that the IF is a mechanism
to balance the fees charged to consumers and merchants under imperfect competition.
He points out that the privately optimal IF depends mainly on differences between
acquirers and issuers, and “symmetry makes a zero interchange fee optimal”. Rochet
and Tirole (2011) introduces tourist test and finds that it is warranted to maximize the
total user surplus, with few exemptions when issuer’s margin is not constant. In their
model, the open system is a not-for-profit association; Issuing banks have market power
and collectively set the IF. Their finding hinges on the assumption that merchants are
homogeneous. When the opposite is the case, no clear conclusion is drawn on validity
of test.
Wright (2012) explores one step further and establishes that the IF has been set
excessively high when merchants are heterogeneous, and tourist test is a valid approach
in most cases with heterogeneous merchants. He also shows that merchant fees are set
excessively high in a closed system, but does not draw a conclusion whether the test is
applicable in this case. Bourguignon et al. (2019) discuss how imperfect information
on card use policy affect the regulation of IFs. In particular, they assume consumers
are not perfect informed about merchant card/cash policy (surcharge or not, or cash
discounts). Their model follows the framework in Rochet and Tirole (2011). To focus
on the element of imperfect information, they assume the perfect competition among
issuing and acquiring banks. The platform is therefore maximizing the transaction
volume. The major finding suggests when the NSR is imposed, the IF should be

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regulated according tourist test; and when surcharging is allowed, there is no need to
regulate IFs, but the surcharges should be subjected to a regulatory cap.
Some other literature also discuss the issue of IFs. Aurazo and Vasquez (2019) add
the element of account informality (or the tax evasion associated with cash payments
in developing countries) into the model of Rochet and Tirole (2011). They find that
the presence of benefit in tax evasion with cash payments decrease the net benefit
with accepting card payments, and therefore lower the threshold of interchange fee
in tourist test. Reisinger and Zenger (2019) also follow exactly framework of Rochet
and Tirole (2011) in market structures, properties and maximizing functions of each
party, but incorporating the investment incentives of a card platform. They find that
tourist test will yield a too low incentive to invest under a total welfare standard, but an
approximately optimal level of incentive under a total user surplus standard. Bourreau
and Verdier (2019) discuss how IFs affects investment incentive of competing issuers
to improve consumer services. They mainly discuss the factors affecting innovation
in a credit card market, and do not focus on the discussion of regulatory benchmarks.
This article distinguishes itself from literature in the following aspects. First, we
move one step further from Wright (2012). We establish that tourist test is invalid
in a closed system with heterogeneous merchants, where Wright only shows that the
merchant fee is set excessively high. Second, we update the mechanism in setting fees
for an open system. Most of literature discuss the issue in the premise of pass-through
logic in setting fees, which is the case prior to IPOs. The only choice variable or pricing
instrument is the IF. Once the IF is set, the issuing banks and acquiring banks charge the
customer fee and merchant fee according to a pass-through rate, which is determined
by the competition among both types of banks. There must be a linear relationship
between customer and merchant fee. In comparison, this article considers the issue
on condition that the systems are for-profit entities, and pass-through logic falls apart.
The credit card company has three instruments – IFs and two network service fees –
to impact the fees borne by both groups of end users. Carlton and Winter (2018) take
the same setting as us. The final fees borne by the both end users are determined by
the three fees. This implies not only the fee level – total fees borne by both users – but
also the fee structure – the decomposition between two fees – can be determined by
the credit card company. When this is the case, our model for the closed system can
also be used to examine the policy in an open system. This is because what matters
is the final two prices – merchant fees and customer fees. The only modification is
to introduce the margins of issuing banks, which would not change the property of
analysis or policy implication. So, our model can also be the first one to discuss the
regulation of an updated open system.

2 Model

The notations in this paper are similar as in Wright (2012) and Wright (2004). As
mainly investigating the issue of transaction function of credit cards, we focus on
usage fees without considering the membership fees. Both interchange and merchant
fees are one of the major revenue to the credit card companies. Evans and Schmalensee
(2005) documents that merchant fees account for 56% of AmEx’s revenue in 2001.

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Likewise, IF constitutes 15% revenue of an average issuer affiliated to Visa or Master-

Card and only 2% of Visa’s revenue comes from membership fees. Most consumers
have a credit card nowadays and their concern is how to use it according to usage fees.
The membership fee is a fixed fee paid up front. Therefore, the consumers are more
concerning about the usage fees. We assume the platform merely charges usage fees
to two groups of end-users (consumers and merchants). The customers in the end-user
group i (i = B, S, standing for consumers and merchants) differ in their transac-
tion benefits bi form enjoying the card service. The transaction benefits include the
convenience not to deal with cash or/and check, fraud protection, the ability to make
or accept purchases paid by floats and credits and etc. The transaction benefit bi has
continuous cumulative distribution function G i (bi ), and probability density function
gi (bi ) over bi , b¯i . The hazard rate gi (bi ) /1 − G i (bi ) is increasing in bi to insure
the concavity of optimization problems. A monopoly platform charges customer fee
p B to consumers and merchant fee p S to merchants. For a given pi , consumers or
merchants use or accept the credit card if bi > pi , and the quasi-demand of group i
users is given by Di ( pi ) = Pr ob (bi > pi ). Each value of b S stands for a “sector”,
in which a product is sold. In each sector, there could be a monopolistic merchant
as in Wright (2012), two or several Hotelling competing merchants as in Rochet and
Tirole (2002), or perfectly competitively merchants as in Rochet and Tirole (2011).
These competition settings have well introduced in previous literature, and we shall
not unfold here. But, one point should be mentioned is that the market of the product
in each sector is fully covered for each competition setting. This implies each con-
sumers will purchase one product from each sector, and pricing of card fees will not
influence the purchase of product. As such, the welfare of product market is always
fully realized, and we can focus on the market of card services. The total transaction
volume in the system is given by the product of two quasi-demands from both user
groups as consumers purchase a product from each sector. Notably, the model best
fits the case of AmEx, which directly charges a merchant fee and customer fee to end
users. The model could also mimic the case of an open system, in which a for profit
card company, ultimately determine the merchant fee and customers borne by end
users via its three pricing instruments. We mainly consider the case with no surcharge
rule (NSR), under which merchants are limited to set a uniform price regardless of the
transaction methods. This also applies to the situation where merchants are reluctant
to surcharge due to the cost to impose surcharges despite that they are allowed to do
so. The case with surcharging is also discussed briefly.

2.1 Must-take cards and tourist test

When the NSR is in place, the “must-take” argument prevails because of a phenomenon
called merchant internalization (MI). MI refers to the fact that merchants take into
account consumer surplus of cardholders when decide to accept the card or not. Alter-
natively, as merchants compete strategically, they may accept the card to attract more
consumers, and are willing to accept the card even if the cost to do so exceeds her trans-
action benefit b S . The premium that merchants are willing to pay equals to consumer
surplus in various modeling of merchant competition, such as Hotelling in Rochet

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and Tirole (2002), perfect competitive in Rochet and Tirole (2011) and monopoly
in Wright (2012) and etc. The MI implies merchants accept cards if and only if the
following (1) is true.

bS + v B ( p B ) ≥ pS (1)

where v B ( p B ) ≡ E (b B | b B ≥ p B ) − p B is the consumer surplus of cardholders.

Due to merchant’s inability to refuse the cards, the platform sets the highest merchant
fee p S such that all merchants accept the card, i.e.,

pS = bS + v B ( p B ) (2)

Therefore, MI incurs usage externality and excessive usage of card services. In par-
ticular, consider
 the transaction conducted by consumers with transaction benefit
bB ∈ pB ,  b B , where 
b B = E (b B | b B ≥ p B ) is the benefit of average consumers.
The total benefit falls short of the total price

[b B + b S ≤ E (b B | b B ≥ p B ) + p S − v B ( p B ) = p S + p B

As such, usage externality exists for the transactions conducted by the consumers with
transaction benefit less than the average. The usage externality induces over-provision
of card service under NSR. The fundamental reason is that merchants are unable to set
differentiate prices according to payment methods, and part of the cost to accept the
card will be passed onto the consumers who pay by cash. As a result, cash user cross
subsidizes the card users. To conquer the usage externality induced by MI, Rochet
and Tirole (2011) proposes tourist test to cap the merchant fee p S and hence the IF.4
Tourist test is also called “avoid cost or merchant indifference” test. The test ensures
that merchants are willing to provide card services both ex ante to attract customers
and ex post to enjoy the transaction benefits. Consider a tourist, who has enough cash
in her pocket, shows up at a store and will never come back again. The merchant fees
pass the test if “the merchant allows the tourist to pay by card” as in Rochet and Tirole
(2011) or if the merchant weakly prefer this tourist to pay by card, which is guaranteed
by

pS ≤ bS (3)

The aim of the test is to reveal the transaction benefit b S , which will be used as a
threshold to cap the merchant fees and hence the interchange fees. Jonker and Plooij
(2013) gives a thorough description on how to conduct the test. They mainly compare
the variable costs of payments by card and by cash, and regard the difference between
is the transaction benefit b S .

4 It is easy to verify that when there is no MI among merchants, usage externality does not exist.

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2.2 Tourist test is invalid

Thus far, we show the usage externality and over-provision of card service exist when
merchants are homogeneous as in Rochet and Tirole (2002), Vickers (2005) and Rochet
and Tirole (2011). Wright (2012) formalizes the “gut feeling” of over provision of card
services when sellers are heterogeneous. However, these literature focus on the open
systems before IPOs. If the mechanism in determining the fees alters post IPOs, the
analysis of these literature may not be applicable. Yet, whether tourist test is valid in a
closed system is still not investigated. In what follows, we show the test is an invalid
approach to regulate merchant fees in a closed system. More generally, this result
could also be applied for an open system, hinging on how the practitioners regard
mechanism in determination of fees. Consider the following optimizing problems of
platforms, including monopoly, association, regulator, and social planner.
 b¯B  b¯S
Monopoly: max π = ( p B + p S − c) ∧ ∧ dG S (b S ) dG B (b B ) (4)
p B , pS bB bS
 b¯B  b¯S
Association: max T = ∧ ∧ dG S (b S ) dG B (b B ) s.t. p B + p S ≥ c
p B , pS bB bS
(5)
 b¯B  b¯S
Regulator : max W = ∧ ∧ (b B + b S − c) dG S (b S ) dG B (b B ) s.t. p B + p S ≥ c
p B , pS bB bS
(6)

 b¯B  b¯S
Social planner : max W = ∧ ∧ (b B + b S − c) dG S (b S ) dG B (b B )
p B , pS bB bS
(7)

The choice variables are the customer fee p B and merchant fee p S . The marginal
∧ ∧
users are b B = p B , b S = p S when merchant fees is capped by applying tourist test
∧ ∧
such that MI is curbed, and b B = p B , b S = p S − v B ( p B ) when merchant fees
are unregulated. The regulator and association are bounded by a break even budget
constraint p B + p S ≥ c. The break even budget constraint of regulator reflects the fact
that regulators do not subsidize the platforms. Table 1 shows the calibration results
assuming that bi are drawn from uniform distribution over (0, 1). Regularity conditions
and calculations are shown in the “Appendix”. It is worth mentioning that the total
cost should be less than the total transaction benefits or c < 2.
The calibration results of Table 1 suggest that tourist test is an invalid approach
to regulate the merchant fees. In particular, when the platform maximizes profits,
regulating merchant fees by the test decreases social welfare level from 19 (monopoly
2
a) to 27 (monopoly b);5 when the platform maximizes transaction volume subject
5 In what follows we omit the positive scalar (2 − c)3 .

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Table 1 Welfare comparison under the NSR

Governance Margins Prices Welfare Transaction Profit

∧ ∧
bB bS pB pS

Monopoly (a) 2c−1 c+1 2c−1 1 (2 − c)3 2 (2 − c)2 2 3

3 3 3 1 9 9 27 (2 − c)
Monopoly (b) c+1 c+1 c+1 c+1 2 3 1 (2 − c)2 1 (2 − c)3
3 3 3 3 27 (2 − c) 9 27
Association (a) c−1 c c−1 1 1 (2 − c)3 1 (2 − c)2 0
2 8 2
Association (b) c c c c 1 (2 − c)3 1 (2 − c)2 0
2 2 2 2 8 4
Regulator (a) 2c−1 2c−1 2c−1 c+1 4 3 4 (2 − c)2
3 3 3 3 27 (2 − c) 9 0
Regulator (b) c c c c 1 (2 − c)3 1 (2 − c)2 0
2 2 2 2 8 4
Social planner (a) 2c−1 2c−1 2c−1 c+1 4 3 4 (2 − c)2
3 3 3 3 27 (2 − c) 9 0
Social planner (b) 2c−1 2c−1 2c−1 2c−1 4 3 4 (2 − c)2 −4 (2 − c)3
3 3 3 3 27 (2 − c) 9 27
Simulated by the authors. Cases (a) are the results when no regulation is imposed and MI is not curbed, and
“Must-take” argument prevails; and Cases (b) are the results when tourist test is applied and MI is curbed

to a break even constraint, regulating merchant fees by the test do not change the
level of social welfare 18 (association a and b); when the platform maximizes social
4
welfare, regulating merchant fees by the test decreases social welfare level from 27
(regulator a) to 18 (regulator b) with a break even constraint, and does not change the
4
level of social welfare 27 without a break even constraint (social planner a and b).
To sum up, application of tourist test would either decrease, or generate no effect on
social welfare. Then, a natural question to ask is why capping merchant fees by the
test decreases social welfare in a closed system with heterogeneous merchants. Tourist
test are supposed to be used to curb the usage externality, and the social welfare should
be improved after the test is applied. Why have we found an opposite result?
To answer the question, an unusual fact in a typical two-sided market(when both
consumers and merchants are heterogeneous) should be noted: the unconstrained wel-
fare maximization involves some transactions with the total price fall short of the cost.
This can be shown by the solution to the unconstrained welfare maximization prob-
lem (social planner b) in Table 1 where p B + p S < c. Thus, the card service is under
provided in the cases of regulator (b) and association (b) with the transaction volumes
16 4
4 compared to social optimal level 9 . Allowing MI increases the transaction volume
from 4 to 9 for the regulator, and from 41 to 21 for the association. Alternatively, MI
1 4

increases the card usage, corrects the under-provision of card service in the case of
regulator, and therefore increases the welfare. In the case of association, MI brings too
much card usage beyond social optimal level 49 . The increase in transaction volume
from 41 to 49 increases the welfare level, but the increase in transaction from 49 to 21
decreases welfare level. The total effect is zero in the calibration. Therefore, we see
the welfare of associations remains the same after curbing MI.
Our conclusion is mainly drawn from the case of monopoly, which mimics the
reality of AmEx. For the monopoly (b), the transaction volume 19 is well below the

6 When it comes to transaction volume, we omit the positive scalar (2 − c)2 .

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social optimal level 49 . The presence of MI corrects part of under-provision to 29 . It

yields the welfare under monopoly (a) is higher than the level under monopoly (b).
Hence, when the platform maximize profit, the card service is often under provided
despite the presence of MI and that the fee structure is biased against merchants. The
elimination of MI often decreases the transaction volume further below social optimal
level decreasing social welfare. This is why we have found that using tourist test
to regulate the merchant fees often leads to a decrease of social welfare in a closed
system. The results are formally concluded in the following proposition.
Proposition 1 When a monopolistic platform serves heterogeneous consumers and
merchants, and the NSR rule is in place, the application of tourist test will reduce
transaction volume further below social optimal level and leads to a decrease in
social welfare.
Likewise, the above logic would not change in an open system post IPOs. As the
model in Carlton and Winter (2018), we consider the problem of credit card company
in the open system according to the following model:
   
∧ ∧
max π = ( f I + f A − c) D B b B D S b S
fI , f A, a
∧ ∧
s.t. b B = f I − a + m; b S = f A + a − v B ( f I − a) i f unr egulated
∧ ∧
s.t. b B = f I − a + m; b S = f A + a i f apply tourist test

where f I and f A are network service fee charged by the credit card company onto
issuing and acquiring banks respectively. a is the interchange fee paid by acquiring
banks to the issuing banks. m is the constant markup among issuing banks. In effect,
the above model is the same as the monopoly cases for a closed system except for
the distortion induced by market power of issuing banks. Taking this distortion into
account, the card service is further under provided compared to the case for a closed
system. The presence of MI will correct part of the under-provision. The elimination
of MI by tourist test will also further decrease card provision and welfare in an open
system. The conclusion is summarized as follows:
Proposition 2 When a monopolistic platform serves heterogeneous consumers and
merchants via issuing and acquiring banks under the NSR clause, the application of
tourist test will reduce transaction volume further below social optimal level and leads
to a decrease in social welfare.
In effect, the setting in our model for a closed system is similar to the model in
Wright (2012) for an open system. In both models, the credit card company is profit
maximizing, consumers and merchants are heterogeneous, and merchant internaliza-
tion exists. The two more interest parties – issuing banks with market powers and
perfect competitive acquiring banks – would not alter the result if the pass-through
rate of IF is constant or the margins of issuing banks are constant. Why do the two
models yield different policy implications? The key difference between the two mod-
els is that there is not a “hook” between the fees borne by the both end users in our

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model. However, in Wright’s model, merchant fees and customer fees are “hooked
up” by an IF. Visa or MasterCard can only manipulate the IF to reallocate the fee
structure, and fee level is determined passively, hinging on the pass-through rate of
two groups of banks. AmEx and Visa or MasterCard in our models have one more
degree of freedom in setting the optimal fee level and structure. Therefore, we have
found a different policy implication.

3 Policy implication

3.1 Under NSR

If the regulation of merchant fees by tourist test is unwarranted, what should be the
new benchmark? Tourist test has been adopted in European Union. Jonker and Plooij
(2013) finds that the tourist test interchange fees increase from 0.2% of transaction
value in 2002 to 0.5% in 2009 in Netherlands. This is because the labor cost of cash
payments increases, and costs of card payments decreases due to technology progress.
The cost-based approach has also been applied to the credit card in Australia and debit
card in the U.S. However, there is no theory to support the cost-based regulation of
merchant fees to a closed system, and merely a few to an open system. In what follows,
we provide a theory to support cost-based approach to regulate the merchant fees in
the closed system and open systems post IPOs.
Based on the results of calibration in this paper, we find a cap on total fee level will
improve social welfare. If we lower the price level in the case of monopoly (a), the
transaction volume will increase and hence the welfare. In particular, we first solve
   
∧ ∧
max π = ( p B + p S − c) D B b B D S b S
p B , pS
∧ ∧
s.t. b B = p B ; b S = p S − v B ( p B )
s.t. p B + p S = k

and evaluate the welfare level at the equilibrium. Then, we obtain the welfare as
a function of k, or W = W (k). Finally, we find the k at which the highest level
of welfare is achieved. With uniform distribution, the solution is given by p B =
∧ ∧
k − 1, p S = 1, b B = k − 1, b S = 2k , and the welfare level is given by W (k) =

4 (2 − k) 1 − 2c + 2 . The highest welfare level 243 (2 − c) is achieved at k =
1 2 3k 32 3
2+8c
9 > c. The new welfare is still lower than the social optimal level 27 4
(2 − c)3 ,
but improved compared to the case without regulation 19 (2 − c)3 . The result suggests
that the regulator should cap the price level to a level higher than the cost. To what
extent the cap is higher than the cost depends on the relative magnitude of the sum
of highest transaction benefits (here is 2) and of the cost, because the discrepancy is
k − c = 2−c9 .
As the solution to merchant fee p S = 1 is a constant in the uniform case regardless
of k, we resort to the generalized Pareto distribution (GPD) to find out a more general
solution of the merchant fees. If the transaction benefits are drawn from the GPD

123
 H. Tan


2 2c+2ce+e2 2c(1+e)2 −e(4+3e)
over (0, 1), the solution is given by k = , pB = , pS =
(2+e) 2 (2+e)2
 ∧ ∧
e(4+5e)−2c −1+e2
, bB = p B and = 2k . All the calculation is shown in the
bS
(2+e)2
“Appendix”. The result indicates that the proper level of merchant fees and customer
fees depend on the total costs of networks and the market elasticity. Nevertheless,
the realized welfare is much improved compared to the level achieved by tourist test
approach. Therefore, we have the following:

Proposition 3 When a monopolistic platform serves heterogeneous consumers and

merchants under the NSR clause, the optimal fee setting is to cap the profit maximizing
total fee at a level where social welfare is maximized, and the optimal cap hinges on
the costs of networks and market elasticity. If the transaction benefits are drawn from

2 2c+2ce+e2
generalized Pareto distribution over (0, 1), the threshold is given by k = .
(2+e)2

For an open payment system, the model is given as follows. Although three fees are
to be set, what matters is the merchant fee and customer fee borne by the two end user
groups. So, we can solve this problem in the same way as that for a closed system. The
presence of issuing banks would not change the property of policy implication. The
profit maximizing platform will ultimately determine the fee structure and levels borne
by both group of end users, given the competition among issuing banks. Compared
to the model for the closed system, we only add a term standing for the margin of
issuing banks. The analysis remains the same, which suggests that the regulation for
open systems should also be according to costs of networks and banks.
   
∧ ∧
max π = ( f I + f A − c) D B b B D S b S
fI , f A, a
∧ ∧
s.t. b B = f I − a + m; b S = f A + a − v B ( f I − a)
s.t. f I + f A = 7k

3.2 Under surcharging

Under surcharging, Proposition 1 in Wright (2003) shows that a local monopoly mer-
chant surcharges excessively, and the rate of surcharge is give by
   
∧ ∧
s = p S − b S + G B b B /g B b B (8)

Proposition 6 in Rochet and Tirole (2002) shows that Hotelling merchants perfectly
pass through the merchant fees to consumers and the rate of surcharge is given by7

s = pS − bS (9)

7 Proposition 1 in Rochet and Tirole (2011) shows that perfectly competitive merchants also perfectly pass
through the merchant fees.

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The regulation of merchant fees in credit card markets

The platform’s problem becomes

 b̄ S  b̄ B
max π = ( p − c) ∧ ∧ dG B (b B ) dG S (b S ) (10)
p bS bB

∧ ∧ ∧
where b S = b S , because all merchants accept the card. b B is given by b B = p − b S if
∧ ∧ ∧
merchants perfectly pass through, and by b B = p−b S +G B b B /g B b B if merchants
impose surcharges successively. p is the price level equal to p B + p S . The marginal
consumer is so because consumers use the card if b B ≥ p B + s. In the platform’s
problem, we can see the customer fee and merchant fee are always go together. It
indicates the price structure is irrelevant, and only price level matters (as the neutrality
of structure in Gans and King 2003). To limit the monopoly platform’s exercise of
market power, the regulator only need to control the price level. It is possible and easy
to show that the optimal price level depend both on the total costs of banks and on the
consumer’s elasticity of demand under surcharging.

4 Conclusion

During the past decade, the investigations of credit card markets are switched from
a model where merchants are homogeneous as in Rochet and Tirole (2002), Rochet
and Tirole (2011), to a model where merchants are heterogeneous as in Wright (2004,
2012). This process is accompanied and motivated by the development of literature
for the general two-sided market (e.g. Rochet and Tirole 2003; Armstrong 2006).
In either case, the credit card companies are modeled as representative entities to
maximize the collective profit of banks. If the markup of issuing banks is constant,
the profit maximization is equivalent to maximize the transaction volume. The credit
card companies, as Visa or MasterCard, are deemed as not-for-profit associations,
and play no real role in an economic sense. This setting stands exactly the situation
before the IPOs. After both Visa and MasterCard went to public in 2008 and 2006
respectively, they became for profit companies. On top of IFs, they have two more
pricing instruments to collect their own profits. So, we believe the structure change due
to IPOs urges a second thought regarding the mechanism to setting the fee structure
and fee level in the open system. Although some scholars are against our updated
views in fee setting mechanism, we shall provide a different opinion or understanding
on this issue. Not to mention that this paper is the first literature focusing on the
regulatory issue in a closed system, which provides a model to discuss and understand
the optimality of fee setting. Our finding suggests that the regulatory undertakings
should be turned back to the cost-based approach, which was initiated in Baxter (1983).
Admittedly, we merely focus on the case of single platform. Further work could discuss
the very issue in the case with competing platforms.

Appendix

See Table 2.

123
123

Table 2 The comparison with literature

Platform Determination of fees Merchant type Merchant Application in practice Policy implication
maximization internalization

Baxter (1983) Volume IF determines the fee Homogeneous No Open systems before IPOs Cost-based approach
structure
Schmalensee Joint profit of issuers Same as in Wright (2012) Heterogeneous No Open systems before IPOs No clear implication
(2002) and acquirers
RT (2011) Maximize profits for Same as in Wright (2012) Homogeneous Yes Open systems before IPOs Tourist test
Homo-case issuing banks
RT (2011) Volume Same as in Wright (2012) Heterogeneous Yes Open systems before IPOs No clear implication
Heter-case
Wright (2012) Joint profit of issuers IF is the only tool and Heterogeneous Yes Open systems before IPOs Tourist test
and acquirers determines fee structure;
fee level is passively
determined
Bourguignon Volume (competitive IF is the only tool and Homogeneous Yes Open systems before IPOs If surcharges free IF; if
et al. (2019) issuers and acquirers) determines only fee otherwise, tourist test
structure; fee level is
constant
This paper Profit IF and network service fees Heterogeneous Yes Closed systems and open Cost-based approach
for open systems; merchant systems post IPOs
and customer fee for closed
systems
In Baxter (1983), issuing and acquiring banks are perfectly competitive; And the IF does not affect the fee level, because the fee level remains constant and equals to the
cost. RT (2011) stands for the Rochet and Tirole (2011). In the Homo-case of RT (2011), the platform maximizes the profit for issuing banks, and itself plays no real role
in the model. In the Heter-case of RT (2011), the platform maximizes volume because the issuing banks have constant margins in the model. In Wright (2012), the platform
maximizes profits on behalf of all the banks; in cases with constant margins of banks, the platform maximize transaction volume

H. Tan
The regulation of merchant fees in credit card markets

Calculation for Table 1

In what follows, we calibrate the model assuming bi is drawn from uniform dis-
tribution between [0, 1]. We also assume 1 ≤ c ≤ 2. c ≥ 1 ensures that there is
no negative solutions in the results. c ≤ 2 ensures that total cost is also no greater
than the maximum sum of transaction benefits. The user surplus of consumers is
v B ( p B ) = E (b B | b B ≥ p B ) − p B . With uniform distribution, it is equal to 1−2p B .
All the second order conditions for the following solutions are guaranteed by increas-
ing hazard rates—a property that uniform distributions have. Corner solutions are also
omitted. The profit, transaction volume and welfare with uniform distributions are
given by

  
∧ ∧
π = ( p B + p S − c) 1 − b B 1 − bS
  
∧ ∧
T = 1 − bB 1 − bS
   
1 ∧ ∧ ∧ ∧
W = 1 − bB 1 − bS 2 − 2c + b B + b S
2

Therefore, the optimizing problem are given by

Monopoly (a)

  
∧ ∧
max π = ( p B + p S − c) 1 − b B 1 − bS
p B pS
∧ ∧ 1 − pB
s.t. b B = p B ; b S = p S −
2

Monopoly (b)

  
∧ ∧
max π = ( p B + p S − c) 1 − b B 1 − bS
p B pS
∧ ∧
s.t. b B = p B ; b S = p S

Association (a)

  
∧ ∧
max T = 1 − b B 1 − bS
p B pS
∧ ∧ 1 − pB
s.t. b B = p B ; b S = p S − ; p B + pS = c
2

123
 H. Tan

Association (b)
  
∧ ∧
max T = 1 − b B 1 − bS
p B pS
∧ ∧
s.t. b B = p B ; b S = p S ; p B + p S = c

Regulator (a)
   
1 ∧ ∧ ∧ ∧
max W = 1 − bB 1 − bS 2 − 2c + b B + b S
p B pS 2
∧ ∧ 1 − pB
s.t. b B = p B ; b S = p S − ; p B + pS = c
2

Regulator (b)
   
1 ∧ ∧ ∧ ∧
max W = 1 − bB 1 − bS 2 − 2c + b B + b S
p B pS 2
∧ ∧
s.t. b B = p B ; b S = p S ; p B + p S = c

Social planner (a)

   
1 ∧ ∧ ∧ ∧
max W = 1 − bB 1 − bS 2 − 2c + b B + b S
∧ ∧ 2
b B , bS
∧ ∧ 1 − pB
wher e p B = b B ; p S = b S +
2

Social planner (b)

   
1 ∧ ∧ ∧ ∧
max W = 1 − bB 1 − bS 2 − 2c + b B + b S
∧ ∧ 2
b B , bS

Solving all the problems yields results in Table 1.

Model for policy implication

Uniform distribution

The monopoly (b) solves

  
∧ ∧
max π = ( p B + p S − c) 1 − b B 1 − bS
p B pS
∧ ∧ 1 − pB
s.t. b B = p B ; b S = p S − ; p B + pS = k
2

123
The regulation of merchant fees in credit card markets

Or

1
max π = (k − c) (1 − p B ) (3 − 2k + p B )
pB 2

∧ ∧
Solving the problem yields p B = k − 1, p S = 1, b B = k − 1, b S = 2, π
k
=
2 (k − c) (2 − k) , T = (2 − k) and the welfare is
1 2 2

 
1 3
W = (2 − k)2 1 − 2c + k
4 2

Solving ddk
W
= 0 yields k = 2+8c
9 and W |k= 2+8c = 32
243 (2 − c)3 .
9

Generalized Pareto distribution

Generally, the GPD is given by

 1
e (b − μ) e
c.d. f . F (b) = 1 − 1 −
δ

  1
1 e e (b − μ) e −1
p.d. f . f (b) = − 1−
e δ δ

where e > 0, μ < b < δe . The quasi-demand is given by

 1
e (b − μ) e
D (b) = 1 − F (b) = 1 −
δ

To calculate the average net consumer surplus, we have

 b̄  b̄
    ∧ bd F (b) ∧ D (b) db
∧ ∧ ∧ ∧
v b = E b | b ≥ b − b = b − b = b ∧
b̄
∧ d F (b) D b
b

Plugging into the GPD functions, we have

 
 b̄  b̄
1 ∧
  ∧ D (b) db ∧ 1− e(b−μ) e
db δ−e b−μ
∧ δ
v b = b   = b   =
∧ ∧ 1+e
D b D b

123
 H. Tan

For simplicity, let μ = 0, δe = 1. We have

1
c.d. f . F (b) = 1 − (1 − b) e
1 1
p.d. f . f (b) = (1 − b) e −1
e
   1
∧ ∧ e
D b = 1− 1−b
 
∧
  e 1−b
∧
v b =
1+e

Therefore, the regulation problem becomes

 1  1
∧ e ∧ e
max π = ( p B + p S − c) 1 − b B 1 − bS
p B pS
∧ ∧ e (1 − p B )
s.t. b B = p B ; b S = p S − ; p B + pS = k
1+e

Or

 1
1 1 e e
max π = (k − c) (1 − (k − p S )) e 1 − pS + (1 − (k − p S ))
pB 2 1+e

∧ ∧
Solving the problem yields p B = k−2e+ek
2 , pS = 2e+k−ek
2 , bB = k−2e+ek
2 , bS = k
2
and the welfare is

 1  1 1 1 1
W = ∧ ∧ 2
(1 − b B ) e −1 (1 − b S ) e −1 (b B + b S − c) db S db B
bB bS e
 1  1  
1 ∧ e ∧ e ∧ ∧
W = 1 − bB 1 − bS 2e − c (1 + e) + b B + b S
1+e

∧ ∧
Plugging into b B = k−2e+ek
2 , bS = k2 , we have

−(2+e)
2 e 1 1
W = (1 + e) e (−2 + k) e (2k − 2c (1 + e) + e (2 + k))
1+e

123
The regulation of merchant fees in credit card markets


2 2c+2ce+e2
Solving ddk
W
= 0 yields k = . By plugging k into p B = k−2e+ek
, pS =
(2+e)2 2
2e+k−ek
2 , we finally have the customer fee and merchant fee given as follows:

2c (1 + e)2 − e (4 + 3e)
pB =
(2 + e)2

e (4 + 5e) − 2c −1 + e2
pS =
(2 + e)2

Notably, all calculation rules out the corner solutions and the Mathematica code is
given by the supplement material.

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