Your Network or Mine? The Economics of Routing Rules

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Your Network or Mine? The Economics of Routing
Rules

• Benjamin E. Hermalin Michael L. Katz
• University of California, Berkeley

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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.

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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 dont permit multiple bugging (impose
  exclusivity)

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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
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Yet Another Example Choice of Word Processing
Program for Writing Joint Paper on Routing Rules
LaTEX
Word
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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 Bs benefits are independently determined
• Each sides benefits have full support on the
  relevant rectangle in ?2.

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Timing
A and B choose the networks to join and, where
they have the right, specify routing choices
Network set per-transaction charges, pzk, where z
X or Y and k A or B
Payoffs
Networks simultaneously choose routing regimes.
A and B learn their consumption benefits (types).
A partys type is his or her private information
Parties meet to conduct a transaction
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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.

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One-Side-Chooses Routing

• Conflict arises if networks assign routing choice
  to different sides here we assume theyve 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.

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As Strategy
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Bs Strategy
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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)

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A Partys strategy when networks both adopt
network routing
Note ? ? (0,90).
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One Network Stipulates Network Routing

• Suppose X is only network to stipulate network
  routing.
• Doesnt matter what routing regime Y chooses.

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A partys strategy when only one stipulates
network routing
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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.

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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.

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Bs Strategy
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As Strategy
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Normal-Form Game for Routing Regime Choice
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Normal-Form Game for Routing Regime Choice
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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).

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Extension Video Games Application Software

• Can think of game consoles or OSs imposing
  one-sided exclusivity on consumers.
• Should console makers or OS companies impose
  one-sided exclusivity on developers?

X X
Dev. Excl. Not
Y Dev. Excl. ?N ?N ?N ?N
Y Not ?N ?N ?E ?E
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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