By Fumiko Hayashi
November 2008
RWP 08-07
Research Division
Federal Reserve Bank of Kansas City

This paper investigates potential market forces that cause payment card rewards even when providing payment card rewards is not the most efficient. Three factors-oligopolistic merchants, output-maximizing card networks, and the merchant's inability to set different prices across payment methods-may potentially explain the prevalence of payment card rewards programs in the United States today. The paper also points out that competition among card networks may potentially make payment rewards too generous, and thus deteriorate social welfare and its distribution. The situation may potentially warrant public policy interventions.

Key words: Payment card rewards, equilibrium fee structure, oligopolistic merchants, card network competition, no-surcharge-rules