Interchange Fees and Innovation in Payment Systems

We analyze the impact of interchange fees on consumers’ and merchants’ incentives to adopt an innovative payment instrument, in a setting with adoption externalities between consumers and merchants. We show that consumer adoption decreases with the interchange fee for high degrees of externality, and varies non-monotonically with it for low degrees of externality. The profit-maximizing interchange fee coincides with the social optimum when externalities are strong, whereas it is too high when they are weak. We also compare the issuers’ incentives to innovate when they cooperate and when they make their innovation decisions independently.