Transaction Costs, Externalities, and “Two-Sided” Payment Markets

Abstract

Recent study of two-sided markets has generated a rapidly growing and technically complicated body of literature. As we will describe more precisely in this article, a two-sided market is one in which externalities exist amongst market participants. Domestic and international antitrust litigation and regulation involving payment system networks, such as those operated by the MasterCard and Visa bank joint ventures, have contributed to the increased interest in two-sided markets. Central to the issues being litigated are the collective establishment of policies, such as “no-surcharge rules,” that govern how retail merchants may set prices and the setting of transfer payments (“interchange fees”) between the members of the payment system networks. In this paper, we review the fundamental economic forces that underlie two-sided markets and then discuss how these forces relate to current debates over the competitive effects of certain collective policies, such as the setting of interchange fees. Visa, MasterCard, and some economists have put forward pro-competitive justifications for these policies based on the “two-sidedness” of payment systems. We pose and discuss a series of questions that probe the empirical and policy relevance of these justifications.