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.

Are ‘Sin Taxes’ All Smoke and No Fire?

In teaching basic economic concepts, I always enjoy when we arrive at the lesson combining elasticity with taxes. It is an interesting topic, because it allows students to think about the true motivation for different laws, and excise taxes provide a rather simplified example to tie the two concepts together. As an example, I recently came across an article in the Denver Post which details a proposed constitutional amendment in Colorado to implement a pretty drastic increase in the per-pack cigarette tax in the state.

Before I address the article directly, I’ll provide a quick overview of the terms used above. Consider an excise tax to be a tax on a specific item, such as cigarettes, as opposed to a sales tax which would apply to most or all items you purchase. When thinking about elasticity of demand, think of it as measuring the percent increase or decrease in quantity demanded, when the price of that good changes by some percent. Basically, if a good that you want to buy gets more expensive, how much less of that good are you now willing to buy? This elasticity ranges from Perfectly Elastic (you won’t buy any quantity of the good anymore if the price goes up even a penny), to Perfectly Inelastic (you’ll keep buying the exact same amount of the good, no matter how much the price increases).

As you can see in the graphs above, if the price of cigarettes were to increase due to a tax, the quantity demanded would drop off precipitously if demand for cigarettes were very elastic, but would hardly change at all if the demand for cigarettes were very inelastic.

Thus, it is important for us to consider the ultimate goal of those proposing the increased tax. In the article, the proposed initiative is said to include an increase in the per-pack tax on cigarettes in Colorado from $0.84 to a whopping $2.59. It is argued that this would be done “in the hopes of persuading more people never to start smoking.” However, how easy is it really to get people to stop smoking, or never to start, by raising the price of a pack of smokes? This is where elasticity should examined. The article cites “research on consumer behavior” which “suggests as many as 35,000 kids could be kept from starting as smokers by the proposed tax increase.” However, a quick google search finds that estimates of the price elasticity of demand for cigarettes are consistently in the “inelastic” range, with absolute value between 0 and 1.  What this means is that, if the elasticity were -0.50, a 10% increase in the price of cigarettes would only result in a 5% reduction in the quantity of cigarettes demanded. Thus, an increase in the amount of the excise tax on cigarettes wouldn’t get many people to quit smoking, but it would increase tax revenues.  The article notes that the proposed tax is expected “to bring in $315 million in its first year.” If this is the true goal of the tax, the supporters should be clear about it.

The proponents of the amendment seem to be relying on two things in this scenario. The first is that they are focused on preventing children from beginning to smoke, rather than stopping current smokers. Perhaps children’s demand for cigarettes when they do not yet smoke is much more elastic than the other groups cited in the estimates above. Secondly, the money raised through the tax is, for the most part, going to be funneled in to programs aimed at helping people stop or never start smoking. Through these programs, the elasticity of demand for cigarettes could be changed over time. If people did stop smoking, less tax money would be collected, but less money would also be needed to fund programs to help people stop smoking.

A final point of consideration is to keep in mind that elasticities are really just estimating the slope of the Demand curve at one given point. They are great for obtaining an estimate of how steep the Demand curve is in close proximity to this point, and thus for estimating the elasticity of demand for small changes in prices. However, they are much less accurate for estimating how much quantity demanded will change due to extremely large changes in prices. As such, any estimates of a fairly large increase in prices (such as the 159% increase in the proposed amendment) must be taken with a grain of salt.

The point of this post is to keep in mind that when an excise tax increase is proposed, the desired result may be to substantially decrease consumption or to increase tax revenues, but it is difficult to accomplish both.