Efforts to Expand Sales Using Reward Programs

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					Efforts to Expand Sales Using Reward Programs

                      Conference on
        Payment Markets: Theory, Evidence, and Policy
             University of Granada, June 2010

                      David Humphrey
                Florida State University, USA

•    Motivation:
     Contrast earlier and current merchant reward programs.

•    Covering:
         Stamp rewards
         Cash rewards (deep discount stores)
         Card rewards.

•    Interchange fee caps.

•    Compare estimate of card costs with merchant fee changes.

•    Speculate on future of card reward programs.
    Stamp Rewards

•   Stamp rewards (1890s) initially given to customers who did not ask for store
    credit. Later applied to all payment methods.

•   1 stamp for each $.10 of sales (S&H Green Stamps most popular stamp).

•   Stamps were pasted into books: 1 book = 1,200 stamps = $120 in sales.
    Books used to redeem rewards.

•   Most popular from 1930s to 1960s.

•   More popular in US than Europe.
    Stamp Rewards

•   In 1960s:
         Over 60% of US households collected stamps
         3 times more stamps were issued than all postage stamps in mid-1960
         Reward catalogue was largest publication in US
         $825 million in rewards in one year in 1960s
         Over $10 billion in rewards total.

•   Since almost all merchants gave stamps (gas stations, supermarkets,
    department stores, etc.), the stamp market became saturated.

•   In a saturated market, merchant sales or market share benefits from offering
    stamps no longer exists. Giving stamps becomes a defensive measure.

•   Merchant cost base rose but no longer have any net sales benefit.
    Stamp Rewards

•   Stamps almost disappeared in inflation/recessions of 1970s.

•   Merchants cut costs to retain margins. By 1999, only 100 stores still offered
    S&H stamps.

•   Merchants replaced stamps with store-specific, “preferred customer”
    loyalty/reward programs which were less expensive.

•   Stamp programs (green points) still exist at some Internet websites.

•   Other reward arrangements: dish sets and wigs when deposit funds in a non-
    interest deposit account for 1 year.

•   Supermarket in Florence, Italy, gives loyalty points for small gifts.
    (After 9 months of shopping, only close to getting a flashlight.)
    Stamp Rewards

    Reward examples:

•   A JVC noise-cancellation headphone (actual cost $46.99) requires 43,000
    green points from spending $430,000.
    (value = $.001 per point)

•   AMEX requires 385,000 points for a 46” flat-screen TV (actual cost around
    $570) and took one person 5-6 years of card spending.
    (value = $.0015 per point)
    Stamp Rewards

•   Near death of stamps came when:

       1. Almost all merchants offered stamps, so no longer have any
          sales benefit to giving stamps;

       2. Merchants faced strong pressure to cut costs during recessions
          of the 1970s; and

       3. Merchants had control over whether to offer stamps or not and
          almost all dropped stamps in favor of cheaper store-specific
          “preferred customer” rewards.

•   1 and 2 exist now for network credit cards in the US.
    3 does not since networks, not merchants, control reward values and
    consumers control card use.
    Cash Rewards (Deep Discount Stores)

•   Deep discount pricing not possible due to resale price maintenance laws.

•   Manufacturers set minimum (sometimes maximum) resale prices to protect
    their base of small retail stores from chain store competition.

•   US Sherman Antitrust act--resale price maintenance contracts:
     – Illegal per se before 1930s
     – Mostly reversed during Depression to protect small merchants from
       chain stores and called “fair trade” laws
     – 1968 Supreme Court ruled most resale price maintenance illegal per se.

•   UK legislation (1964) makes restrictive resale price maintenance illegal.
    Cash Rewards (Deep Discount Stores)

•   Before 1968, due to resale price maintenance laws, there were only a few
    discount stores and these were organized as co-operatives. Consumers paid
    a membership fee to shop there.

•   After 1968, no longer needed co-operative legal structure. Discount store
    volume took off. Includes general merchandise (WalMart) and specialty
    stores (Best Buy, Toys-R-Us, Home Depot, etc.).

•   Result: many, many smaller merchants went out of business, unable to
    compete with very low prices and large selections.

•   Discount stores have own store card but also take network cards.
    “Double reward” of low price + card rewards.
    Store and Network Card Rewards

•   Store credit cards:
     – Long history of providing store credit—now with a card
     – Expands sales (for credit needing customers)
     – Ties customer to store (store cards are merchant-specific).

•   Network credit cards in the beginning:
     – First adopted by merchants catering to travelers in 1950s (hotels, restaurants)
     – Assures merchant gets paid (eliminated bad checks and having to
       accept/carry cash).

     Greatly expanded to many different merchant types:
     – Volume rises as rewards induce consumers to use cards
     – Sales expand only when a limited number of merchants accept network cards.
    Store and Network Card Rewards

•   Network credit cards in a mature environment:
     – When almost all merchants accept network cards, there is no sales or market
       share benefit to a merchant. Accepting becomes a defensive measure.

U.S. data                          2000                      2010
                                   Bank     Store            Bank     Store
# of cards (mil)                   455      597              563      513
Purchase Value ($ bil)             768      120            1,330      121
Debt outstanding ($ bil)           480       92              672       93

•   Network card purchase value 11 times store card value in 2010. Adds greatly to
    merchant cost base. Hence merchant complaints.
    Interchange Fee Cap (Rochet-Tirole model)
•   Tourist Test:
     – Interchange fee ≤ cost of non-card payment alternative.
     – European Commission may use as guideline for network credit card
       interchange. Debit cards not covered since few have rewards.
     – Cash costs differ by transaction value, probably are not lowest cost overall.

                  Merchants:         credit card > debit card > check > cash
                  Banks:             credit card > debit card > cash > check
                  Consumer:          cash > check > debit card > credit card

         Overall Cost Rank:          cash > credit card > check > debit card
         Overall Unit Cost:          $1.49      $1.16      $1.07     $.90

•   My preference: apply a cost-based cap—transaction cost without rewards since
    this deals with the hidden cross-subsidy and card overuse (Australia and Spain).
     – If rewards remain, they would be paid for by the card user, not the merchant
         (principle of “user pays” balances costs with benefits).
Interchange Fee Cap (Rochet-Wright model)

•   Convenience user:
     – Due to rewards, cards overused by convenience users.
     – Apply tourist test to cap interchange fee (so merchant is indifferent).

•   Credit user:
     – When store credit cost > network card credit cost, add merchant net
       credit savings to tourist test value.
     – Raises interchange cap.

     – When store credit cost < network card credit cost, subtract network
       card net extra cost from tourist test value.
     – Lowers interchange cap.

•   Both store and network cards involve cross-subsidies among consumers.

•   Store credit card:
     – Corte Ingles gives free parking when use card in store.
     – Corte Ingles accepts network cards, but need to pay for parking.

•   Network credit card:
     – Obtain airline miles when use for purchases.
     – Cross-subsidy is to network card user from all other consumers.

•   Magnitude of cross-subsidy is quite different. Network card purchase
    value is 11 times store card value.
 Payment Scale Economies
           U.S. Cents per


             1987 (Blue)



                                   1995 (Red)

 2.5                                                                                   2004 (Black)

       0    1000   2000     3000   4000   5000   6000   7000   8000   9000   10000 11000 12000 13000 14000 15000

 • Predicted unit payment costs versus payment transaction volume.
       (Bolt and Humphrey, 2007)

 • OC/TA ratio fell -34% for 11 European countries over 1987-2004.
   Fell by -50% for Spain (-52% for Germany, 0.0% for France).
     Payment Scale Economies

                                         Cash                 Card
Norway 1994-2001
d(payment costs)/d(volume)                                      0.43

Netherlands 2002
Marginal Cost/Average Cost                0.37                  0.39

Belgium 2003
Marginal Cost/Average Cost                0.25                  0.39

U.S. 2005
d(payment costs)/d(volume)                                   0.31 – 0.39

Netherlands 1997-2005
Bank Data, Econometric Model                                 0.27 – 0.31

Sources: Gresvik and Øwre (2002); Brits and Winder (2005), Table 4.3; Quaden (2005),
Table 3; First Annapolis Consulting (2006); Bolt and Humphrey (2009).
    Payment Scale Economies

•   Spain 2002-2009
     – POS card transactions rose by 105% (terminals by 73%).
     – Can estimate change in unit or average cost from just change in POS
       transactions and Spain’s payment scale economy value (.30).
     – Estimate that average card costs fell by 36% (5% per year over 7 years).

•   “Consultations” in Spain reduced merchant discount fee by 52% over 2002-2009
    (from 1.59% to .77%). Fee also fell 21% during 1999-2002.

•   Appears that realized scale effects are being passed on to merchants in Spain.
    Not done in other countries.
     Future of Network Card Reward Programs

•   Recall near death of stamp rewards came when:

       1. Almost all merchants offered stamps, so merchants no longer
          received sale/market share benefits;

       2. Merchants faced strong pressure to cut costs during recession; and

       3. Merchants had control over offering stamps and almost all dropped
          them in favor of cheaper store-specific rewards.

•   1 and 2 exist now for network credit cards in the US.
     Future of Network Card Reward Programs

•   Merchant network card purchase value 11 times store card value.

•   Merchant costs rise but have no control. Network cards control value of
    rewards (raising merchant costs) and consumers control card use due in
    part to rewards.

•   Cards experience substantial scale economies but merchant fees in most
    countries are stable rather than falling with volume growth.

•   If remove card rewards, two studies suggest card use would fall but have
    little effect (-1%, -4%) on network card market share due to “habit
    persistence” (Simon, Smith, and West, 2010; Ching and Hayashi, 2010).
       Future of Network Card Reward Programs
•   Court cases and proposed state/federal legislation are focused on returning
    control of merchant fees to merchants.

•   Political power trumps economic issues. As 10 largest US banks receive 80%
    of the $48 billion in credit card interchange fees, merchants will ultimately
     – Challenging & overturning “honor all cards” rule
     – Legislation requiring negotiation of interchange fees
     – Legislation giving FR authority to impose cost-based interchange fees
     – Legislation permitting minimum value for card use and discount for cash.
         (last 2 items are now law in Vermont, except enforcement is at state level)

•   Possible cheaper payment instrument with no interchange fee:
     – Consumer-initiated electronic check at POS or via Internet for bill payments
     – Makes checks 100% electronic; big cost savings in B-to-B payments

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