Interchange Fees in Payment Networks: Implications for Prices, Profits, and Welfare

Abstract

This paper develops a two-sided model of the payment card market, incorporating elastic consumer demand, merchant and network market power, ad valorem interchange fees, cardholder rewards, and cash as an alternative payment method. Building on principles from public finance, we introduce the concept of a credit card tax—an endogenous wedge between consumer and merchant prices determined by three key factors: (i) interchange fees, (ii) rewards, and (iii) the rate of credit card adoption. We analyze how this tax influences equilibrium prices, platform profits, and social welfare. Our results demonstrate that when consumer demand elasticity is low, capping interchange fees can increase equilibrium rewards and improve consumer welfare for all buyers, including those using cash. Even in cases where rewards decline, the net consumer benefit may remain positive. Furthermore, we establish conditions under which interchange fee caps enhance allocative efficiency and promote desirable payment choice. The analysis provides novel theoretical insights for the regulation of twosided payment markets.