Do you know how credit card companies can give you 2% or more cash back? They charge merchants 1-3% processing fees! Plus they earn interest when people carry credit card debt.
Why do merchants put up with these 1-3% fees? Because the credit card companies provide them with a valuable service. It makes getting payments from people easier, especially in the days of fewer people carrying cash. This expands their sales and more than makes up for the 1-3% fees they’re being charged by the credit card companies, although they’d rather not get charged such high fees, especially when many companies’ profits are not much more than 3%.
This is a tricky game the credit card companies are playing. They’ve found that to get more people to use their cards, they need to give rewards like cash back. And there’s this delicate balance created. They want to get the most people using their cards by offering the most generous rewards, but they can’t charge merchants too much to fund those rewards or else merchants will stop accepting those cards. Except that the biggest credit card companies are too important to stop accepting, so they can get away with charging even higher fees. It rewards size. The bigger companies are rewarded with even more market share. It tends toward monopoly, or at least oligopoly, which means the middle men will be empowered to take an even larger share of the total price paid.would make their cards’ usefulness lower and maybe not worth the more generous rewards.
Let’s look at what is happening in the market in aggregate. Merchants, to cover the added expense of high credit card fees, end up charging higher prices. And then the credit card companies are passing some of that money on to the consumer. It’s all because credit card companies are creatively finding ways to leverage their market power to win more customers.
Wouldn’t this all be simpler if credit card companies couldn’t give rewards? Then consumers would be faced with true prices from merchants rather than having to guess at the net price of things after accounting for rewards, and they’d probably lose less of the total price to extra profits for the middle men. With decreased complexity comes greater market transparency, which makes hiding extra profits in the shadows of complexity much more difficult.
Can you see how this is exactly the role pharmacy benefit managers (PBMs) play? They’re a middle man that gets the drug manufacturer to give them a bunch of money (“rebates”), and then they pass a portion of it on to the insurer in an attempt to win as many insurer contracts as possible. Instead of simply competing by offering the best service and charging reasonable fees to win insurer contracts, they’ve expanded into these strange (but ingenious) complexity-increasing strategies. I described the evolution of PBMs into this complicated middle man position here.
In business school, I didn’t learn about this middle man game of leveraging market power to take extra money from suppliers and pass some of it directly on to their customers. Maybe this is a well-understood phenomenon and there’s a term for it and I just have been unaware. But whatever we call it, I don’t like it because of the additional complexity it creates and how it rewards size with even more size (tending toward fewer market competitors). I haven’t noticed any other examples of this, but I’d be interested to hear if anyone has one.