The strange case of a Cup of Coffee, Credit Cards and Costa Rica vacations

Utpal Dholakia always has interesting posts on pricing.  This one got me thinking about the strange way that buying a coffee can result in wealth transfer to an airline. 

Airlines make a lot of money off of their loyalty programs (often all of their profit). 71% of those miles are purchased, many by banks for their credit card programs.  This is strange.

Credit card payment processing is not a very economically efficient market: there's close to a duopoly with MasterCard and Visa (80% market share).  That, along with the scale efficiencies, consumer switching costs, and merchant risk aversion (more on this below) mean they can charge high fees to merchants, capturing huge value.  (Capturing rather than creating IMHO, since this is rent-seeking behavior. It's a high-margin, commodity business. MasterCard net profit margin is 50%!)

MasterCard and Visa member banks then compete with each other in a profitable but near-commodity market. One way they compete is on price: sharing some of the fees they earn via the processing companies with consumers. They could do this with a simple cash-back scheme or other reward programs, but it turns out that airline loyalty points work well since many people value them higher than their actual worth. It's basically a parallel currency with a highly variable exchange rate to valuable services. An exchange rate the airline controls.

Why do consumers get this wrong (on average)?  Three main reason I think.  Travel rewards are aspirational: my coffee helps me to take that vacation to Costa Rica (albeit with a LOT of coffee).  Secondly, airlines promote the best value options for using the miles, while in practice seats are only available for less attractive, lower-priced flights  You can do quite well on this (intercontinental business class is my fav, albeit not so much these days), but on average consumers are not so strategic.  And finally I think it’s the psychology of big numbers: 50,000 miles feels like it should be worth more than $500 (United sells them for 3.5c per mile at list price, rarely less than 2c). 

Back to the coffee: in many places credit cards can be used with no charge to the consumer, so the miles ‘earned’ are free.  But in reality, the merchant pays a service fee for 1.5-2.5+%.  While this is only pennies for your espresso, it adds up, and is a big chunk of a merchant’s profit.  Why don’t they not accept credit cards or surcharge them: the first results in lost business, the second is not popular with consumers and adds complexity to the transaction.  Most swallow the cost.

So the pricing power of credit card issuers along with few other pricing concepts results in coffee shops subsidizing airlines.  For that matter, Amazon does too!  Kinda weird!

Is any of this a problem?  To me it seems sub-optimal.  Taking a societal viewpoint, pricing should help us get to the most desirable outcome (if you buy me a beer we can debate what that looks like).  Anytime a company can make 50% profit margins in a mature industry, it’s rent seeking and red flags should go up.  But just because it’s not illegal doesn’t mean it’s a good thing for all of us in aggregate. 

So next time you want to support a local business, skip the credit card and use your debit card.