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

This paper develops a two-sided model of the payment card market with elastic consumer demand, merchant and network market power, ad valorem interchange fees, cardholder rewards and cash as an alternative payment method. Drawing on insights from public finance, we define a credit card tax—an endogenous wedge between consumer and merchant prices generated by interchange fees, rewards, and credit card adoption. We show how this tax affects equilibrium prices, platform profits and welfare. Our analysis yields a novel and policy-relevant result: Contrary to conventional wisdom, capping interchange fees can increase equilibrium rewards when consumer demand is relatively inelastic. This, in turn, raises credit card adoption and intensifies cross-subsidization, benefiting card users, potentially at the expense of cash users. By contrast, when demand is more elastic, fee caps reduce rewards and card usage, improving outcomes for both groups. We also characterize the conditions under which interchange fee caps enhance allocative efficiency and encourage socially desirable payment choices. Overall, the paper offers new theoretical insights into the regulation of two-sided payment markets.