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This paper provides a new theory for two-sided payment card markets by positing better micro-foundations. Adopting payment cards by consumers and merchants requires a fixed cost, but yields lower marginal costs of making payments. Considering this together with the heterogeneity of consumer income and merchant size, the theory derives card adoption and usage pattern consistent with cross-section and time-series evidence. The analyses also help explain the observed card pricing pattern, particularly the rising merchant (interchange) fees over time. This is because a private card network, besides internalizing the two-sided market externality, has the incentive to inflate the card transaction value.
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