Playing Our Cards Wrong: Behavioral and Competitive Challenges in U.S. Payments Markets

Abstract

Last year, Americans spent $2.4 trillion dollars on payment cards through roughly 75 billion annual card transactions. Despite this, few understand how the U.S. payments system works. Behind each simple card swipe lies a complicated series of market dynamics, financial institutions, network technologies, and banking systems. This thesis argues that despite the ubiquity and ease with which the U.S. payments system operates, it rests flawed due to competitive and behavioral challenges. The result is a system deeply rooted in modern society in need of explanation and modification. The thesis begins by describing how payments markets operate in addition to the economic theory that describes them. Using this, the paper contends that American payment card markets are affected by a serious competitive failure. Two dominant firms process over 90 percent of all U.S.-based payment card transactions. At the same time, the system enjoys sustained profits that would not exist in competitive markets. This competitive failure occurs because significant barriers to entry keep possible competitors from entering the market and competing with existing payment card networks on price. Because they don’t need to protect their market shares, Visa and MasterCard are able to compete against each other without any fear of losing merchant acceptance to other payment schemes. The result is an inefficient status quo that is difficult to replace. In this way and others, the Visa-MasterCard payment card system fits the description of a natural monopoly. A second source of failure stems from consumer irrationality. Due to a set of deeply rooted psychological biases, consumers have tendencies to irrationally overspend when using payment cards. In addition, individuals are generally illogical when selecting among credit card offers and often choose cards with high long-term costs. These behavioral challenges pose real consequences in the form of billions of dollars in unnecessary debt, bankruptcies and macroeconomic effects of decreased spending. Having identified these challenges, the thesis explores the extent to which recent technological innovations might mitigate the earlier-identified issues. It finds that while many innovations only promote access to the existing system, a market solution may be possible, as technology has greatly decreased the cost barriers to platform entry. As such, payments innovation might mitigate the aforementioned competitive failures. The effect of innovation on consumer-based inefficiencies is less clear. Finally, the thesis concludes by discussing the implications of these findings for regulatory interventions in U.S. payments market. Price regulation of the payments industry is a very difficult, if not impossible, endeavor. The result is a need to regulate a natural monopoly in which price controls are not possible. Thus, regulators should attempt to encourage as much system competition as possible and protect entrant networks. In addition, policymakers should consider creating a government-backed platform for digital transactions. It is clear that electronic payments are the way of the future. With a thorough understanding of the challenges facing U.S. payments markets, this enormously valuable yet flawed system can move forward with a better, innovative, and beneficial payments infrastructure that continues to aid consumers, businesses, and financial institutions alike.