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Working Papers

May 2013, No. 13-06R

Price Cap Regulation in a Two-sided Market: Intended and Unintended Consequences (Revised December 2015)

Zhu Wang

This paper studies intended and unintended consequences of price cap regulation in the two-sided payment card market. The recent U.S. debit card regulation was intended to lower merchant card acceptance costs by capping interchange fees at the issuer cost, but for small-ticket transactions the interchange fee instead rose post-regulation. To address the puzzle, I construct a two-sided market model and show that card demand externalities between large-ticket and small-ticket transactions rationalize card networks’ pricing response. Based on the model, I provide a welfare assessment of the issuer cost-based interchange regulation and discuss alternative regulatory approaches.