The no surcharge rule and its welfare implication

Abstract

This paper investigates the welfare implications of banning the no surcharge rule (NSR) in credit card markets. Conventional wisdom indicates that banning the NSR may increase or decrease social welfare. This paper finds that lifting the NSR unambiguously decreases social welfare in a closed system and in an open system when Visa and MasterCard privatize. In a closed system, the unambiguous welfare implication is due to the fact that the distortion of Merchant internalization (MI) fully offsets the distortion of market power, and the monopolistic credit card company acts as a social welfare maximizer when it maximizes its own profit. The credit card service is always optimally provided under the NSR, and lifting it, which eliminates the distortion of MI, always leads to an under-provision of credit card service and a decrease of social welfare. In an open system, the credit card service is always under provided under the NSR, because the market power of issuing banks works as another distortion in addition to those in a closed system. Banning the NSR will further drive down the card usage and social welfare decreases.