A Theory of Credit Cards

Recent U.S. antitrust litigation and concerns by regulatory authorities over fees in Australia and the European Union have questioned the nature of various bilateral relationships and associated fees underlying credit card transactions. A two-period model is constructed to study the interactions among consumers, merchants, and a card issuer. The model yields the following results. First, if the issuer’s cost of funds is not too high and the merchant’s profit margin is sufficiently high, a credit card equilibrium exists. Second, the issuer’s ability to charge higher merchant discount fees depends on the number of customers gained when credit cards are accepted. Thus, credit cards exhibit characteristics of network goods. Third, each merchant faces a prisoner’s dilemma where each independently chooses to accept credit cards, however all merchants’ two-period profits are reduced because of intertemporal business stealing across industries.