Platform Competition in Two-Sided Markets: The Case of Payment Networks

1. Platform Competition in Two-Sided Markets: The Case of Payment Networks Sujit Chakravorti Federal Reserve Bank of Chicago Roberto Roson Universita’ Ca Foscari di Venezia The Economics of Payments Federal Reserve Bank of Atlanta April 1, 2004 The views expressed are not necessarily those of the Federal Reserve Bank of Chicago or the Federal Reserve System

2. Two-Sided Markets • Markets where a single or multiple providers serve two distinct types of end-users where one type of end-user benefits from greater usage from the other type • A market is said to be two-sided if a change in the price structure at a given price level affects the volume of transactions (Rochet and Tirole, 2004) • Examples: yellow pages (advertisers and users), Adobe Acrobat (creators of documents and readers), and video games (developers and users)

3. Retail Payment Networks • The market for payment services is an example of a two-sided market with two distinct end-users—consumers and merchants • Merchants seldom charge different prices based on the type of payment instrument used • Policymakers concerned with the effects of competition on price level and price structure • U.S. vs Visa (2001) • The Walmart Case (originally filed in 1996 and settled in 2003, class action of around 5 million merchants) • Reserve Bank of Australia regulations on credit card markets

4. Existing Literature • Modeling of a four-party payment network • Baxter (1983) • Single payment platform • Chakravorti and To (2003) • Gans and King (2003) • Rochet and Tirole (2002) • Schmalensee (2002) • Schwartz and Vincent (2002) • Wright (various) • Multiple payment platforms • Guthrie and Wright (2003) • Manenti and Somma (2003) • Rochet and Tirole (2003)

5. Key Differences with the Literature • Consider network-specific benefits to consumers and merchants, hcand hm, respectively, where hc isdrawn from the interval [0,] and hm is drawn from the interval [0,] • Consider the effects of competition on both price level and price structure • Consumers pay fixed fees, f c, to participate on the network whereas merchants pay per-transaction fees, f m • Do not explicitly consider interchange fees

6. The Model • 3 Types of agents • Consumers (continuum of consumers) • Each consumer buys one good from every merchant • Choose among three payment instruments • Assigned benefits from participating on each payment network • Pays fixed fees to join a payment network (only joins one) • The consumer’s utility function is:

7. The Model • Merchants (continuum of merchants) • Each merchant sells one good to each consumer • Choose to accept one to three payment instruments • Assigned benefits for accepting each network’s payment instrument • Pays per-transaction fees to join one or both payment networks • The merchant’s utility function is:

8. The Model • 2 Payment Networks • Face fixed consumer cost, g, and per-transaction merchant cost c • Set f c and f m to maximize:

9. Assuming uniform distributions for consumer and merchant benefits, we diagram consumer demand as: C A E D B

10. Demand Functions where:

11. Timeline • Consumers and merchants learn their level of benefit for each network • Networks maximize profits, by choosing f c and f m • Merchants decide which payment forms to accept • Consumers decide which payment option to purchase • Transactions are realized

12. Results Proposition 1: Profit maximizing fees can be determined on the basis of the “modified Rochet-Tirole rule,”

13. Proposition 2: Prices in duopoly are always lower than in monopoly, so that competition is always welfare enhancing for both consumers and merchants.

14. Proposition 3: In the symmetric market, there is more competitive pressure on the consumer side (higher marginal profits from a fee reduction), if for the monopolistic equilibrium:

15. Corollary 1: A sufficient condition for the consumer fees falling less than the merchant fees under competition is:

16. Simulations

17. Consider Asymmetric Competition • Consider two networks that have different cost structures and different ranges of benefits • As before, competition increases welfare of both consumers and merchants • However, the price structure is different for the cartel versus duopolistic competition

18. Conclusion • Consider networks that offer differentiated payment products • Competition improves consumer and merchant welfare by reducing the price level for symmetric and asymmetric competition • We explore whether the monopolistic and duopolistic price structures for a given price level are efficient