Thursday, June 25, 2015

How monetary systems cope with a multitude of dollars

Over the last few decades, dollars have become incredibly heterogeneous. People can pay for stuff with traditional paper bank notes, debit cards, or a plethora of different credit cards. Each of these dollar brands comes with its own set of services and related costs. On the no frills side is cash. Paying with paper still incurs the lowest transaction costs, although at the same time it offers its owner no associated perks. On the fancy side is an American Express card, which costs around 3.5% per transaction but is twinned with a raft of benefits including reward points, the right to dispute a transaction, and insurance coverage. Mastercard and Visa come somewhere between. As you can see, spending one sort of dollar is very different from spending another sort.

The free banking era and the "multitude of dollars" problem

There's a precedent for this sort of dollar heterogeneity. During the U.S.'s so-called "free banking era" that lasted from the 1830s until 1863, hundreds of different types of banknotes circulated, each issued by a unique bank. Notes were universally redeemable in a certain quantity of gold. Varying physical distances between a note's final resting point and its birth at an issuing bank (often in another state) led to widely disparate redemption costs across note brands. A merchant in Philadelphia who was paid in local bank notes need only take a short walk in order to redeem the note. If that same merchant was paid in a note issued by a bank in Chicago, however, redemption was much more onerous due to the time and distance required to travel from Philadelphia to Chicago.

So in the same way that an American Express dollar is the most costly of the modern day dollars, a distant bank's notes were the most costly of the free banking era's dollars.

Here are two interesting problems. How can a merchant establish a single set of sticker prices while still accommodating a wide range of disparate dollar payments media? Second, consider the fact that shoppers paying with a premium card like American Express (or distant bank notes) enjoy the widest range of benefits, but should also face the highest costs. How can the system ensure that the person who enjoys the marginal benefits associated with a given payments medium also bears its marginal cost? Put differently, how is quid pro quo ensured?

The solution: surcharging

In the free-banking era, the "multitude of dollars" problem was solved by a form of discriminatory surcharging. To begin with, merchants displayed their sticker prices in terms of a single unit; standard U.S. dollars (defined as 1.5 grams of gold). When the customer arrived at the till, the merchant determined what sort of surcharge to apply to each of the banknotes proffered according to its distance-to-redemption. With hundreds of note-issuing banks in existence, this was a cumbersome task. In order to speed up the process, the merchant would consult what was called a "bank note reporter." This handy publication, which was compiled by professional bank note analysts, provided merchants of a certain location, say Philadelphia, with the rates for all bank notes that circulated in Philadelphia adjusted for their shipping costs.

The image below is a section from Van Court's Bank Note Reporter and Counterfeit Detector, which I've snipped from Gary Gorton's introduction to the subject. It shows the the recommended price at which a merchant in Philadelphia should accept notes from Vermont, Maine, Pennsylvania, and elsewhere.

A page from  Van Court's Bank Note Reporter and Counterfeit Detector (1843), showing multiple prices for various dollars. Notation: do=ditto, same as above | par=no discount | 20 = 20% discount | 1 = 1% discount | no sale = 100% discount | fail'd=failed bank, 100% discount | clos'd=bank closed, 100% discount

After a merchant had consulted his bank note reporter and tacked on the appropriate surcharge, it was time to redeem the note. Merchants didn't actually ship the notes themselves but sold them to a local note broker at a discount to face value. In fact, the numbers that Van Court published would have been sourced from this broker market. The broker in turn shipped the note back to the issuer, getting full face value upon redemption. The gap between face value and the initial purchase price covered the broker's shipping costs.

Thus the "multitude of dollars" problem was solved. By surcharging relative to a benchmark dollar, merchants succeeded in setting a single array of prices while accommodating a much wider range of heterogeneous payments media. This also allowed them to efficiently pass the marginal cost of using distant notes onto those customers who chose to pay with them, while rewarding customers who used low-cost local notes by not applying such surcharges.

So why not implement this same technique of surcharging today?

Consider that in our modern era, credit card networks recoup much of the cost of the services they provide (which are many, but include perks like rewards and the right to dispute a transaction) by requiring that card accepting retailers collect a fee from customers on the network's behalf. This parallels the free banking era, in which banks required third-parties to bear the cost of transporting notes for redemption.

The best way for a modern retailer to establish prices in this heterogeneous dollar world would be to replicate the solution settled upon by their free banking ancestors: set sticker prices in terms of the most basic unit, paper dollars, and exact an appropriately-sized surcharge on each card transaction at the till.

Rather than an old-fashioned Van Court's Recorder, a merchant could go about this by installing card-reading software that would quickly determine both the card being used and the appropriate surcharge. Thus, consumers who paid with premium cards, those cards that offer the most bundled services per transaction (and therefore incur the highest costs), would have to bear the largest surcharge while those with bare bones cards would pay a minimal surcharge. Anyone paying in cash, much like those who payed with local banknotes during the free banking era, would not incur any surcharge whatsoever. This system would ensure that each customer bears the marginal cost of their chosen means of payment. The retailer, who routes all of the surcharges they collect back to the card network, doesn't eat any costs and therefore succeeds in preserving their margins.

If only things were that easy. Though surcharging would be a great way to deal with the "multitude of dollars" problem, card networks like Visa and Mastercard have typically "legislated" against surcharges.* The networks can successfully impose this no-surcharge obligation on retailers because as an oligopoly, Visa and Mastercard can banish offenders from the network, putting a huge dent in the offender's sales. Why prevent surcharges? One reason the card networks probably do this is because they don't want the card-paying public to feel that they are being penalized in any way. If the feel put off, consumers might choose alternatives like cash and debit that aren't subject to surcharge.

Another solution: discounting

The no surcharge rule puts retailers in a bind. They are obligated to collect fees on behalf of the card networks, but without the ability to surcharge they're left absorbing the costs imposed by the networks while the customer enjoys all the benefits.

There's a neat way that that retailers can get around this hurdle. All they need to do is to mark up all their sticker prices to the level of the highest cost credit card, and then offer discounts to everyone who uses lower cost credit cards, debit cards, or cash. Discounting allows the merchant to collect the appropriate fee from each customer, funneling these fees back to the networks. As before, a given set of prices can accommodate a wide range of dollar payments media. Each party who enjoys a given marginal benefit also bears its respective marginal cost.

So as not to leave our analogy hanging, if this solution had been chosen by free-banking era retailers (perhaps because the free banks insisted that merchants avoid bank note surcharges), then the price level in Philadelphia would have been marked up to the value of the most-distant bank notes in circulation, say those from Chicago. Those paying in less-distant bank notes, say New Jersey notes, would have received an appropriately-sized discount.

An anomaly: we don't see discounts

Having outlined how to solve the modern "multitude of dollars" problem without surcharging, what happens in the real world? An odd phenomena tends to play out. While retailers have certainly marked up prices to a premium card standard (or thereabouts) in order to cover their costs, for some reason they rarely offer their customers discounts on cheaper payment options. Try asking for a cash discount at Walmart the next time you visit. This means that anyone who purchases something with cash, debit, or a bare bones credit card is being forced to pay for a juicy set of benefits associated with usage of an American Express card, namely fancy rewards and dispute rights, without actually getting to enjoy those benefits. Put differently, the merchant is effectively overcharging their customers by collecting more network fees than the networks actually require, keeping this excess to pad their bottom line.

Why this predatory behavior? Briglevics and Shy note that merchants may be wary of discounting if it creates confusion and distrust among customers. Potential delays at checkout counters might impose an extra set of costs on all parties. They also point out that merchants may not find it profitable to offer a cash discount to consumers who would use low-cost payments anyway. Schuh, Shy, Stavins, and Triest report that merchants may lack complete information on the full and exact merchant discount fees for their customers’ credit cards, and therefore can't implement a policy of accurate discounting.

Could it be that the right set of tools to provide discounts hasn't yet been created? Perhaps we need a modern version of Van Court's Bank Note reporter. Such a technology would allow merchants to rapidly determine the proper discount to apply to each disparate dollar type and clearly inform customers about the saving they have enjoyed.

Lack of technology may explain why cheap credit cards don't receive discounts relative to expensive ones, but it doesn't explain why cash discounts has never been adopted by retailers. One theory is that even if certain retailers start to offer discounts, the public may be too overloaded with information to switch, thus allowing the practice of predatory pricing to remain the status quo. Supporting this view is the following observation: while discounting for cash and debit payments is rare in most sectors of the economy, it is quite common among gas stations, as the image below shows.

Why so? Gas stations sell one homogeneous, universally available, repetitively-purchased good. Gas consumers are by-and-large brand insensitive, gas from one station being just as good as gas from another. Repetitive trips to buy one simple commodity probably makes it easier for lethargic consumers to make dispassionate price comparisons across competing gas stations. From the gas station owner's viewpoint, the consumers' price sensitivity only increases the efficacy of a policy of price discounts on cash and debit. After all, a gas station that offers users of low-cost credit cards a 0.5% discount or a cash discount of 1% should be able to win business away from station across the street that doesn't offer any discount whatsoever.

Other retailers, say department stores, sell a wider variety of things than gas stations, many of these items only being purchased from time to time. This makes comparison shopping more costly. Brand loyalty only increases the hassles of switching. Department stores may find that a policy of cash discounts is simply not worth the effort as discounts get lost in the morass of data that a consumer is bombarded with on an hourly basis.

That being said, the online world's ability to provide faster cross-retailer comparisons than are possible in a bricks & mortar world could shake things up. Surely some smart fintech entrepreneur can create a way for online merchants to rapidly measure the appropriate discount (or surcharge in those jurisdictions that allow it) to apply to each card before consummation. This same tool would provide a user-friendly format for online shoppers to "see" competing card discounts across a number of merchants prior to hitting the buy now button. Just like they'll cross the street to hit the cheapest gas station, they may divert their purchase to the lowest cost website. If this sort of thing caught on, we'd see long forgotten free banking customs replicated in our modern era.

*This is currently the case in Canada. In Australia, merchants have been allowed to surcharge since the early 2000s. US merchants recently won the right to surcharge, although it is probably too early to know what effect these rule changes will have.


  1. Merchants do not discount because, as with surcharges, credit card companies contractually forbids them to do so if they want to accept credit cards.

    These contract clauses should be illegal because they enable kickback schemes where customers get points in exchange for producing high fees that they don't bear by themselves but are instead passed on to every customers even those who don't use credit cards.

    It's basically banks levying a sales tax on everyone.

    1. Benoit, Canada has allowed merchants to provide differential discounts on credit cards since 2010, and according to one of the articles I linked to the U.S. has allowed differential discounts since 2011 or so. Merchants have always been allowed to provide cash discounts.

      I disagree that banks are at fault here, at least on the cash side. Retailers could be providing cash discount but they don't. They are effectively forcing their customers to pay for points that they don't actually get.

    2. I guess my information is outdated.

    3. The legal right to differentially discount and contracts forbidding discounts are not mutually exclusive. Unless the law explicitly prohibits contract clauses that prohibit discounting vis a vis other cards, the credit card oligopoly will continue to have these clauses, which merchants must agree to in order to be able to accept any credit card. Are you saying these clauses have been legally forbidden? Because my understanding is the same as Benoit's, they still enforce what amounts to an anti-competition clause that's perfectly legal.

  2. Big retailers rarely offer cash discounts, but they are common for mechanics, body shops, plumbers, gardeners, etc. (Although this probably has more to do with tax-avoidance.)

    I wonder how much it costs merchants to handle bank notes. Between the costs of cash registers, armored cars, hand counting, theft, etc., it wouldn't surprise me to learn that credit cards might actually be cheaper than bank notes.

    1. I like to use big retailers like Walmart and Mobil as a benchmark for cash acceptance since it strips out the tax avoidance aspect.

      Cash handling certainly has its costs. Cash's huge cost advantage is the lack of a dispute mechanism. The cost of abiding by the banking industry's standards for returns are very high. Fraudulent chargebacks can create significant costs for merchants who accept cards. (link).

    2. In the classic check era, 3% handling for bad ones was common.

  3. JP: the gas station doesn't care about the benefits I get from paying with a credit card vs cash or interac. But it does care about its costs of handling cash or credit card or interac. If credit cards raise the fee they charge the gas station, we should expect to see the gas station charge a premium for paying by credit card (if they were allowed to.)

    BTW, didn't that BoC study say that interac generally has lower transactions costs than cash, for larger transactions?

    1. "But it does care about its costs of handling cash or credit card or interac.If credit cards raise the fee they charge the gas station, we should expect to see the gas station charge a premium for paying by credit card."

      Yep. In the same way that if the costs of feeding horses rose, we'd expect a free banking retailer to charge a larger surcharge on non-local notes.

      Not sure about a study, but it wouldn't surprise me.

  4. I lean towards the "technology" explanation. You can, for example, encounter various discounts and surcharges in online shopping, it's not merely a theoretical. Not everywhere but it certainly occurs. In Europe, for example, you can do a 1 day bank transfer without any fee for payee or payer (SEPA) and many webshops offer this as an option. Also common is direct debit (which also tends to be free unless the order is declined). So you can encounter credit card surcharges in European webshops.

    Then there's also the issue that I like to mention often, integration into accounting. The merchant depends on how the the payment processor is integrated into his accounting. If he doesn't support surcharges/discounts, the merchant can't do anything about it.

    1. I'm not very familiar with Europe. Do major European retailers offer discounts or surcharges based on the chosen means of payment? Any examples?

    2. I'm not sure what "major retailers" means. Amazon does not offer such discounts as far as I remember (neither the German nor UK). But many smaller ones do.

      Here is a page from a price comparison website that I often use, comparing shops offering an Apple Mac mini (which I randomly picked as a representative item):
      The section delivery ("Versand") in at least half of the companies has different rates that depend on payment method. Even paypal and credit card rates often differ. The cheapest tends to be "Vorkasse" (payment in advance with SEPA).

    3. Great find. "Nachnahme" means cash at the door? Do you know what "sofortü" is? What is the U.S. equivalent of SEPA, or "vorkasse"?

      It seems like vorkasse is always the lest expensive, and credit card is usually cheaper than paypal. Nachnahme is sometimes one of the cheaper options, sometimes the most expensive one.

      My understanding is that Europe *does* allow surcharging and that has been the case for some time. That would explain why we never see this sort of thing in North America (or at least, I haven't stumbled upon situations like this). Surcharging over on this side of the world is either illegal (in Canada) or only recently legalized (US).

    4. "Nachnahme" is indeed cash at the door (I believe the exact term is "Cash on Delivery"). Sofortüberweisung is a service provider that, on your behalf, logs into your online banking, initiates a SEPA transfer to the merchant and notifies him (basically allowing your online banking to be integrated into a webshop checkout).

      The US equivalent of SEPA would probably be a wire transfer in advance. In US I suspect people often mail cheques instead of doing a wire transfer, but in large parts of Europe cheques have been discontinued.

      I must say though that surcharges in physical (as opposed to online) shops are very rare, but that's from my personal experience and might not be representative. Shops that do not like payments with cards usually will tell you to get cash from a nearby ATM, this is much more frequent than surcharges.

      I don't know the history of surcharges in Europe, but it's possible that it was never forbidden here.

  5. An argument is that premium cardholders are also bigger spenders worth attracting and holding..

    1. That's one argument. Sort of like offering a volume discount.

  6. As an Aussie I was shocked reading this - I never noticed that other countries didn't have credit card surcharges*

    I use my Amex whenever I can, but most small shops here charge a 1-5 % surcharge, as they should. For them I usually switch to visa or mastercard which are rarely surcharged. If there is a surcharge for them, I pay with e.g. cash.

    The smallest and cheapest shops (often cheap restaurants) simple do not offer electronic payment methods, pointing you to the nearest ATM. Of course, this reduces their bottom line, and they can offer cheaper prices.

    If I was in a country that legislated against surcharges, I'd be paying for everything with Amex. If i had a small business there, I would not offer electronic payment.

    *Now that I think about it, all of the Asian countries I've visited have had very well followed credit card surcharge structure. Small business rarely offered electronic payment.