Credit for Trying - Is Banning Transactions Fees a Win for the Consumer?

Take a second and think back to the last time you bought something that was on sale. How great did it feel? It’s easy to recognize and appreciate deals when you get a better price for something you were going to buy anyway. But how do you feel when the tables are turned, and you’re charged extra to buy something?

For example, when you go to the gas station to fill up your SUV, do you pay with cash or credit? At most stations, the price that you pay per gallon when using cash is different than the price per gallon for using credit. Either way, you’re getting the exact same gasoline, so how do you perceive this difference in price? If you see it as a mark-up or extra fee for using credit, you’re probably not a huge fan of the price differential. On the other hand, if you see it as a discount for using cash, you may view it favorably, and would be unlikely to want to see the discount removed.

When you purchase something, you often weigh 
the cost and benefits of using cash vs. credit

(Photo credit: 401kcalculator.org)

It is with this in mind that this article from The Telegraph, across the pond in the UK, caught my eye. The article was written by The Telegraph’s Consumer Affairs Editor, who chalks up a new law banning charging many credit card fees as a clear victory for consumers. If the title of the article, “[e]nd to rip-off credit card fees…” doesn’t make this position clear, the description of these “rip off” fees as being “used by shops, restaurants and travel firms to make extra profit at the direct expense of customers choosing to pay by card” should remove all doubt. But is the removal of these fees truly a clear “win” for consumers, at the expense of the greedy shops, restaurants, and travel firms?

Let’s begin by considering a portion of the quote above. These fees are charged to customers who are “choosing to pay by card.” This implies that the customers have other options (usually cash), but find paying by card to be preferable for some reason. Presumably, either they find using credit more convenient, or they may receive some cash back or points for using their credit cards. No matter the reason, some citizens chose to pay in credit despite the fee, and others chose to avoid the fee by paying in cash. Essentially, you’re free to sort into the group (cash or credit) that you feel is the best deal for you, after taking the fees into account.

Now what happens if you ban the ability to charge credit card transaction fees? If you’re a consumer, perhaps you’re hoping that the cash price will stay the same, and the credit price will be lowered to match it. Those who previously paid in credit would now be better off, since they still get the perks (convenience, points, etc…) of using credit, but for a lower price. If this scenario were to play out, even those previously using cash would be as well off, if not better off. Some of them may even choose to switch over and begin using credit cards for their purchases! Consumers would clearly be better off, and the costs would fall on either credit card companies or those greedy shops, restaurants and travel firms. The problem is, this scenario has some assumptions that aren’t likely to play out in the real world.

How do you view the price difference in
paying for gas with cash vs. credit?

(Photo credit: 127driver via Wikimedia Commons)

The issue with the scenario above is that it assumes the cash price will stay constant. It’s like assuming that if gasoline is currently $2.00/gallon when using cash, and $2.10/gal when using credit, that all gas would be $2.00/gal after the fees were banned. But it’s costly for gas stations and other stores to offer the payment option for credit cards. They even have to pay fees to the credit card companies for facilitating these transactions. If gas stations can’t pass along these fees to consumers, they have to find some other way to not lose money on the transaction. In this example, gas stations will do one of two things. First, they may increase the price of gas for everyone, let’s say to $2.05/gallon. While those consumers using credit cards are now better off, those who still use cash are clearly worse off, as they are helping subsidize the purchases of their credit using neighbors. The other possible result of the ban on fees is that vendors may choose to cease offering credit cards as a payment option all together. In this case, those who previously used credit cards are clearly worse off, as they used to have to choice to use either cash or credit and chose credit, but now must choose their second best option.

The lessons in the example above could easily be extrapolated to apply to all sorts of shops and firms. It’s easy to see that a law which essentially limits the choices of the consumer is not necessarily a clear “win” for all consumers, or even the average consumer. Viewing the issue as a discount for using cash rather than a penalty for using credit allows us to see more clearly the true costs and benefits of such a regulation. Perhaps The Telegraph is giving lawmakers more credit than they deserve.

Nice Guys Finish Last? You Can Bank on It

Remember when you were growing up in elementary school, and the teachers made pretty much everything a competition versus your peers in order to keep your attention and teach you valuable life skills? Perhaps it was determining who got to walk at the head of the line on the way to lunch by who did the best on a quiz, rather than deciding based on height (which I, at 6’3” would have preferred). These incentives were used to motivate us to work harder in order to have a chance to reap the rewards, as well as to convey a sense of “fairness” about the process which would otherwise be seen as a process involving either favoritism or randomness (or both) on the part of the teacher. As economists, we recognize how valuable such incentives can be as a motivational tool. The (unintended?) consequence of all of this competition among school children is that the common refrain, “he cheated!” rings out across the schoolyard on a frequent basis. And why shouldn’t some children test the boundaries, immediately discovering whether the costs of cheating outweigh the benefits, as they are caught and sent to the back? Thus, the incentive to cheat is greatly restrained by the swift doling out of a penalty moving you to the back of the line. The added benefit is that those students who don’t cheat aren’t relegated to the middle or even the back, due to the immediate punishments of the wrongdoers.

Things work out well in the school competition scenario described above, but with a slightly different set-up of incentives things can quickly go awry. This appears to have been the case for Wells Fargo, as the bank was recently fined $185 million due to the discovery that many of its employees had “cheated” by opening fake accounts in order to receive bonuses associated with meeting sales goals. It has been widely acknowledged that there have been winners and losers as a result of this practice. There are the account holders who never consented to having new accounts opened in their names, but were still charged fees associated with those accounts. Wells Fargo has agreed as part of the settlement to refund those approximately $2.6 million. There is the Wells Fargo Unit Leader who oversaw the “cheaters,” who left with $125 million just after news of the scandal broke. This is akin to a teacher getting credit for her students’ impressive test scores, only to find out later that the students had cheated. And of course, there are the 5300 employees who were eventually fired for “cheating” by opening the fraudulent accounts.

But there is one affected group which has largely been ignored in this situation; the Wells Fargo employees that simply chose not to cheat. Unlike the schoolchildren in the example above, the offending employees who cheated were not caught and reprimanded immediately, but rather over a five-year period that culminated in the recent ruling. Throughout those five years, there were thousands of Wells Fargo employees who played by the rules, and didn’t open fraudulent accounts. Because the penalties weren’t immediate, these honest employees were relegated to the middle/end of the metaphorical line. Where are the articles calling for these “nice guys” to be compensated for lost bonuses that they may have rightly earned had everyone played by the rules?

To be fair, even the honest employees would have benefited some from Wells Fargo’s success before the cards came tumbling down. If they owned stock in the company, they would have seen the rising value as the company appeared to be performing better than it actually was. If they are still holding that stock, however, those gains would have quickly dissipated this week. It could also be argued that some honest employees were only able to be retained by Wells Fargo over this period due to the company’s relative success. However, the flip-side of that coin is that some honest employees may have been fired for not meeting elevated sales goals that would have been lower had the cheating not occurred.

The problem here is that the lag in punishment for cheaters leads to what amounts to an immediate punishment for non-cheaters, which is never fully rectified. Wells Fargo has even announced that they are removing the sales goals in an effort to restructure incentives, but they aren’t going as far as to retroactively compensate the “honest” employees according to the new pay structure. They are now “Taking appropriate actions—including disciplinary‚ to address those who have served our customers in ways that were counter to our ‘Vision & Values,’” but make no mention of addressing those who served customers honestly and by the rules.

From an economic perspective, it is important to consider that people are rationally motivated by incentives, but that they may not realize or consider the negative impact that their actions have on others. However, this does not mean that the negatively impacted group should be ignored or forgotten. It’s important not only to punish those who cheat, but also to be sure that those who play by the rules get their turn at the front of the line.