Consumer Choice and Merchant Acceptance of Payment Media (REVISED, September 2009)

The authors study the ability of banks and merchants to influence the consumer's payment instrument choice. Consumers participate in payment card networks to insure themselves against three types of shocks income, theft and their merchant match. Merchants choose which payment instruments to accept based on their production costs and increased profit opportunities. The authors' key results can be summarized as follows. The structure of prices is determined by the level of the bank^s cost to provide payment services including the level of aggregate credit loss, the probability of theft, and the timing of income flows. They also identify equilibria where the bank finds it profitable to offer one or both payment cards. Their model predicts that when merchants are restricted to charging a uniform price for goods that they sell, the bank benefits while consumers and merchants are worse off. Finally, we compare welfare-maximizing price structures to those that result from the bank's profit-maximizing price structure.