Two-sided network effects, bank interchange fees, and the allocation of fixed costs

Two-sided network effects in card payment systems are analysed under different market structures, e.g., competition, one-sided monopoly, bilateral monopoly and duopoly; with and without an interchange fee; for the so-called Baxter case of non-strategic merchants. A partial ranking of market structures according to their welfare effects is provided. Fixed central (card) system costs are introduced and analysed under free entry and duopoly. It is shown that under free entry, a per-transaction distribution of fixed costs is preferrable to dividing the fixed cost in equal proportions between the paritcipants. Under duopoly, (and no entry) a fixed division of central costs will yield lower prices.