Incentives at the counter: An empirical analysis of surcharging card payments and payment behaviour in the Netherlands

Abstract

In card payment systems, no-surcharge rules prohibit merchants from charging consumers extra for card payments. However, such rules are prohibited in the Netherlands. Dutch retailers are allowed to surcharge consumers for debit card use. This setting permits an empirical analysis of the impact of surcharging card payments on merchant acceptance and consumer payment choice. Based on consumer and retailer survey data, our analysis shows that surcharging steers consumers away from using debit cards towards cash. Half of the observed difference in debit card payment shares across retailers can be explained by this surcharge effect. Removing debit card surcharges may induce cost savings of more than EUR 50 million in the long run.

Introduction

The retail cards payments industry is subject to increasing attention by economists and policymakers. While there is widespread consensus that the ongoing shift of cash and paper to electronic forms of payment can confer large economic benefits, card payments in particular have remained expensive for many merchants. The cost of card payments is hidden from most consumers, because legal or contractual restrictions often prohibit merchants from adding a surcharge for payment card transactions.¹ These so-called “no-surcharge rules” have recently come under attack by antitrust and competition authorities, who argue that they harm competition at the retailer level and may yield inefficient cash and card usage.² Our study provides a first empirical analysis of the impact of using surcharges on merchant acceptance and consumer payment choice.

The recent burgeoning theoretical literature on the industrial organization of payments has greatly improved our understanding of payment pricing, payment card competition, and economic welfare. Starting point is that payment card networks set optimal payment fees for consumers and merchants so as to keep both sides on board while making profits overall. Based on a two-sided market approach, Rochet and Tirole, 2002, Rochet and Tirole, 2003 show that the structure of payment fees between consumers and retailers becomes irrelevant if retailers are able to fully pass on their payment cost to consumers by charging different prices for cash and card payments. In effect, when the no-surcharge rule is removed, the total price of card services is entirely borne by cardholders. Rochet and Tirole (2002) conclude that under costless surcharging, lifting the no-surcharge rule may or may not increase welfare, depending on card issuers’ market power and merchant resistance to accept cards. In particular, when issuers’ market power is large then removing the no-surcharge rule is likely to be welfare decreasing due to an aggravation of under-usage of card services. On the other hand, when merchants’ resistance is strong so that interchange fees cannot be set too high, banning the no-surcharge rule is likely to be welfare improving because it can act as a countervailing force to initial overprovision. Wright (2003) extends the analysis of Rochet and Tirole (2002) by looking at alternative specifications of retailers’ competitive behaviour. He concludes that if merchants are monopolistic, the no-surcharge rule partially corrects potential underprovision which occurs under perfect surcharging. When monopolistic merchants are allowed to surcharge, they extract “too much” surplus ex post from card customers with higher prices for card purchases resulting in lower welfare than when merchants set one price. If merchants are perfect competitors the no-surcharge rule has no impact on card payment volumes or social welfare.³

In the Netherlands, cash and the debit card are the most intensively used payment instruments at the point of sale. In contrast to many countries, competition authorities in the Netherlands have prohibited payment card schemes to impose the no-surcharge rule on retailers, allowing Dutch retailers to surcharge consumers for card payments. A large minority of retailers—mostly small shop owners—makes use of this differential pricing mechanism and applies surcharges to debit card payments. Hence, the Dutch retail payments market allows a useful “economic experiment” to assess the potential impact of debit card surcharges on card acceptance by merchants and consumer payment choice. This article examines whether surcharging could lead to possible under- or overprovision of card services, and attempts to quantify the effects of surcharging on the total costs of the Dutch point-of-sale (POS) payment system. Furthermore, we investigate what type of retailers chooses to surcharge card payments.

This paper is structured as follows. Section 2 describes the characteristics of the Dutch POS payment system with respect to the cost structure and the fee and tariff structure that Dutch banks employ to charge consumers and merchants for payment transactions. Section 3 discusses the set-up of the consumer and retailer surveys and presents a first exploration of the data. Section 4 provides estimation results illustrating the impact of surcharging on debit card usage, and compares payment behaviour of consumers in stores with and without surcharges. Finally, Section 5 summarizes and concludes.