Your Network or Mine? The Economics of Routing Rules

Benjamin E. Hermalin & Michael L. Katz

University of California, Berkeley

The Issue

Two parties A and B want to complete a transaction that requires a network (e.g., a debit-card transaction).

In some situations, there is more than one network to which A and B commonly belong.

Which network carries the transaction in such a case is determined by the operative routing rule.

This paper studies the economics of routing rule choice.

An Example: PIN Debit Cards

In US, many debit cards can run over multiple PIN debit networks and many merchants belong to multiple networks

Can be seen as a game between the issuing bank, A, and a merchant, B.

Possible routing regimes: Issuer chooses (common in US) Merchant chooses Network chooses Networks don’t permit multiple bugging (impose exclusivity)

Other Examples

Situation A B Networks

Credit cards Consumer Merchant Credit card assns.

Telephone termination

Caller Receiver Wireless vs. Land line

Internet ISP Web host Service backbones

Shipping Consumer Merchant Shipping companies

Yet Another Example: Choice of Word Processing Program for Writing Joint Paper on Routing Rules

Word

LaTEX

A Model

A and B are two sides of market X and Y are two networks Gross consumption benefits for A & B are az & bz,

respectively if transaction conducted on network z. They are zero if no transaction is completed. Consumption benefits are randomly distributed

A and B’s benefits are independently determined Each side’s benefits have full support on the relevant

rectangle in +2.

Timing

Networks simultaneously choose routing regimes.

Network set per-transaction charges, pzk, where z = X or Y and k = A or B

A and B learn their consumption benefits (types). A party’s type is his or her private information

A and B choose the networks to join and, where they have the right, specify routing choices

Parties meet to conduct a transaction

Payoffs

Connection Continuation Game

Lemma 1: In equilibrium: If k gains surplus from neither network, then k

joins neither network. If k gains surplus from only one network, then k

must join that network and must not join the other. If k gains surplus from both networks, then k must

join at least one network.

One-Side-Chooses Routing

Conflict arises if networks assign routing choice to different sides; here we assume they’ve chosen a common side.

Suppose we have A-chooses routing. Because A has choice and B might tremble,

A should join any network that yields her positive surplus.

A’s Strategy

B’s Strategy

Network Routing (2-sided exclusivity)

Network stipulates that, whenever possible, transactions be carried on it.

Because they risk being in breach of contract, A and B can join only one network when both networks stipulate network routing.

Two cases to consider Both networks adopt network routing Only one network adopts network routing (choice

of other is irrelevant)

A Party’s strategy when networks both adopt network routing

Note (0°,90°).

One Network Stipulates Network Routing

Suppose X is only network to stipulate network routing.

Doesn’t matter what routing regime Y chooses.

A party’s strategy when only one stipulates network routing

Which Network Gets Trade

Corollary 1: Suppose network X stipulates network routing, but Y does not. If X and Y charge the same prices and distribution of user types are uniform on the unit square, then the equilibrium probability that trade is on Y is greater than the probability it is on X.

Network routing appears disadvantageous against a rival network with a different routing regime.

One-Sided Exclusivity

Exclusivity looks like network routing if … … either network requires exclusivity of both sides; or …one network requires exclusivity of one side and the

other network requires exclusivity of the other.

Case to consider is if exclusivity required of just one side (by both or only one network).

Suppose that side is A. Possibility of trembles B should be on a network if

and only it provides him positive surplus.

B’s Strategy

A’s Strategy

Normal-Form Game for Routing Regime Choice

Normal-Form Game for Routing Regime Choice

Conclusions of Main Model

Networks should give choice of routing to one side of the market. Privately optimal Socially optimal

Some results at odds with actual debit-card experience in US. Suggests need to consider inter-merchant competition consider a dynamic model of growth & penetration consider one side (merchants) perceive no

differentiation other than price (i.e., bX = bY).

Extension: Video Games & Application Software

Can think of game consoles or OS’s imposing one-sided exclusivity on consumers.

Should console makers or OS companies impose one-sided exclusivity on developers?

XDev. Excl. Not

Y

Dev. Excl.

N

N

N

N

NotN

N

E

E

Other Extensions (Future Versions)

Random routing Conflicts in routing rules could be modeled as

resolved via random routing. Deciding party pays

Often when A or B has choice of routing, he or she is the only one charged for using the network.

While known to be inefficient, common in practice. Hence, worth considering consequences for

pricing game and routing-choice game. Membership fees