Is the Debit Card Revolution Finally Here?

Federal Reserve Bank of Kansas City - Economic Review, Fourth Quarter 1994 by Caskey, John P, Sellon, Gordon H Jr

After a slow start, use of debit cards has grown impressively in recent years (Chart 1). (Chart 1 omitted) From 1990 to 1993, the number of both on-line and off-line debit transactions grew at an average annualized rate of 30 percent to a total of over 700 million transactions in 1993. An important stimulus to the recent growth of on-line transactions is the greater willingness of merchants to install the specialized equipment needed to process on-line transactions. Indeed, from 1990 to 1993 the number of on-line terminals increased threefold, and in 1994 alone the number of installed terminals more than doubled to 344,000 units (Chart 2). (Chart 2 omitted) Because off-line debit transactions can be processed using existing credit card authorization equipment, terminal growth has not been as important a factor for off-line cards. Rather, off-line debit growth has been driven by increased availability of off-line cards as both Visa and MasterCard have undertaken promotional programs.

Despite these impressive growth rates, the debit card is currently used in only a small percentage of retail transactions. In 1993, the consulting firm, Payment Systems Inc., conducted a national survey of 540 merchants in six retail categories: oil and gas, restaurants, hotels/motels, durable goods (hardware, furniture, etc.), grocery and convenience stores, and specialty retailers. According to this survey, cash, checks, and credit cards continue to be the dominant means of retail payment. Indeed, customers at these businesses used cash for over half of all transactions, while checks and credit cards accounted for most of the remaining payments (Chart 3). (Chart 3 omitted) Customers at surveyed firms used debit cards for only 2 percent of transactions.

Debit card use is also highly concentrated by type of business and geographic location (Chart 4). (Chart 4 omitted) The vast majority of on-line terminals are located in just three business categories: grocery stores, gas stations, and convenience stores. And, use of debit cards is most prevalent on the West Coast, in the Northeast, and in Florida. In fact, California, where debit programs are most advanced, accounts for one-half of all on-line transactions.

NETWORK EFFECTS AS A BARRIER TO DEBIT CARD GROWTH

The slow acceptance of debit as a means of payment can be traced partly to problems inherent in any attempt to make a major change in the payments system. Economic models of network effects stress how insufficient standardization, compatibility, and leadership can serve as barriers to change in situations where adopting a new product involves the interrelated decisions of many consumers and producers. As a consequence of structural changes in the banking system, however, these technological barriers to debit growth will become less important in the future.

Network effects and product development

Economists use the term "externality" to describe situations in which one individual's behavior has spillover effects on others. A positive "network externality" exists if the benefit an individual derives from using a product increases as the number of other individuals using that product increases (Farrell and Saloner; Katz and Shapiro). There can be various causes of such an effect. In some cases, the usefulness of a product, such as the telephone, can depend on how many other people also have telephones. In other cases, benefits may occur because certain goods have complementary uses. For example, the usefulness of a personal computer depends on the range of software available for the computer. The more people who own a particular type of computer, the more likely it is that there will be a wide range of software written for that computer.