Back in theme 1, one of our Senior Advisers asked what has been the best thing since sliced bread? James Jamieson, Technical Specialist and Economist at the PSR, has spent years working as a Competition Economist and thinks competition might be the answer.
He states it is only natural he would consider competition to be able to solve all problems, and make markets everywhere better. To back up this claim, James goes back to first principle and asks himself why competition is generally considered to be a good thing. When does it work well? And will competition be the thing to solve all payments’ ills?
To help him answer these questions, he takes a simplified example to begin with, away from payments.
Beans, Beans, Beans
If I want to buy a tin of baked beans from my local shop, my options are probably a major brand, another slightly less well-known brand, the shop’s own brand, and possibly a budget option. You may argue that 4 different types of baked beans are too many. And that’s just beans; try buying a car or a tent for that matter!
But why have more than one in the first place? Well, the reason goes something like this:
- If I only had one choice of baked beans, the maker of baked beans would set a (relatively) high price, which is just at the point before I start considering whether baked beans are the best thing to be feeding my kids instead of pizza, fish fingers or something else.
- When a second brand enters, the two brands compete with one another on price, flavour, quantity of beans or a mixture of all three. Entry forces both the incumbent and the new entrant to cut out inefficient costs, expand output, reduce margins, put in better quality ingredients and find more innovative ways of getting us to buy beans.
- In theory, the more baked bean producers that enter, the more that price is driven down and quality is driven up to the optimum levels.
Prices don’t necessarily all end up being the same: each tin of beans is a different proposition for customers, from those who value higher quality beans or a particular brand and are willing to pay a bit more, to those who want something which is much cheaper, but may be unbranded, lighter on flavour or the amount of beans in the tin relative to sauce. Each consumer ends up picking the price/quality mix that is best for them. However, one important aspect in this example is that when I choose which baked beans option I want, I face both the costs (i.e. the price) and the benefits (yummy beans!) of my choice.
So, what happens when we move into the world of payments? This is where things start to get a bit more complicated.
Now that I’ve chosen my preferred tin of baked beans, I take it to the till and I then have a choice of payment options. Either I use cash, or a card (debit or credit). If I choose to pay via card, I can do so using the contactless card itself or I could pay via a mobile wallet. So, which one to use? If I’m cost conscious, I may choose based on the price.
If I use cash, it costs me… the price of the beans. If I use a card or mobile wallet, it costs me … the price of the beans again. There’s no difference in terms of price! But there are differences in costs when using these payment methods. It’s just that they are hidden and I, as a consumer, am not facing them directly. This was true even before shops were stopped from surcharging (i.e. charging extra) for certain payment methods.1
So, can I choose based on other criteria? If I chose to use a credit card, I have very different options for recourse if something goes wrong compared to if I had chosen to use cash, as I may be able to claim a refund under section 75 of the Consumer Credit Act 1974. Hence, I may feel using a credit card is a better option for me, but is it for everyone?
On a per-transaction basis, credit cards typically have higher costs associated with them. We know I’m not paying for those, but who is? Well, that would be the shop or merchant. They face the costs of my choice and they don’t necessarily get all the benefits. This is a result of payments being two-sided, with the consumer (payer) on one side and the merchant (payee) on the other side.
A merchant’s choice
But surely, you say, merchants can choose which payment methods they accept?
In theory, a merchant can choose if they accept cash, cards, or any other payment option. But in practical terms, their choice is limited. Why? Because if they do not accept one of the major forms of payment, they potentially prevent a number of their customers from using their preferred – and sometimes only – payment method. That makes it much less likely consumers will choose to shop with them. The shop has to consider the consumer.
This contrasts with a more conventional market. When a merchant is choosing which baked beans to stock (sorry back to beans!), they may play one producer off with another, having alternatives to the options they are stocking. But in the case of payments, different payment methods may act more like complementary offerings rather than alternatives to one another. And if they complement each other, can a merchant still play off one payment method with another? And if that’s not the case, to what extent are payment schemes competing with one another for merchants?
In addition, in the realm of payments, the one who bears the cost (the merchant), is often not the one who chooses which payment method is used. Merchants choose what goes on their payments menu, but ultimately it is the customer who chooses which payment method is used. And the one who is choosing does not seem to be paying. At least not directly.
In the end, consumers do end up paying for higher cost payment methods. They do so through higher retail prices. A merchant may consider increasing its prices to pay for the cost of offering different payment methods but, as the price for goods remains the same regardless of the payment methods accepted, consumers choosing a lower cost payment method end up subsidising consumers choosing a high cost payment method.
All that is to say that, the fact the consumer chooses but doesn’t bear the cost of payment directly also has implications for whether we can expect competition between payment methods to result in a similar outcome to that of our bean producers, namely lower prices, higher quality and more variety.
From what we know about the merchant side, from the information above, we can’t just assume that more competition between payment methods will automatically lead to lower prices and higher quality. But what about the consumer side?
Let’s go back to who makes the choice of which payment method to use. It’s the consumer, right? Well, yes and no.
Yes: because they decide whether to pull out cash or card (and which card) when paying at a shop. They decide which payment options they have in their (physical or virtual) wallet and they decide who they bank/take a credit card with and that may be influenced by which scheme is on the card, particularly if one scheme is accepted more by merchants than another.
No: because they typically don’t decide whether their credit or debit card is Visa or Mastercard, that’s the choice of the bank or credit card company who issues the card.
In days gone by, the choice of which card scheme (Visa or Mastercard) appears on the card may have been driven by differing interchange fees (the fee the merchant’s bank pays your bank) between card schemes, but under the Interchange Fee Regulation, those differences have been pretty much eliminated. So, what is driving the issuer’s (the consumer’s bank) choice of card scheme? And if issuers benefit from that choice, do they pass that benefit on to consumers?
These are important questions because it affects how competition drives outcomes. Let’s take an example of where this could go wrong. What if two card schemes competed for the same issuer by offering a fee for every transaction going over the card scheme. It’s not unimaginable that card schemes competing to provide services to issuers could then lead to higher costs for merchants, (e.g. through increases in scheme fees, which get passed on to the merchant via the acquirer – the payee’s bank). Competition would then lead to either more costs in the system or increasingly unbalanced prices between consumers and merchants. And those higher fees would not necessarily come at the benefit of higher quality (e.g. better security). That doesn’t sound like a good outcome.
So, what does effective competition look like? Normally it would mean something like prices being as low as possible, quality being as high as possible and variety being as large as possible, and no actions available which increase benefits more than costs. For that to happen, does it mean that in each stage, those making the choice also face all the costs and benefits of that choice? Is that even possible?
If we lived in a world where merchants chose the payment method used, things could look quite different. Merchants may still accept higher cost payment methods if, for example, the coverage offered by them was sufficiently unique, but merchants would likely steer customers to the lowest cost option. Knowing this, consumers would then need to choose the payment options to have in their wallet (digital or physical) to maximise their chances of a payment method being accepted. But in this world, would consumers still choose payment methods that offered them a degree of protection if something went wrong? What if either acceptance by merchants of these options was low, meaning customers couldn’t use these payment methods, or merchants actively steered customers to cheaper options which would offer less protection to consumers? In that scenario, merchants choosing the payment method may not lead to good outcomes either!
Perhaps more radically, what if consumers kept making the choice, but faced the costs of their choice, e.g. through higher fees for paying by one type of card over another? Could that be a solution?
Ultimately, solving these questions comes down to deciding what the right benchmark is for effective competition. And what the best routes are for getting there? And if we do, does it then still hold true that competition is indeed the best thing since sliced bread?
Answers on a postcard (or indeed tweet, email or LinkedIn post) please!
1 Note that this is partly due to PSD2 prohibiting surcharging. Some shops were not surcharging before the introduction of PSD2, so it can’t be fully attributed to the change in the law
James Jamieson is a Technical Specialist and Economist at the Payment Systems Regulator and has previously worked at Fingleton and the Competition and Markets Authority. The views, thoughts and opinions expressed in this blog are his own and do not necessarily represent those of the Payment Systems Regulator.