This week’s decision by Congress that the Federal Reserve may regulate the “swipe fees” merchants must pay banks on sales paid via debit cards provides a mother lode of examples for microeconomics teachers like me.
On the surface, the fight was between two different business groups – retail merchants and large banks – over who captures which benefits of a specific payment technology.
Merchants like the extra sales they get by accepting plastic but claim the fees are too high. The other side retorts that limits on fees are undue government interference into private business and that if fees are arbitrarily lowered, other bank charges will have to be raised to make up the difference.
One way to look at this fight is as an example of “rent seeking.” This is when a group uses political influence to get laws or regulations changed to the group’s own financial benefit. (The word “rent” for financial benefit is as used by David Ricardo, the 19th century British economist who pioneered modern finance and trade theory.) Rent seeking involves using resources to wrest away value created by someone else rather than using them to create value yourself.
In this case, the banks see themselves as victims of retailers who are using their political power to break the sanctity of long-established private contracts that set terms under which merchants can accept payments via credit or debit cards.
Libertarians largely side with the banks and credit card firms, accepting the argument that Fed regulation of fees is government interference in voluntary private exchange. Such interference inherently will waste resources and make society worse off compared to what would happen in an unhampered free market.
The problem is that libertarians don’t have good answers for what to do when the necessary conditions for a free market to reach a societal optimum don’t exist. These conditions include having many buyers, many sellers, no monopoly power, no external costs or benefits, and good information available to all parties.
Consensus economic theory holds that when there is monopoly power, simply leaving things up to unregulated interactions between buyers and sellers does not result in an ideal or efficient outcome.
There certainly is considerable monopoly power in electronic payments. The large banks and the major credit card firms, Visa and Mastercard, have dominant market power. Just as an individual family in St. Paul needs electricity and gas but does not have bargaining clout relative to Xcel Energy, a small merchant needs to be able to accept credit and debit cards, but has little power compared to the banks and card issuers.
When there is monopoly power, two government responses may improve outcomes. One is to break up the monopoly, as we did with Standard Oil and International Harvester a century ago. Another alternative is to regulate the fees the monopolistic firms may charge. That, in effect, is what Congress decided to do this week.
This is the better alternative in cases of “natural monopoly.” That is when there are economies of scale in providing a good or service, as in utilities like gas and electricity. It is cheaper for society to have one company with one set of pipes than two or more companies that would have to duplicate their very costly physical plants to achieve competition in serving residences.
Moreover, once one firm is in place, without regulation, it could use predatory pricing to keep any other firm from getting started.
The total cost to society of providing the gas would be higher with two or more small firms compared with one monopolistic firm. Letting a firm have a monopoly, but regulating what it charges, is the best alternative.
Some industry experts argue that electronic payments are just such a natural monopoly like a utility: that breaking up Visa and Mastercard would increase overall costs. So if we are not going to let these companies, and large banks they work with, set the fees, we need to regulate. But others see room to break up both credit card firms and banks with excessive market share.
One little-discussed option is to regulate the terms of contract between electronic payments providers and merchants. Merchants commonly must agree not to offer discounts to customers who pay cash. If they don’t like that requirement, they must forgo access to electronic payments. And thus, cash customers pay more than they otherwise would to cross-subsidize the fees that merchants bear on debit and credit sales. Government could, however, outlaw such no-cash-discount clauses just as they outlawed analogous practices by railroads in the 1800s.
Or, again following the history of railroad monopolies, we could wait for technology to erode existing monopoly privilege. Railroads had great market power in the 1880s because the next best substitute, horses and wagons, were much more expensive per ton mile. But after paved roads and internal combustion engines changed that, railroads’ power dwindled. We correctly decided during the Carter Administration that it was better to abolish the regulation of transportation that we had erected a century earlier.
Wireless technology similarly destroyed monopoly power in telephony. And new payment technologies in the post-PC world, based on “cloud computing” and handheld devices, may well relegate existing payments monopolies to the trashcan of history.
In the meantime, Fed regulation of swipe fees is probably the least-bad alternative.
© 2011 Edward Lotterman
Chanarambie Consulting, Inc.