The Failure of Price Competition: Credit Cards

There is an ongoing debate about the credit card industry regarding how effective competition has been at reducing prices. Some experts argue that intense competition is clearly evident and leads to low prices that contain no excess profit. However, other experts find evidence both in price data and in market concentration that competition has failed. A model is presented here showing that if there are temporarily excess profits in a competitive market with a structure resembling that of the credit card market, firms seeking to increase demand for their particular product may lead to costs that rise to meet prices rather than prices that fall to match costs. The intuition of the model is that firms can either reduce prices or increase mail solicitations while holding prices constant to expand market share. It is entirely possible under reasonable conditions for market share expansion through increased solicitation to be the most profitable option. If the market were perfect except for this information cost, then it would still be socially optimal for issuers to spend money on marketing rather than reducing prices because when it is the most profitable course of action, marketing also informs consumers of products that are beneficial to them leading to net gains for issuers and consumers combined that are larger than for price reductions. However, in the market for credit cards, there are other potential imperfections. For example, there may be systematic errors caused by known behavioral biases in borrower sensitivity to various pricing attributes. Furthermore, it is shown here statistically using historical response rate and mail volume data that an externality exists when an individual issuer decides to increase mail volume. These factors combine can lead to a situation where competition for market share does not lead to meaningful price reduction and does not create a significant benefit for consumers. In addition to exploring a theoretical model, actual historical data from the credit card industry in pricing, mail volume, and costs are used to demonstrate that the industry is consistent with the scenario shown in the model. More specifically, the credit card industry does indeed appear to have had excess profits, and while the profits have made the market subject to intense competition among the leading issuers, the competition has been focused on expansion through marketing rather than expansion through true price reductions (though some price “signals” have declined). While the focus here is on the credit card industry, it is likely that analogous situations can arise in other industries with some structural similarities. Discussion Draft: Not for citation or quotation without permission The Failure of Price Competition: Credit Cards Josh Frank