WASHINGTON, Oct. 25 /PRNewswire-USNewswire/ -- The Dodd-Frank financial reform legislation requires the Federal Reserve to set interchange fees for electronic debit card transactions. These fees are a subset of the total costs paid by merchants for the business advantages accruing from acceptance of debit cards.
In setting the interchange rate, the legislation instructs the Federal Reserve to focus on the "the incremental cost incurred by an issuer…in the authorization...of a particular electronic debit transaction...." As a Federal Reserve Bank of Richmond publication explained, however, "It is important to distinguish between incremental and marginal costs." The FRB went on to explain that incremental cost is greater than marginal cost and includes some fixed costs.
Economists in both government and academia have concluded that cost-based regulation of interchange fees is a mistake. As a Congressional Research Service report explained, "one should not expect either a cost based or zero interchange fee to be optimal."
Debit cards are an example of a "two-sided market" which occurs in industries which need to bring together two distinct groups of customers such as merchants and consumers. Two-sided markets present special challenges to regulators because they have two different supply and demand curves, one for each side of the market.
In the attached paper, CRE recommends five principles to guide the Federal Reserve in their regulatory deliberations to minimize the harm from the statutorily-required but ill-advised regulation. These principles are:
1. Price does not equal marginal cost in two-sided markets.
2. To estimate marginal cost in a two sided market, the costs associated with serving both sides of the market have to be tallied.
3. Marginal costs for debit card processing include a probabilistic share of lumpy costs that may be incurred when processing a particular transaction.
4. Marginal costs are a subset of incremental costs.
5. Incremental costs include some fixed costs.
Please read "Understanding Marginal Costs in a Two-Sided Market: Implications for Debit Card Interchange Regulation" at http://www.thecre.com/premium/wp-content/uploads/2010/10/Marginal-Costs-in-Two-Sided-Markets1.pdf
The Center for Regulatory Effectiveness is a regulatory watchdog group located in Washington, DC which was founded by former regulatory officials of the White House Office of Management and Budget http://thecre.com/ombpapers/OMB_Officials.htm
SOURCE Center for Regulatory Effectiveness