Consumer Choice and Merchant Acceptance of Payment Media: A Unified Theory

In this article, we present a theoretical model to study the ability of banks to influence the consumer’s payment instrument choice. Unlike most two-sided market models where benefits are exogenous, we explicitly consider how consumers’ utility and merchants’ profits increase from additional sales resulting from greater security and access to credit lines. Consumers participate in payment card networks to insure themselves from three types of shocks— income, theft, and their merchant match. Merchants choose which payment instruments to accept based on their production costs and are categorized as cash only, debit card and cash, or full acceptance. The model considers the merchants’ ability to pass on payment processing costs to consumers in the form of higher goods prices. Our key results can be summarized as follows. The structure of prices, i.e. what share of the total price of the payment service is paid by consumers and merchants, is determined by the level of the bank’s cost to provide payment services. Furthermore, the level of aggregate credit loss impacts the credit card price structure. In addition, we identify equilibria where the bank finds it profitable to offer one or both payment cards simultaneously. Finally, one price policies benefit the bank when it supplies both payment cards and credit card transactions are more profitable.