Network issues and payment systems

Credit & Financial Management Review, First Quarter 1998 by McAndrews, James J

Networks play an integral part in the production and consumption of certain goods and services, including transportation, communications, and payment systems. A network good or service has two main characteristics: the value a person gets from the product increases as more people consume it and the technique a firm chooses to produce the product will depend on techniques chosen by other firms. For example, consider a telephone system. The greater the number of people connected by telephone lines, the greater the number of people any member of the system can call and the more he or she will enjoy belonging to that telephone network. Similarly, firms that offer phone service will produce switches and lines compatible with those of other firms that offer phone service, so that they can offer their customers the valuable service of connecting to all other parties.

It is helpful to think of network components as nodes connected by links.l Perhaps the most transparent example is a railroad system, a physical network composed of lines (the links) that connect destinations (the nodes). A railroad to one destination is of some value, but a railroad system that connects a traveler to many destinations potentially has great value. To create an extensive railroad system, regional rail lines must use compatible gauges. This complementarity between the components of a network leads consumers to place a higher value on larger networks and leads firms to take into account the production decisions of their rivals.

Other examples of physical networks include highways, oil and natural gas pipelines, water systems, and computerized airline reservation systems. Certain information services also have network characteristics. The Internet, for example, can be thought of as a network in which the computers are the nodes, and the software and the telephone lines to which the computers are connected form the links that allow files to be exchanged and seamlessly read by different machines.

Payment systems, such as credit cards, ATMs, currency, and checks, are also examples of network goods. Here, the nodes might be merchants, consumers, and banks, which are linked by the exchanges of information among them. In some cases, such as in an ATM network or a point-of-sale (POS) debit system, the links may also consist of telephone lines. In others, such as in the checking system, the links consist of methods of delivery of the check from the merchant to its bank, and from that bank, through a clearinghouse (similar to a telephone switching system), to the consumer's bank. In a credit card system, the complementarity between the components is obvious: as more people use credit cards, more merchants are induced to add terminals, since allowing customers a convenient means of payment will potentially increase their sales, and as more merchants permit credit card payment, the value to the customer of having a credit card increases too.

Economists have recently renewed their interest in many of the unique issues that arise in network-dependent industries. Below, we'll discuss some of these issues, including compatibility and standard-setting among service providers, the role of an installed base of network facilities, and access to network facilities.2 In addition, the more common economic issues of pricing policies, the tendency toward monopoly, and the introduction and adoption of alternative technologies take on new dimensions in network industries. Network economics is increasingly relevant in today's economy because of the growth of the communications industry and the computer hardware and software industries and the introduction of new forms of payment systems such as electronic money. An understanding of the economics of networks and the unique features of network goods gives insight into the organization of markets for these goods and provides the basis for formulating good business and public policy concerning these goods. Below, we'll also analyze some payment-system issues from the perspective of network economics and show that formulating appropriate public policy would be difficult without a knowledge of the economics of payment networks.

Network Issues

Not all goods have network characteristics. For non-network goods, firms compete to be the main producer, and the techniques one firm uses in producing the goods need not be related to the techniques used by other firms. Typically, the firm that is the most efficient producer will gain market share, and other firms will lose market share or be driven from the market entirely. Moreover, the pleasure one person receives from purchasing the good would be the same no matter how many other people purchase it. Think of ice cream: different firms compete to be the most popular brand, each using a technique it believes produces the tastiest product, and one person's pleasure from eating a cone doesn't depend on how many others buy ice cream cones.

But the situation is different for network goods. Consider a communications system: if one person uses Morse code and another uses semaphores, they could not communicate. For communication to flourish, a coordinated system of signals that can be mutually understand is necessary. So firms that want to provide some of these services must consider what other firms are providing. Rather than competing, these firms' decisions complement one another.3 Furthermore, as more adopt the communication system, its value increases, since it provides access to more people; this encourages larger networks.