A Puzzle of Card Payment Pricing: Why Are Merchants Still Accepting Card Payments?

This paper presents models that explain why merchants accept payment cards even when the fees they face exceed the transactional benefits they receive from a card transaction. Such merchant behaviors can be explained by competition among merchants and/or the effectiveness of the merchant’s card acceptance in shifting cardholders’ demand for goods upward. The prevalent assumption used in payment card literature—merchants accept cards only when their transactional benefits are higher than the fees they pay— holds only for a monopoly merchant who faces an inelastic consumer demand. A card network that wants all merchants in a given industry to accept cards sets a lower merchant fee initially and then gradually increases it to the highest possible level, which may be higher than the sum of the merchant’s transactional benefit and the merchant’s initial margin without cards. Such merchant fees potentially create inequality between cardholders and non-cardholders. Fumiko Hayashi is a senior economist in the Payments System Research Department, Federal Reserve Bank of Kansas City, 925 Grand Boulevard, Kansas City, MO, 64198, e-mail:[email protected], Phone: (816) 8816851. The views expressed in this article are those of the author and do not necessarily reflect those of the Federal Reserve Bank of Kansas City or the Federal Reserve System.