Platform Fee Floors, Market Power, and Missing Markets in Digital Payments: An Industrial-Organisation Calibration

Technical Summary: Platform Fee Floors, Market Power, and Missing Markets in Digital Payments

Problem Statement
This paper addresses a specific industrial-organisation problem within digital payment systems: the role of fixed per-transaction fees as market-boundary instruments. While existing literature on two-sided markets (e.g., Rochet and Tirole, 2003; Schmalensee, 2002) focuses on the division of surplus among observed transactions, this paper argues that fixed fees define the feasible set of exchange. A relationship with a periodic value flow $x$ and surplus rate $m$ can only settle on a payment rail if $mx \geq \phi$, where $\phi$ is the fixed fee. Consequently, a positive fixed fee creates a "missing lower tail" in payment data: low-flow relationships (e.g., machine-to-machine payments, micro-transactions) are excluded from the market entirely, not because they lack economic value, but because their periodic flow cannot cover the fixed cost of participation.

The central question is how the feasible set of exchange changes when the fixed component of payment pricing falls by orders of magnitude, while trust (legal enforcement, identity, compliance) remains supplied by institutional mechanisms rather than anonymous consensus.

Methodology
The paper employs a structural industrial-organisation model calibrated with US card data and public fee schedules. The approach is distinct from point forecasting; it is a bounds and sensitivity exercise designed to estimate a "feasible-flow envelope."

1. Theoretical Model:

   • Two-Sided Platform: The model features a monopolist processor (later extended to competition), buyers, and sellers.
   • Cost Structure: Per-transaction costs are decomposed into a value-independent switching cost ($s_\theta$) and trust costs (fixed $\tau_0$ and proportional $\tau_1$).
   • Fee Structure: Platforms charge a fixed fee ($\phi_0$) and an ad valorem rate ($\phi_1$).
   • Participation Inequality: A relationship settles only if $mx \geq \phi_0$. This defines a minimum viable transaction value $v^* = \phi_0 / (p_S - \phi_1)$.
   • Market Power and Pass-Through: The model explicitly separates resource-cost savings from surplus-transfer stakes. It demonstrates that lower switching costs do not automatically lower the user-facing fixed fee; pass-through depends on market power and the semi-elasticity of volume.

2. Empirical Calibration:

   • Data Sources: Federal Reserve Payments Study (transaction value distributions), Visa FY2024 earnings reports (operating expenses), and public fee schedules (Visa, FedACH, FedNow).
   • Counterfactual: The study compares the incumbent card architecture (fixed fee \approx \0.10–$0.22$) against a counterfactual "low-fee rail" with a value-independent fixed fee (central benchmark \approx \0.000003$).
   • Sensitivity Analysis: The paper does not rely on a single Pareto extrapolation. It tests robustness by varying the lower-tail attenuation, capping the density below $1, and altering the fixed-fee floor.
   • Distinction of Objects: The calibration strictly separates three quantities often conflated in policy debates:
     1. Resource-cost savings on observed transactions (intensive margin).
     2. Platform-margin stakes (surplus transfer).
     3. Feasible-flow envelope (extensive margin: value of relationships excluded by the current fee floor).

Key Results

1. The Fixed Fee as a Market Boundary: The primary comparative static result is that lower switching costs only expand the market if they are passed through to the user-facing fixed fee. If a platform with market power retains cost savings as margin, the participation floor remains unchanged, and the "missing market" persists.
2. Welfare Decomposition: Welfare gains are split into:
   • Intensive Margin: Resource savings on existing transactions (estimated at ~$700 million annually based on switching cost differentials).
   • Extensive Margin: Surplus from newly viable transactions. This is the dominant potential gain, representing the value of relationships that are currently excluded.
3. Feasible-Flow Envelope: Under a central Pareto scenario with a low fixed fee of \0.000003, the model-implied feasible flow exceeds current card value, reaching approximately \18.4 trillion annually. However, this magnitude is conditional on the lower-tail distribution.
   • Robustness: Even under conservative assumptions (raising the low fee to \0.001$or attenuating the lower tail to 10$0.7 to $7.7 trillion), significantly larger than the resource savings on existing transactions.
4. Nature of Missing Markets: The paper identifies that small transactions (e.g., sub-$5) currently observed on card networks are often sustained by cross-subsidization within broader customer relationships. The "missing market" consists of standalone low-flow relationships (e.g., machine-to-machine, metered data) that cannot be cross-subsidized and are therefore priced out entirely by the incumbent fixed fee.

Significance and Claims
The paper claims to contribute to the literature on two-sided markets and industrial policy by shifting the focus from the division of surplus on observed transactions to the creation of markets via fee floors.

• Industrial-Organisation Insight: The paper argues that fixed fees are not merely processing charges but instruments that determine which firms, platforms, and automated services can transact. Regulation of interchange fees on observed transactions reallocates surplus but does not necessarily expand the feasible set of exchange.
• Policy Implication: Industrial policy should target the extensive margin. Mechanisms such as fixed-fee caps, regulated access to low-fee settlement rails, or public/private instant-payment infrastructure can alter the participation set, enabling low-flow relationships to become commercially addressable.
• Scope Limitation: The paper explicitly distinguishes its scope from anonymous, permissionless consensus models (e.g., Budish, 2025). It does not claim that proof-of-work can secure Visa-scale value at low cost. Instead, it argues that in a legally governed environment with identified operators, the mechanical switching cost can be decoupled from trust costs, allowing for a low fixed fee that changes the participation set without eliminating the need for institutional trust.
• Modesty of Claims: The authors emphasize that the paper provides a "feasible-flow envelope" and a "bounds and sensitivity exercise," not a point forecast of adoption, revenue, or realized demand. The claim is structural: the fixed fee defines a boundary, and lowering that boundary theoretically expands the set of feasible economic relationships.