Sustainable growth of payment card networks: a two-sided market approach.

Abstract

The payment card industry is a typical "two-sided market" where two groups of agents (i.e. merchants and cardholders) interact with each other via a common network platform (i.e. a card network) and the value of participating in the network for agents in one group depends on the number of participants from the other group. The positive network externalities across the two sides create the "chicken-and-egg problem": without sufficient merchants accepting a particular card network, few consumers are willing to apply for the card," without sufficient cardholders, few merchants are willing to accept the card. While economists have addressed the issue from social welfare perspective, we focus on business strategy implications. Modeling network externalities in dynamic systems, we show that network platform owners could overcome the "chicken-and-egg problem "through strategies such as merger and acquisition, licensing, forming strategic alliance, as well as adjusting product and pricing strategies, etc. We provide a history of the U.S. payment card industry as empirical evidences to support our findings.

Introduction

The payment card network has recently attracted much attention from researchers (Chakravorti, 2003; Rochet & Tirole, 2002, 2003; Schmalensee, 2002; Wright, 2003a, 2003b, 2004) due to its special structure: two different groups of agents, the merchants and the consumers, interact with each other via the payment card networks; and the value of participating in a particular card network for agents in one group (say, merchants) depends on the number of participants from the other group (the consumers, correspondingly). For example, if more consumers carry VISA card, merchants accepting VISA card will be able to capture higher sales volume from these cardholders; on the other hand, if more merchants accept VISA card, it will be more convenient for VISA cardholders to pay for their purchases.

Such positive network effect also exists in other markets. For example, in yellow directory business, more advertising in a particular directory leads to more consumer usage, which in turn leads to more advertising in that directory (though in the next publication); in the PC industry, if more consumers use Windows operating system, more software developers would like to write application software for this system, which will make the system even more appealing to consumers. Similar phenomena can also be seen in the markets for academic journals, advertising, shopping malls, dating services and nightclubs, etc.

Markets with such cross-group network effect are termed as "two-sided markets" (Armstrong, 2004; Rochet & Tirole, 2003). The cross-group network effect is a double-edge sword: it can either lead to spiral growth of the network or create the "chicken-and-egg problem." For example, if few consumers carry VISA cards, few merchants would be willing to accept VISA, which further discourages consumers from using this type of cards. Unless the network has reached a critical mass in the number of participants, it cannot take off.

While the "chicken-and-egg problem" in two-sided markets has been discussed in the economics literature, few focus on how to overcome it from business strategy perspective. In this paper, we use a dynamic system model to provide mathematical explanations to the "chicken-and-egg problem" and explore strategies for overcoming it. Such strategies include merger and acquisition, licensing, forming strategic alliance, as well as adjusting product and pricing strategies, etc. We provide a historic account of the U.S. payment card industry to demonstrate relevance of our findings to business strategies in two-sided markets.

The paper is organized as follows. We introduce the characteristics of two-sided markets in section II, followed by a brief literature review in section III. In section IV, we present a dynamic system model of network growth and study the long-run behavior of the system. In section V, we propose business strategies for overcoming the "chicken-and-egg problem" based on model findings in the previous section. In section VI, we study the U.S. payment card industry and demonstrate the relevance of our propositions. Section VII summarizes and concludes.

Characteristics of two-sided markets

Network structure

In a two-sided market such as the payment card network, the two sides interact with each other through a common network platform. For example, in the payment card network, the electronic payment systems and equipment (e.g. point-of-sale (POS) terminals) are the platforms via which consumers interact with merchants; the hardcopy yellow directory provide a platform via which thousands of households find information about the merchants who advertise in the directory. Besides the two sides, there is a third party who creates and services the network. We call it network platform owner or sponsor. VISA, MasterCard, American Express, and Discover are platform owners of the U.S. payment card network; SBC, Verizon and other yellow directory publishers are platform sponsors in the yellow directory business; Microsoft and Apple Computer are platform owners in the PC operating systems market.

Figure 1 illustrates the payment card network. Merchants represent one side of the market and consumers represent the other side. Each merchant installs a POS terminal in its store, which is linked to the electronic payment system owned by network platform owners (e.g. VISA, MasterCard). Consumers can purchase goods or services from any merchants in the network. The platform owners operate the payment system and provide services to network participants (e.g. clearing & settlements, fund transferring, fraud protection).

[FIGURE 1 OMITTED]

In many two-sided markets, there is also a 4th type of agents which has not been discussed in the two-sided market literature. We call them the distributors of a network. They are the agents who produce and sell network-specific products to participants on either or both sides of the market. In the payment card network, banks such as Bank of America, Wells Fargo, Chase, etc. issue VISA or MasterCard cards to consumers and sign up merchants. They are neither the network platform owner nor any side of the market. Instead, they are the distributors of the corresponding network (i.e. VISA or MasterCard).

The roles of network distributors are not essential in a two-sided network because a network platform sponsor may decide to take this role by itself and not allow any distributors in its network. For example, American Express had been issuing its Amex cards to cardholders solely by itself until 2004 when it started to allow distributors (i.e. banks) to issue Amex-branded cards. Discover, the owner of the fourth largest credit card network in the U.S., is still the only distributor of its proprietary Discover card network as of today.

Although inessential to a two-sided network, network distributors may affect the diffusion speed of a network. Their collective efforts in signing up network participants and in improving the quality and features of the network could have a critical impact on the growth and even survival of a network, as will be shown later in the paper.

Cross-group vs. within-group network externalities

The defining characteristics of two-sided markets are the cross-group network externalities. For example, a consumer's decision to use VISA card imposes positive externalities to merchants, while a merchant's decision to accept VISA card imposes positive externalities to consumers. Such cross-group network externality represents an instance of indirect network externalities (Katz & Shapiro, 1985).

Besides cross-group externalities, there could also be within-group externalities, either positive or negative, within either side of the market. For example, in the payment card network, negative externalities exist among merchants: given the number of cardholders, more merchants in a particular card network will lead to less incremental sales from accepting the card for an individual merchant. This is because merchants are competing against each other for businesses from the same cardholders. Such negative within-group externality is called the congestion effect (Rysman, 2004, p.484) and can also be found in other two-sided markets such as yellow directory, shopping mall, dating services, and PC operating system.

Fee structure

Usually, the two sides of the market can interact with each other without a network, though it will be at greater inconvenience. For example, a consumer could purchase goods from a merchant using cash or checks. However, such transactions are less convenient to both sides than using credit cards: consumers need to bring enough cash, sometimes in large amount, which could be beyond their current liquidities or could be easily lost or stolen; merchants may face the risk of returned checks or counterfeiting money as well as lost business due to consumer's lack of finance from credit cards.

Since the network platform provides added-value to both sides of the market, the platform owner can charge both sides for its service, either on lump-sum basis or on per-transaction basis. For example, payment card network owners (e.g. VISA) charge merchants on per-transaction basis which is usually 2-3% of the transaction value. They could also charge cardholders a lump-sum membership fees, although most choose not to do so or only charge cardholders of certain risk profiles (e.g. those with low credit scores).

Literature Review