Interchange Fees in Payment Networks: Implications for Prices, Profits, and Welfare

In a two-sided model of the payment card market, we introduce a specific form of elastic demand (constant elasticity), merchant market power, ad valorem fees, and cash as an alternative. We derive the “credit card tax,” consisting of an endogenously determined interchange fee and any rewards paid. We characterize how this tax influences prices, profits, and welfare. We also examine how these relationships vary under different assumptions about the elasticity of demand, merchant market power, and differentiation between cash and credit. Under the assumptions of our model, by endogenizing the credit card tax, we show that capping interchange fees benefits all consumers by lowering these taxes, even if rewards decrease.