Managerial Economics Writing Assignment

– Read both attached articles (the writing assignment revolves around these two articles)

– Adhere to Outline and focus on what’s asked

-Thoroughly answer both questions attached in correspondence to articles and outside research need be

-The paper must be a minimum of five (5) pages

Report Outline

Purpose of the case study: Why was the case study written, what is so important about it, why is it interesting, etc.

Pricing at Deutsche Telekom

Discussion Question

Describe the market for telephony services prior to the enactment of the 1996

Telecommunication Act in Germany. Why is it unlikely that DT would face new

competition in the market for retail fixed-line telecommunication services prior to

1996?

Visa and MasterCard’s Association Potentially Anticompetitive

Discussion Question

What is the ownership structure of Visa and MasterCard? How is the

management set up to reflect this?

Managerial Economics and Business Strategy, 6e Page 1

Pricing at Deutsche Telekom

Michael Baye and Patrick Scholten prepared this case to serve as the basis for classroom
discussion rather than to present economic or legal fact. The case is a condensed and slightly
modified version of the public copy documents involving the Commission of the European
Communities’ Case Comp/C-1/37.451, 37.578, 37.579 – Deutsche Telekom AG.

Overview of Germany’s Telecommunication Industry

Deutsche Telekom (DT) owns and operates the fixed telephone network in Germany.
DT’s local networks consist of a number of local loops, which are the physical circuits
connecting subscriber’s to the fixed public telephone network. Prior to 1996, the German
State wholly owned DT and was responsible for building the fixed telephone network
with public resources, which it did over a long period of time. On November 18, 1996, a
25 percent equity share in DT was sold to private investors in order to generate over
DEM 20.1 billion in capital to fund further expansion of its network. After DT took over
VoiceStream/Powerel in 2000, the German State surrendered part of their holdings.
Today, 56.95 percent of DT is owned by institutional and private investors, 30.92 percent
by the German State and 12.13 percent by the German recovery bank – Kreditanstalt für
Wiederaufbau.

Prior to the enactment of the Telecommunications Act on August 1, 1996, DT was a legal
monopoly in the provision of retail fixed-line telecommunication services. To compete
with DT, new entrants needed to invest large sums of capital to develop a network
infrastructure (optical fiber, cable television, power lines, etc.) to provide retail
telecommunication services. Overcoming the economies of scale experienced by DT
along with its extensive nationwide coverage made entry by new firms unprofitable.

The 1996 Telecommunication Act, however, required DT to allow new competitors
direct access to its infrastructure and thereby created more competition in the provision of
retail access to telephone services. While DT is the only operator with nation-wide
network coverage, post Telecommunication Act, it faces varying degrees of competition
in the provision of telecommunication infrastructure (wholesale access to its network)
and in the provision of retail telephone services. The Telecommunication Act leveled the
competitive playing field by permitting financially weaker competitors to gain direct
access to the German retail market through DT’s network. The rules that govern
telecommunication services in Germany are regulated according to access type. That is,
the rules governing retail access are different from those regulating wholesale access.

This case examines alleged unfair pricing practices against DT by competitors and retail
customers after the Telecommunications Act of 1996. The primary charge against DT is
that the margin between the prices DT charges competitors for unbundled access to local

Page 2 Michael R. Baye

loops (wholesale access) in Germany and the prices charged for retail access is
sufficiently small making it unprofitable for new entrants to compete.

Product Markets and Regulatory Environment

Wholesale Access

Local-level access to DT’s fixed-telephone networks can take two different forms. One
way DT was permitted to provide access to its networks was line sharing, whereby
competitors pay fees for shared use of local loops (initially this connection type was not
required). Line sharing permits an incumbent firm (in this case DT) to continue offering
voice telephony services and use the same line to permit an entrant to offer a new service,
like high-speed Internet access. From a technical perspective, voice and data line sharing
are achieved by connecting a splitter and multiplexer (a voice-data filter) between the
incumbent’s switch and the local loop. Under line-sharing arrangements the local loop
remains an integrated part of the incumbent’s (DT’s) network.

In contrast to line-sharing arrangements, full unbundled access to a local loop occurs
when a market entrant completely takes over selected local loops. Technically, at the
switch different retail consumers are separated and connected to the subscriber’s main
distribution frame. This structured arrangement between the incumbent (DT) and new
entrants allows new entrants to access their own local loops without using the
incumbent’s switching facilities. Full unbundling of wholesale access, then, gives new
entrants complete control over local loops; even control of transmission technologies and
types of services offered.

According to German law, charges for wholesale access must have a cost basis and
receive prior authorization by the regulatory authority. Moreover, charges set by DT must
contain no other special charges or discounts, and cannot confer an anticompetitive
advantage to particular operators.

In accordance with German telecommunication law, DT filed an application with the
regulatory authority to authorize monthly charges for unbundled access to DT’s local
loop, one-off charges for opening new connections and one-off charges for taking over an
existing serviceable connection. In 1998, the regulatory authority authorized DT’s one-
off charges of EUR 309.84 for opening a new connection and EUR 135.49 for taking
over an existing line. But, instead of accepting DT’s proposed monthly charge of EUR
14.73 for unbundled local loop access, the regulatory authority authorized a monthly
charge of EUR 10.56. At the time of the decision, the regulatory authority required DT to
submit more detailed cost calculation and conjectured that the competitors’ monthly
unbundled access charge would fall below EUR 10.

After several years of negotiations between DT and the regulatory authority, by April
2003 the regulatory authority had set competitors’ unbundled monthly access rates to
EUR 11.80. Moreover, one-off charges were reduced to EUR 81.12 for new, basic

Managerial Economics and Business Strategy, 6e Page 3

connection, EUR 70.56 for straightforward takeover and EUR 34.94 for discontinuance
(with simultaneous customer transfer) or EU 50.71 (without simultaneous transfer).

Retail Access

Retail access to DT’s fixed telecommunication network is achieved in two ways. First,
retail consumers can access DT’s network via a traditional analogue connection. The
second means of access is through a digital narrowband connection (integrated services
digital network, or ISDN). Both of these access methods provide connection over DT’s
existing copper pair network. Upgraded broadband connections are also available for
faster Internet connection.

Retail charges (tariffs) for access to one of these connection types consist of two
components. This first is a basic monthly charge that varies with the connection quality.
The second component is a one-off charge for a new line connection or the take over of
an existing line.

Unlike charges for wholesale connections to competitors, which are regulated according
to cost principles, retail prices for analogue and ISDN lines are regulated under a price
cap system and only permitted to change according to a set basket of telecommunication
services (prices do not adjust as the cost of providing individual services change). Retail
prices for broadband connection, however, are not subject to either type of regulation.

In 1997, the Federal Ministry of Posts and Telecommunication introduced the price cap
mechanism for retail fixed-network charges. At that time, two baskets were established:
One for residential connection to standard analogue or ISDN lines, the other for services
to business customers for similar connection types.

At this time, the Ministry ordered DT to reduce the aggregate price for each basket by 4.3
percent during the first price cap period; the period spanning 1 January 1998 to 31
December 1999. After this period ended, the price for a basket was further ordered to fall
by 5.6 percent during the second price cap period; the period spanning 1 January 2000 to
31 December 2001. The logic behind these mandatory price-cap reductions was to
capture productivity and efficiency gains realized by DT.

Given the mandatory price reductions, DT was free to modify charges for individual
components with the caveat that these changes were subject to the approval of the
regulatory authority. There was no restriction on the number of adjustments for which DT
could apply in any price-cap period. This means that DT could increase prices for one or
more basket components provided that the cap for the overall basket was not exceeded.

During periods one and two, DT reduced retail prices far below the required reductions.
These reductions applied only to call charges. The monthly and one-off access charges
for standard analogue connection remained unchanged over both periods. During those
periods, DT’s monthly subscription fees were EUR 10.93. Yet, basic monthly charges for
ISDN connections remained relatively stable until 31 March 2000. DT did, however,

Page 4 Michael R. Baye

apply to reduce the prices on several specialized ISDN lines in December 1999, which
were given regulatory approval on 16 February 2000. Retail one-off charges for analogue
and ISDN lines remained at EUR 22.22 for takeover of a serviceable connection and
EUR 44.45 for providing a new connection over the period 1998 to 2001.

In January 2002, a new price cap systems was established by the regulatory authority.
The new system replaced the two basket model for residential and business consumers
with a four basket system. Baskets for retail services now consisted of a basket for retail
lines (end-user lines), local calls, domestic long-distance calls, and international calls. As
a result, DT was required to increase its charges for retail lines.

As mentioned, retail prices for broadband connections are not regulated under the price-
cap system. Instead, DT is free to set these prices at its own discretion. After prices for
certain broadband connection decreased and several complaints from DT’s competitors
occurred, the regulatory initiated an investigation of broadband connection pricing
practices. The basis for the investigation was whether DT lowered its price below cost
and constituted anticompetitive pricing practices. Despite having found some evidence
that DT’s prices were below cost for certain products, the regulatory authority took no
action against these prices. Instead, in other decisions made during March 2001, the
regulatory authority ordered DT to make it possible for competitors to sell wholesale
local network services to other consumers and to make joint use of local loop (line
sharing). DT, however, did not comply with these orders resulting in re-investigation of
the alleged broadband connection charge abuses. DT did eventually increase its monthly
charges for broadband connection services, which resulted in the regulatory authority
terminating its case again DT.

Complaint Against DT

Several competitors allege that DT’s charges to competitors for wholesale access to its
fixed network (both monthly charges and one-off charges) are so expensive that
competitors are forced to charge prices to retail consumers that are far in excess of what
DT can charge retail consumers for similar services. Thus, competitors argue that they
can never make a profit or efficiently compete with DT. This situation is called a margin
squeeze.

DT argues that its pricing practices cannot constitute a margin squeeze since wholesale
charges are imposed by the regulatory authority. DT contends that a margin squeeze must
be the result of excessive wholesale prices or insufficient retail prices (or some
combination of the two). The legal solution, DT argues, can only be corrected if it can
vary both wholesale and retail charges. In the present environment, DT only controls
retail charges.

Others’ contend that the margin squeeze is relevant to this situation since a competitor
buys wholesale services from an established operator and depends on the established
operator to compete in the retail market. Thus, a margin squeeze can exist between
regulated wholesale and retail prices.

Managerial Economics and Business Strategy, 6e Page 1

Visa and MasterCard’s Association Potentially
Anticompetitive

Michael Baye and Patrick Scholten prepared this case to serve as the basis for classroom

discussion rather than to represent economic or legal fact. The case is a condensed and slightly
modified version of the public copy of the Complaint filed in United States of America v. Visa U.S.A.,
Inc. et al. dated October 7, 1998. No. 98-civ.7076.

OVERVIEW OF MARKET FOR GENERAL PURPOSE CARD SERVICES

Visa and MasterCard compete in the market for general purpose card network
products and services. General purpose cards, which include credit cards and charge cards,
are payment devices that enable consumers to make purchases from unrelated merchants
without immediately accessing or reserving funds. Visa and MasterCard are the two largest
general purpose card networks. Together, they account for over 75% of all purchases made
with general purpose cards in the United States.

Visa and MasterCard are joint ventures — or, as they call themselves, “associations”
— created, owned, governed, and operated by and in the interests of their member banks.
These banks use the associations’ products and services either to issue cards to consumers,
provide card acceptance services to merchants, or both.

The same large banks control both associations by simultaneously serving on the
board of directors of one and on important committees of the other. In addition, each of
these banks issues significant numbers of both Visa and MasterCard cards. The control of
the two associations by banks that have significant interests in both — known in the industry
as “duality” — has possibly substantially lessened competition between Visa and MasterCard
because these banks seem to have been, and continue to seem to seem to be, significantly less
willing to fund and implement competitive initiatives that would cause consumers to switch
their business from one association to the other.

In addition, both Visa and MasterCard — on behalf of and in collaboration with the
banks that govern them — have adopted rules and policies that might restrict the ability of all
member banks to do business with American Express, Discover/Novus, or any other network
that the controlling banks deem to be “competitive.” Importantly, Visa and MasterCard do
not apply these rules to one another. Banks can therefore do business with the two largest
general purpose card networks, but not with smaller competitor networks. These
exclusionary rules and policies might eliminate certain forms of competition among the Visa
and MasterCard member banks, and might have effectively precluded American Express and
Discover/Novus from competing to enlist banks in the U.S. to issue their cards.

Through their common control of both Visa and MasterCard, the largest banks might
have stifled competition between these two networks and might have thwarted competition
from smaller competitor networks. This possible reduction in competition among general
purpose card networks might have hindered and delayed the development and

Page 2 Michael R. Baye

implementation of improved network products and services, and might have lessened
consumer choice. If allowed to continue, the possibly anticompetitive structure and practices
of the associations could threaten competition in the development and marketing of new
general purpose card products, such as products that integrate credit, debit, and stored value
functions.

Since the mid-1960s, Visa and MasterCard have operated general purpose card
networks throughout the United States. They provide card network products and services in,
and those products and services affect a substantial amount of interstate commerce. In 1997,
transaction volume on the Visa and MasterCard networks exceeded $600 billion.

RELEVANT MARKET

General purpose cards are payment devices that a consumer can use to make
purchases (a) from unrelated merchants and (b) without accessing or reserving the
consumer’s funds at the time of the purchase. There are two principal types of general
purpose cards:

• credit cards — such as Visa and MasterCard Classic and Gold cards, the
American Express Optima card, and the Discover card — that usually permit
the cardholder to either (i) pay all charges within a set period after a monthly
bill is rendered, or (ii) pay only a portion of the charges within that time and
pay the remainder in monthly installments, including interest; and

• charge cards — such as the American Express Green Card — that require the
cardholder to pay all charges within a set period after a monthly bill is
rendered.

General purpose cards do not include cards that can be used at only one merchant
(e.g., department store cards) or cards that immediately access funds on deposit in a checking
or savings account (e.g., debit cards).

General purpose cards provide a consumer with a combination of convenience,
widespread acceptance, security, and deferred payment options that are not effectively
replicated by any other form of payment. For a significant number of consumers and types
of transactions, other forms of payment are not a close substitute for general purpose cards.

Competition to provide general purpose cards occurs at two levels. First, Visa and
MasterCard compete with American Express, Discover/Novus, Diners Club, and Japan
Credit Bureau (JCB) in an upstream market, hereinafter referred to as the general purpose
card network market. Second, individual Visa and MasterCard member banks compete with
each other and with American Express, Discover/Novus, Diners Club, and JCB in two
downstream markets:

• the card-issuing market — the market for issuing general purpose cards to
consumers;

• the card-acceptance market — the market for providing the services that enable
merchants to accept general purpose cards for the purchase of goods or
services.

Managerial Economics and Business Strategy, 6e Page 3

The Visa and MasterCard associations compete only in the upstream network market.
Their member banks — with the exception of Citibank, which owns Diners Club — compete
only in the two downstream markets. American Express, Discover/Novus, Diners Club, and
JCB are integrated entities that compete in all three markets.

Product Market

Certain functions essential to the acceptance and use of general purpose cards are
most efficiently performed by general purpose card networks, often because the functions
require broad coordination across the network. For example, among these functions, all
general purpose card networks:

• Invent, develop, and implement systems and technologies, including systems
to authorize and settle card transactions and reduce fraud;

• Develop, market, advertise, and promote their brand names among consumers
and merchants;

• Invent, develop, implement, standardize, market, and advertise types of card
products;

• Develop and implement rules and standards to govern their networks;

• Set fees and assessments for use of the network’s products and services,
including the interchange fee that accounts for the largest part of the price that
merchants pay for the right to accept general purpose cards; and

• Extend card acceptance to merchant segments that have not accepted cards in
the past.

The products and services provided by general purpose card networks form a network
market, which is relevant product market. Banks and other entities that issue cards and
provide card acceptance services to merchants rely on general purpose card networks to
provide a core set of these products and services for which there is no cost-effective
alternative. Card issuers and banks that provide card acceptance services to merchants thus
cannot substitute other products and services for the products and services provided by
general purpose card networks in an amount sufficient to deter the exercise of market power
in the network market. In addition, consumers do not substitute other forms of payment, and
merchants do not stop accepting general purpose cards, in amounts sufficient to deter the
exercise of market power in the network market.

The products and services provided by general purpose card networks are critical
inputs to the entities that issue cards to consumers and provide card acceptance services to
merchants.

Card issuers compete for cardholders with respect to interest rates, annual cardholder
fees, payment terms and conditions, card enhancements, and customer service. Entities that
provide card acceptance services to merchants compete with respect to their fees and the
quality of service they provide. This competition among Visa and MasterCard member
banks in the card-issuing market and the card-acceptance market is not a substitute for, and
does not replace, competition at the network level. Competition at the downstream levels

Page 4 Michael R. Baye

thus cannot protect consumers from the anticompetitive effects of the exercise of market
power by general purpose card networks. Competition among card issuers does, however,
ensure that if network competition is vigorous, the benefits of that competition will be passed
on to consumers.

Geographic Market

The United States is the relevant geographic market for each relevant product market.

Almost all of the general purpose cards issued by banks based in the United States are
issued to domestic cardholders, and these consumers use their cards predominantly at
merchants located in the United States. Most general purpose card transactions with
merchants located in the United States are made using cards issued in the United States, and
most merchants would not consider networks operating outside the United States to be a
substitute for networks operating in the United States.

Visa and MasterCard consider the United States to be a separate geographic market,
as demonstrated in part by their establishing separate Boards of Directors for — and separate
rules governing the operation of — their card networks in the United States. For example,
the Visa and MasterCard rules permitting the member banks to issue Visa and MasterCard,
but no other network’s cards, apply only in the United States.

VISA AND MASTERCARD HAVE MARKET POWER IN THE NETWORK
MARKET

Visa and MasterCard’s questionable actions related to anticompetitive effects occur
primarily in the network market. Visa and MasterCard together have and exercise market
power in the network market. Visa and MasterCard are the two largest general purpose card
networks in the United States. Their only significant competitors are the American Express
and Discover/Novus networks, and entry into the network market is extremely difficult.

Visa and MasterCard Dominate the Market

In 1997, Visa accounted for approximately 50% of the dollar volume of transactions
on all general purpose cards in the United States and approximately 53% of the number of
general purpose cards issued. In 1997, MasterCard accounted for approximately 25% of the
dollar volume of transactions on all general purpose cards in the United States and
approximately 33% of the number of general purpose cards issued. Together, Visa and
MasterCard account for approximately 75% of general purpose card dollar volume and
approximately 86% of the number of general purpose cards issued.

In the United States, approximately 3.4 million merchant outlets accept both Visa and
MasterCard. Practically every merchant that accepts Visa also accepts MasterCard and vice
versa. This common merchant base is significantly larger than the base of any other network
competitor. In 1997, American Express accounted for approximately 18% of dollar volume
and 5% of general purpose cards issued in the United States. Cards on the American Express
network were accepted at approximately 2.5 million merchant outlets in the United States. In
1997, Discover/Novus accounted for approximately 6% of dollar volume and 8.5% of
general purpose cards issued in the United States. Cards on the Novus network were
accepted at approximately 3.1 million merchant outlets in the United States.

Managerial Economics and Business Strategy, 6e Page 5

There are two other general purpose card networks that compete in the United States:

• Diners Club/Carte Blanche (Diners), which is owned by Citicorp — the bank
that has issued the largest number of Visa and MasterCard cards — and

• JCB, a network based in Japan that issues cards in the United States primarily
to Japanese expatriates.

Both networks have competitively insignificant market shares and limited merchant
acceptance in the United States.

Competition among Card Issuers is Not a Substitute for Network Competition

Card issuers may compete on interest rates, fees, enhancements, and customer
service. This competition, however, cannot cure the harm to consumers arising from a lack
of competition among card networks, nor does it prevent the Visa and MasterCard member
banks from collectively exercising power in the network market to the detriment of
consumers.

There Are Significant Barriers to Network Entry

The prospect of entry by new card networks does not prevent Visa and MasterCard
from exercising market power in the network market. Entry is extremely difficult because
establishing a new general purpose card network requires large investments to develop both
cardholder and merchant bases. Coordinated development of both cardholder and merchant
bases is critical because the utility of a particular card product to cardholders and merchants
depends not only on the cost and features of the card, but also on the ubiquity of its
acceptance and use.

Since Visa and MasterCard were formed in the mid-1960s, only one network has
successfully entered the relevant market. In 1985, Sears created that new network, then
called Discover and now known as Novus, by building on the infrastructure and the
cardholder and merchant bases of the Sears single-retailer card system. At the time, Sears
was one of the largest retailers and card issuers in the United States.

In the early 1980s, Citicorp — the largest issuer of Visa and MasterCard cards and, at
the time, a large provider of card acceptance services to merchants — unsuccessfully
attempted to enter the network market. Other companies that considered entering the network
market concluded that the high cost of building a merchant and cardholder base made entry
too difficult. For example, in the late 1980s, AT&T considered forming a new general
purpose card network. After analyzing the Discover and Citicorp experiences, however, it
decided not to enter the network market. AT&T instead entered only at the card-issuing level
by becoming a member of Visa and MasterCard.

Visa and MasterCard have adopted and maintained possible anticompetitive rules and
policies that further increase an entrant’s cost of developing cardholder and merchant bases.
By virtue of their dominant market shares and the difficulty of entry into the highly-
concentrated network market, Visa and MasterCard together have potential power to injure
competition in that market. As described below, they might have exercised that power to the
detriment of consumers by reducing competitive investments in the innovation, development,

Page 6 Michael R. Baye

and marketing of improved network products and services, and maybe by restraining the
competitiveness of smaller networks.

THE SAME BANKS HAVE TAKEN CONTROL OF BOTH VISA AND
MASTERCARD

Both Visa and MasterCard are organized as membership corporations that ostensibly
operate on a not-for-profit basis. Their activities are financed through fees and assessments
levied on their members. Both card networks permit a variety of financial institutions to
become members, including commercial banks, thrifts, credit unions, and entities that are
engaged primarily in the card business, commonly known as “non-bank banks” or “monoline
banks.” From here on, all types of financial institutions that are eligible to become members
of Visa and MasterCard are referred to collectively as “banks,” and all financial institutions
that are members of Visa and/or MasterCard are referred to collectively as “member banks.”

Under Visa’s and MasterCard’s corporate structures, a member bank in either
association has the right to issue cards bearing the association’s trademark and to offer card
acceptance services for the association’s cards. Most member banks — including all of the
largest ones — also become owners of the association and receive a bundle of rights similar
to those of a shareholder in a corporation. These rights include the opportunity to vote for a
board of directors, participate in the governance of the association, and share in the
association’s assets upon dissolution. Voting and dissolution rights are apportioned
according to the dollar volume of transactions that the bank has transmitted through the
network. Member banks also agree to abide by the associations’ bylaws, rules, regulations,
and policies.

Visa and MasterCard Began As Entirely Separate Systems

Prior to 1970, Visa and MasterCard were controlled by different groups of banks. In
1970, one of Visa’s member banks, Worthen Bank of Arkansas, sought to become a card-
issuing member of both networks. MasterCard did not object, but Visa responded by
adopting a bylaw that prohibited member banks from issuing any other network’s cards.

Worthen then sued Visa and the district granted summary judgment for Worthen.
The Eighth Circuit, however, reversed and remanded for trial. While the case was awaiting
trial, Visa asked the Department of Justice to express its views — pursuant to a Department
procedure called a “Business Review” — on the legality of a more restrictive bylaw that
would have prohibited Visa members from both issuing cards and providing card acceptance
services for “any other [card] program presently existing or which may develop.” The
Department responded that it would not object to a bylaw that restricted Visa members to
issuing Visa cards exclusively “to the extent it is necessary to insure continued intersystem
competition.” But the Department expressed concern that Visa’s proposed prohibition on
banks providing card acceptance services to merchants for both networks “might well
handicap efforts to create new bank credit card systems and may also diminish competition
among the banks in various markets.”

The Visa and MasterCard Governing Banks Adopted Duality

Notwithstanding the Business Review Letter, the member banks on Visa’s Board of
Directors, over the objections of Visa’s General Counsel, voted to permit Visa member banks
to own and participate in the governance of MasterCard, and to permit MasterCard members

Managerial Economics and Business Strategy, 6e Page 7

to own and participate in the governance of Visa. MasterCard’s Board of Directors also
permitted MasterCard member banks to become owners and governors of Visa, and Visa
members to become owners and governors of MasterCard. This overlapping ownership and
governance structure has become known in the industry as duality.

Since 1975, virtually all significant card-issuing banks have become owners of both
Visa and MasterCard. Almost all of the largest card-issuing banks have representatives on
one of the associations’ boards of directors as well as have representatives on the important
committees that influence policy for each network. For example, MasterCard’s Business
Committee and Visa’s Marketing Advisors Committee advise their respective network’s
professional staff and management on key strategic and competitive issues. In 1996, twelve
of the twenty-one banks represented on Visa’s Board of Directors were also represented on
MasterCard’s Business Committee. Seventeen of the twenty-seven banks on MasterCard’s
Business Committee had representatives on Visa’s Marketing Advisors Committee. Seven of
the twenty-two banks represented on MasterCard’s Board of Directors also were represented
on Visa’s Marketing Advisors Committee. In total, as of year-end 1996, approximately
nineteen banks — including Chase Manhattan, Citibank, First Chicago, Bank of America,
and NationsBank — had a representative on the board of directors of one association and on
at least one important committee of the other association.

Despite this overlap in ownership and governance, neither Visa nor MasterCard
enforces the safeguards necessary to prevent one association from obtaining confidential
competitive information about the other. In 1992, MasterCard International’s Executive Vice
President and General Counsel wrote in a letter to the Department of Justice that “when one
board acts with respect to a matter, the results of those actions are disseminated to the
members who are members in both organizations. As a result, each of the associations is a
fishbowl and officers and board members are aware of what the other is doing, much more so
than in the normal corporate environment.”

VISA AND MASTERCARD POTENTIALLY RESTRAIN COMPETITION

Visa and MasterCard — on behalf of and in collaboration with their governing banks
— make competitive decisions that (a) possibly restrain competition between the two
associations; and (b) possibly restrain competition from other networks and eliminate certain
forms of competition among the member banks. As a result of this potentially
anticompetitive behavior, certain possible competitive initiatives that would have benefited
consumers have been abandoned, delayed, suppressed, and diluted; consumer choices have
been reduced; and competition among general purpose card networks has been restrained
substantially.

Duality Possibly Restrains Competition between Visa and MasterCard

The common control of both Visa and MasterCard by banks with significant financial
interests in both networks possibly restrains competition between those two general purpose
card networks.

Duality Possibly Lessens the Associations’ Incentives to Compete Against One
Another

Page 8 Michael R. Baye

The banks that govern Visa earn substantial profits from issuing MasterCard cards.
For example, as of year-end 1997, Visa U.S.A.’s Board of Directors included representatives
of First Union Corporation and Associates First Capital Corporation, both of which had
issued nearly 40% of their general purpose cards on the MasterCard network.

The banks that govern MasterCard earn an even greater percentage of their profits
from issuing Visa cards. For example, as of year-end 1997, at least five banks that placed
directors on the MasterCard board for the United States Region issued more Visa cards than
MasterCard cards. The most pronounced examples among MasterCard’s 1997 board
members were Providian Bancorp Inc. and Capital One Bank, which had issued more than
95% and more than 66% of their cards on the Visa network, respectively.

Because of these significant overlapping financial interests, the banks that govern
each association have possibly rejected investments in, and implementation of, competitive
initiatives that might lead consumers to switch from one association’s brand of card to the
others. From the banks’ perspective, these innovations would merely shift their profits from
cards issued on one of their networks to cards issued on the other. Because the same banks
control the associations, the overlapping interests of the governing banks possibly
substantially restrain the ability of the separate managements of Visa and MasterCard to
compete.

Visa and MasterCard Top Executives Admit that Duality Restrains Competition

Officials at the highest levels of Visa and MasterCard have acknowledged —
repeatedly, publicly, and under oath — that the common ownership and governance of Visa
and MasterCard significantly limit competition between the two associations.

In 1992, Visa International’s President and Chief Executive Officer testified:

Q: So you believe consumers would be better off without duality?

A: Yes.

He explained that “Visa was a better organization before its owners acquired an
interest in MasterCard. It created more, it was more innovative and it was more vital and
more imaginative. . . . The real creativity, ingenuity, desire to develop, [and] support from
members that made Visa what it is today came before duality because there were groups of
banks who wanted to support Visa to go beat up on MasterCard, and there were groups of
banks in MasterCard who wanted to support MasterCard to go beat up on Visa. And they
weren’t sitting there as shareholders of both organizations not really caring who beat up on
whom or if they didn’t beat up on anyone or not caring who won. If you’ve got one foot
firmly placed on both sides of the street, who cares . . . and I think that not only would the
banks have benefited had they gone this way [without duality], but ultimately the consumer
would, too . . . . ”

In 1992, Visa International’s Executive Vice President and General Counsel testified
that “it is very difficult for us to take a step, an aggressive step that hurts MasterCard because
the same banks who sit there on the board, who are in Visa are also in MasterCard.” In
response to the question whether “duality has led to a decrease in intersystem competition
between Visa and MasterCard,” he replied, “Absolutely,” and when asked whether duality

Managerial Economics and Business Strategy, 6e Page 9

harmed consumers, he answered “I think in the long run they would be better off without
duality . . . .”

In 1992, MasterCard International’s Executive Vice President and General Counsel
wrote in a letter to the Department of Justice that Visa’s and MasterCard’s “members, which
necessarily underwrite the [networks’] costs, view the associations as complementary and are
displeased when one attempts to enhance itself at the expense of the other. . . . MasterCard
and Visa simply do not ‘compete’ in any conventional business sense.”

In January 1997, the President of MasterCard International’s U.S. Region testified: “It
is clear that because of duality today you don’t see MasterCard and Visa in the marketplace
attacking each other . . . The owners . . . don’t want us attacking the other thing they own . .
.”

Also in January 1997, the President and Chief Executive Officer of Visa U.S.A.
testified that “you can’t compete in certain areas if you’re co-owned.” He emphasized that
Visa would seek to differentiate its network services from MasterCard’s to a greater extent if
Visa were not owned by the same banks that own MasterCard.

Proposals to Roll Back Duality Were Rejected

Recognizing that duality blunts competition between the associations, each network’s
staff and management have sought at various times to increase their network’s independence
and enhance network competition. The banks that control Visa and MasterCard have resisted
these efforts.

In 1991, Visa International’s President and Chief Executive Officer proposed
eliminating the overlap between the two networks. Under the proposal, each member bank
would issue prospectively only one general purpose card brand, Visa or MasterCard, and
would participate exclusively in the governance of the system on which it chose to issue
cards. Also in 1991, Visa’s U.S. Executive/Planning Committee considered the advantages
and disadvantages of phasing out duality. According to an internal Visa document, an
anticipated benefit of eliminating duality was to create “real competition with MasterCard.”
The Visa Board rejected these proposals, voting instead to continue to permit a bank to
govern Visa regardless of the extent of the bank’s interest in MasterCard.

Similarly, throughout the 1990s, MasterCard’s professional staff repeatedly urged the
network’s Chief Executive Officers to end the practice of providing member banks with
equal access to MasterCard network services regardless of the banks’ interests in Visa. In
1992, a MasterCard staff memorandum reported that MasterCard’s “innovative ideas are
totally neutralized in a dual world.” Then in 1994, a MasterCard management team advised
MasterCard International’s then-new President and Chief Executive Officer about the
“tyranny to issuer duality” and the “drive . . . to homogenize” that resulted in “no meaningful
difference” in the network products and services offered by MasterCard and Visa. In 1996, a
high-ranking MasterCard executive again emphasized that increasing the revenues collected
by card issuers, advertising more effectively, and increasing overall efficiency are “matters
that become marginalized in a dual world with a larger competitor.”

As one of these memoranda concluded, “The cure is in a core of dedicated issuers;
dedicated not dual.” Under these staff proposals, new MasterCard innovations would have
been made available only to member banks that agreed to favor MasterCard over Visa.

Page 10 Michael R. Baye

Despite these proposals, MasterCard, like Visa, continued to permit banks to govern
MasterCard, regardless of their interest in Visa.

Duality Has Potential Anticompetitive Effects on Brand Development

Brand development is an essential aspect of establishing and developing a general
purpose card network. A network promotes and differentiates its brand in order to attract
consumers, merchants, and banks to use its brand rather than a competing network’s brand.
Advertising campaigns, such as Visa’s ubiquitous “they don’t take American Express”
advertisements, are an important component of network competition because they educate
consumers and merchants about important attributes of the network. In recent years,
advertising has accounted for approximately a quarter of all expenses for both Visa U.S.A.
and MasterCard’s U.S. region.

Because consumers value the ability to use their cards to make purchases whenever
and wherever they want, a card network must offer widespread merchant acceptance. In the
United States, virtually all merchants that accept any credit card accept both Visa and
MasterCard. Yet, studies have long shown that consumers wrongly perceive that Visa is
accepted by significantly more merchants than MasterCard.

In 1992, MasterCard management was advised by its advertising consultant that
MasterCard “must name Visa” in its advertisements in order to combat this misperception.
As a result, MasterCard management proposed that MasterCard institute an advertising
campaign proclaiming: “No other card is more accepted. Not Visa. Not American
Express.” Bank representatives on the MasterCard Business Committee objected on the
ground that this advertisement would harm Visa. MasterCard’s U.S. Region President
responded to these objections by assuring member banks that MasterCard’s acceptance claim
comparison to Visa would be used only if it “did not negatively impact Visa.”

During the same time period, MasterCard faced a similar perceived acceptance gap
vis-à-vis Visa in Canada, where duality does not exist. There, MasterCard’s Canadian
Region ran the advertising that was rejected in the United States. It used the tag line — “No
card is accepted in more places worldwide than MasterCard. Not Visa. Not American
Express.” Within two years, MasterCard’s Canadian Region concluded that “the use of this
tag line . . . has helped improve acceptance imagery as well as reduce the Visa brand
awareness advantage.” One study showed a drop in the perceived acceptance gap in Canada
from 15% to 4% during a one-year period in which MasterCard named Visa in its
advertisements.

Notwithstanding the success of this campaign, MasterCard has not named Visa in a
comparative acceptance advertisement in the United States. Surveys continue to show that
consumers in the United States wrongly perceive that Visa is significantly more widely
accepted than is MasterCard. Similarly, Visa does not name MasterCard in its U.S.
advertising. But, in the non-dual Canadian market, Visa has named MasterCard. For
example, in one advertisement, Visa highlighted a Canadian merchant that only accepted
Visa. A Visa executive testified that Visa management never proposed running the Canadian
advertisement in the U.S. “because we knew that they (the banks) wouldn’t accept it.” He
further testified that when Visa’s U.S. Marketing Advisors Committee was shown the
advertisement, “their reaction clearly was don’t you show that in the U.S., on U.S.
television.”

Managerial Economics and Business Strategy, 6e Page 11

Duality Has Possible Anticompetitive Effects on Product Development

The overlap in control of Visa and MasterCard constrains each association’s
professional staff and management from proposing competitive initiatives likely to lead
consumers to switch from one brand to the other. In 1991, a Visa executive testified that
member banks opposed Visa initiatives “against MasterCard because they had a vested
interest on that side too, and this was an ongoing problem in almost everything we did and
continue to do.” He added that Visa’s managers “often don’t even propose them
(competitive initiatives) because we know they are unacceptable to members.”

The possible anticompetitive effects of duality exceed what can be readily observed
because many products, services, and innovations that would have emerged in a competitive
environment were never even considered by the associations or their managements.
Nevertheless, there are several instances in which the controlling banks seem to have
restrained critical competitive initiatives developed by the managements of Visa and
MasterCard.

Smart Cards

In the 1980s, MasterCard developed and extensively tested smart cards. A smart card
differs from the cards in widespread use in the United States in that it can store information
on an integrated circuit instead of, or in addition to, a magnetic stripe. Integrated circuits are
capable of storing significantly more information than magnetic stripes. This additional data
storage capacity would enable a card network to enhance its products by, among other things,
storing cash and personal information such as airline and hotel preferences, identification
numbers, and medical data. Smart cards would also enable issuers to reduce their costs by
providing superior fraud and credit risk control.

In 1987, MasterCard’s staff concluded that introducing this product would give
MasterCard a significant advantage over Visa, and sought board approval to introduce smart
cards. Bank representatives on the MasterCard Board’s Executive Committee refused,
however, to approve the initiative without Visa’s agreement. MasterCard then approached
the Visa Board, and the two networks hired a consultant to consider whether to introduce this
new product jointly.

After several banks represented on Visa’s Board of Directors expressed their
opposition to the introduction of the smart card, Visa notified MasterCard that it would not
introduce the product. MasterCard’s Board then refused to permit MasterCard to move
forward, and the planned development was shelved. After a decade of delay, Visa and
MasterCard are now finally testing separate smart card options, although with full knowledge
of each other’s strategic plans.

Commercial Cards

In 1993, Visa staff concluded that prohibiting Visa member banks from issuing both
Visa and MasterCard commercial cards — i.e., corporate cards and other cards issued to
businesses rather than consumers — would enable Visa to innovate and differentiate its

Page 12 Michael R. Baye

commercial products from MasterCard’s more effectively than if duality were permitted.
Based on Visa management’s recommendation, its Board initially adopted a resolution that
would have required Visa member banks to decide by early 1996 whether to issue Visa or
MasterCard commercial cards exclusively. Visa then planned to promote its commercial
cards aggressively and allocated a substantial budget to the initiative.

Widespread bank opposition led Visa to reverse its decision and allow banks to issue
both MasterCard and Visa commercial cards. Soon after the decision to permit banks to issue
both associations’ commercial cards, Visa scaled back its investment in developing
commercial card products. Visa’s former Executive Vice President of Market Development
testified that “the amount of money that Visa spent (on the commercial card) was reduced
because it became apparent that it was going to be a dual world.”

Secure Transactions over the Internet

The member banks also delayed Visa’s introduction of the first system to provide
secure general purpose card transactions over the Internet and thereby prevented Visa from
gaining a competitive advantage over MasterCard.

In October 1995, Visa and Microsoft jointly announced the specifications for a
system to provide secure transactions over the Internet. Visa intended to use Microsoft
encryption software to implement the announced standard. In a message to member banks,
MasterCard stated that it had “no choice but to respond competitively” to the Visa-Microsoft
alliance and it began to form alliances with other software providers. The member banks
pressured Visa to abandon its agreement with Microsoft in favor of a cooperative effort with
MasterCard to develop a standardized approach. Visa complied with the banks’ wishes.

In a 1995 presentation to the Federal Trade Commission on joint ventures, Visa
International’s Executive Vice President and General Counsel blamed duality for the delay in
introducing the Internet security system. He stated that if “we had our group (of banks) and
(MasterCard) had their group . . . this thing would be out there already.” In 1997, Visa
U.S.A.’s President and Chief Executive Officer testified that this was yet another case in
which Visa “had an opportunity to get out ahead [of MasterCard] and had to come back,
work again with MasterCard.”

Also in 1997, Visa U.S.A.’s former Executive Vice President of Market Development
testified in regard to Internet security that the Visa staff and management “deserve(d) the
opportunity to either prove that we were right or to fail. Standardizing things too quickly in
new, emerging products and markets, from my experience as a marketing person, has the . . .
capability of stifling innovation.”

Visa and MasterCard Possibly Restrain Competition from Other Networks and Prohibit
Certain Forms of Competition among Their Member Banks

In addition to restraining network competition between themselves, Visa and
MasterCard — on behalf of and in collaboration with their governing banks — have adopted
and maintained rules and policies that might prohibit all member banks from doing business
with other general purpose card networks such as American Express and Discover/Novus.
These rules might restrain competition (a) between the bank-controlled Visa and MasterCard
networks and the general purpose card networks not so controlled, and (b) among the Visa
and MasterCard member banks.

Managerial Economics and Business Strategy, 6e Page 13

Prior to the mid-1980s, Visa and MasterCard did not compete directly with other
networks. At that time, other general purpose card networks, such as American Express,
issued charge cards intended primarily for use in the travel and entertainment sectors. In
contrast, Visa and MasterCard cards were targeted for use in the general retail sector.

By the mid-1980s, Visa and MasterCard had expanded into travel and entertainment;
American Express had expanded into the retail sector; and Sears had entered the network
market with the Discover network, now called Novus. These changes brought the bank-
controlled Visa and MasterCard networks into direct competition with American Express and
Discover/Novus.

Visa and MasterCard — on behalf of and in collaboration with their governing banks
— responded to this competitive threat by adopting rules that possibly lessened the ability of
those networks to compete effectively (a) with Visa and MasterCard in the network market
and (b) with the associations’ member banks in the downstream card-issuing and card-
acceptance markets. Visa and MasterCard both exempt each other and the Citicorp-owned
Diners Club network from these exclusionary rules, enforcing them only against American
Express and Discover/Novus.

By adopting and maintaining these possibly discriminatory exclusionary rules, Visa
and MasterCard preserve and extend their jointly held market power. As MasterCard
explained to its members in a 1991 document discussing competition among Visa,
MasterCard, American Express, and Discover: “(Visa and MasterCard form) a segment of
the credit card market(,) . . . a market where MasterCard and Visa together are fighting to
maintain their dominance . . . and minimize incursion of non-bank or competitive quasi-bank
products.” (Emphasis in the original).

Visa and MasterCard Potentially Impede the Ability of Other Networks to Convince
Merchants to Accept Their Cards

One difficulty that a network faces in convincing merchants to accept its cards is that
merchants strongly prefer to use a single card acceptance terminal to process transactions for
all brands of general purpose cards. Processing transactions involves transmitting transaction
data from a merchant’s terminal to a central computer that directs the information to the
appropriate card network for authorization and settlement. Visa and MasterCard permit
banks to process transactions for both networks through a single merchant terminal,
enhancing the ability of both networks to convince merchants to accept their cards.

In the mid-1980s, Visa, MasterCard, and their member banks used their control of
merchant terminals to hinder American Express’s and Discover/Novus’s efforts to build
merchant bases. In response to these practices, American Express and Discover/Novus
developed their own card acceptance terminals capable of handling all card transactions.
American Express and Discover/Novus then entered into agreements with a few Visa and
MasterCard member banks that were willing to permit American Express and
Discover/Novus to process those banks’ Visa and MasterCard transactions through terminals
that accepted all card brands.

Other banks complained to Visa and MasterCard about these agreements, and the
associations then adopted new regulations that prohibited any member bank from permitting
American Express or Discover/Novus to process Visa and MasterCard transactions. These

Page 14 Michael R. Baye

regulations — which were an exception to the existing rules that permitted the banks to
contract with third-party processors — substantially hindered American Express’s and
Discover/Novus’s ability to persuade merchants to accept their cards.

Eventually, because of strong merchant demand for a single terminal, Visa and
MasterCard agreed to modify their regulations to permit banks to link their processing
services to American Express and Discover/Novus. Under the modified regulations, any
network could place a terminal with a merchant as long as all transactions on the terminal
that involved another network’s cards were diverted to that other network for processing.

American Express then began to divert transactions in accordance with the modified
Visa and MasterCard regulations and, by offering card acceptance services at low prices,
American Express placed terminals with a number of merchants. This prompted several Visa
and MasterCard member banks to again complain about American Express’s pricing
practices to Visa and MasterCard.

In response, Visa and MasterCard adopted additional rules effectively requiring
merchants to pay a higher fee for Visa and MasterCard transactions if they used a card
acceptance terminal placed by American Express. According to Visa’s Executive Vice
President and General Counsel, these discriminatory fees were adopted to “make it more
difficult for Amex to price our [member bank] acquirers out of the marketplace” and
remained in effect until at least 1991.

Visa and MasterCard Impede the Ability of Other Networks to Provide Cash Advances

A valuable feature of any general purpose card network is the ability to provide
cardholders with convenient access to cash advances, most importantly through automated
teller machines (ATMs). Visa and MasterCard each own one of the two worldwide ATM
networks, Plus and Cirrus respectively. Visa’s rules permit member banks that issue
MasterCard cards to use the Plus system to provide cash advances on MasterCard cards.
Similarly, MasterCard’s rules permit member banks that issue Visa cards to use the Cirrus
system to provide cash advances on Visa cards. As a result, any member bank can enable its
cardholders to use general purpose cards to obtain cash advances worldwide at over 200,000
locations. To obtain access to these ATMs, a bank merely needs to agree to pay a fee to the
ATM operator whenever one of its cardholders obtains a cash advance, and to agree to accept
cards issued by Cirrus or Plus member banks at its own ATMs.

Visa stated in its 1988 Corporate Strategic Plan that “The successful consolidation of
regional ATM switches into a unified, bank-owned and operated national network will
deprive Discover and American Express of the opportunity to chip away at a major strategic
advantage by the banking industry through the progressive creation of a national network of
their own.” Visa and MasterCard will not permit American Express and Discover/Novus to
use Cirrus or Plus to provide cash access to their cardholders. As a result of Visa’s and
MasterCard’s exclusionary practices, American Express and Discover/Novus have had to
negotiate individually with scores of regional ATM networks and banks to secure ATM
access for their cardholders, often at access prices higher than those paid by member banks.

The cash access networks that American Express and Discover have assembled
through these individual negotiations are smaller, more geographically uneven, and more

Managerial Economics and Business Strategy, 6e Page 15

costly to maintain than those that Visa and MasterCard make available to each other’s
member banks.

Visa and MasterCard Impede the Ability of Other Networks to Contract with Issuers

In the last few years, American Express and Discover/Novus have attempted to
expand their networks by convincing other entities, including banks, to issue cards on their
networks. In the United States, those efforts have been stymied by Visa and MasterCard
rules that prohibit all member banks from issuing cards on the American Express and
Discover/Novus networks.

Visa Adopts Bylaw 2.10(e)

In 1991, Visa U.S.A’s Board of Directors adopted Bylaw 2.10(e), which states that
“the membership of any member shall automatically terminate in the event it, or its parent,
subsidiary or affiliate, issues, directly or indirectly, Discover Cards or American Express
Cards, or any other card deemed competitive by the Board of Directors.”

Visa has asserted that it adopted Bylaw 2.10(e) to prevent Discover/Novus and
American Express from becoming card-issuing members of Visa by acquiring member
banks, as Discover attempted to do in 1990. As written, however, the bylaw also prohibits all
independently owned Visa member banks from issuing cards on the American Express or
Discover/Novus networks. Bylaw 2.10(e) prohibits Visa’s member banks from issuing cards
on any network that is “deemed competitive” by Visa’s Board. But Visa’s Board has not
deemed MasterCard to be a competitor, and Visa’s member banks may thus issue cards
without restriction on the MasterCard network. The bylaw applies only to American Express
and Discover/Novus, the networks not controlled by the member banks.

By 1994, American Express and Discover/Novus had begun to pursue a number of
competitive initiatives to strengthen their networks, including arrangements with certain
banks in the United States to issue cards on the American Express or Discover/Novus
networks in addition to the Visa and MasterCard networks.

Visa U.S.A.’s Bylaw 2.10(e) has effectively precluded member banks in this country
from issuing American Express or Discover cards.

MasterCard Adopts Competitive Programs Policy

In May 1996, American Express, through its Chairman, publicly announced its
intention to contract with banks to issue American Express cards. Unlike Visa, MasterCard
at that time had no rule that prohibited its member banks from issuing cards on other
networks. American Express thus focused its efforts on banks that primarily issued
MasterCard. Many banks expressed interest in American Express’s proposal and, within a
month, discussions commenced between American Express and a number of banks.
MasterCard learned of some of these negotiations.

At its June 1996 meeting, the MasterCard U.S. Board adopted a policy that mirrored
the Visa bylaw. MasterCard’s policy on “competitive programs” provides that:

Page 16 Michael R. Baye

With the exception of participation by members in Visa, which is essentially
owned by the same member entities, and (Diners Club and JCB), members of
MasterCard may not participate either as issuers or acquirers in competitive general
purpose card programs.

At the meeting in which MasterCard adopted the policy, the board considered the
American Express proposal to partner with member banks and concluded that the newly
adopted policy would prohibit member banks from issuing American Express cards.

The Exclusionary Rules Restrain Competition in the United States

Following adoption of the MasterCard policy, those banks that had been negotiating
with American Express terminated the discussions. The banks were not interested in issuing
American Express cards if doing so would require them to forfeit their right to issue both
Visa and MasterCard, the two dominant general purpose card brands. In addition, Visa’s
Bylaw 2.10(e) and MasterCard’s competitive programs policy would prohibit a bank that
issued American Express or Discover cards from accessing the wide array of other Visa or
MasterCard products and services, including the Plus and Cirrus ATM systems and the
associations’ point-of-sale debit cards that can be used to make purchases from merchants
with funds deducted directly from the cardholder’s bank account.

In these ways, the rules raise the cost to a member bank of issuing American Express
or Discover/Novus credit cards to high levels and make it practically impossible for
American Express and Discover/Novus to convince banks — the most experienced and
skilled card issuers and the only entities that hold the demand deposit accounts of most
consumers — to issue cards on their networks.

The current presidents of both Visa U.S.A. and MasterCard’s U.S. Region have said
that, were it not for the exclusionary rules, some of their member banks in the United States
would issue American Express cards. In addition, in 1997, the former Chairman of
MasterCard International and then Chief Executive Officer of a bank that was among the top
ten general purpose card issuers, testified that eliminating Visa’s and MasterCard’s
exclusionary rules in the United States “would force MasterCard and Visa to compete more
intensely for the affection of the members.”

This increased competition between the networks for banks’ card-issuing resources
— as well as competition among the banks to offer additional card brands — would spur the
development and implementation of higher quality and lower priced network products and
services. In addition, consumer choice would be enhanced by eliminating the exclusionary
rules. Consumers would have access to new general purpose cards that would combine the
network attributes of American Express or Discover/Novus with the card-issuing attributes of
individual banks. For example, a consumer would have the option of obtaining American
Express and Discover/Novus network cards from an institution that also offers other banking
products such as a demand deposit checking account or a Visa or MasterCard card.

Finally, eliminating the exclusionary rules would benefit consumers by enhancing the
competitive effectiveness of Visa’s and MasterCard’s smaller network competitors, thereby
enabling those networks to compete more vigorously against Visa and MasterCard. For
example, Visa U.S.A.’s former Executive Vice President of Market Development testified in

Managerial Economics and Business Strategy, 6e Page 17

1997 that issuing through banks would help a competitive network to obtain additional
volume and thereby realize lower costs and “better economies of scale.”

Without ubiquitous merchant acceptance of its cards, a card network cannot compete
fully and effectively with Visa and MasterCard. To ensure ubiquitous acceptance throughout
the United States, a card network needs a substantial market share. Without issuance by
some Visa and MasterCard member banks, a network could not, as a practical matter,
maintain the necessary minimum market share.

Visa’s internal documents reveal that allowing competitive networks to issue cards
through Visa member banks would increase competition. For example, Visa documents state
that the member banks are a “huge and effective distribution network;” that “through
partnerships with Visa member banks” competitor networks would “threaten to rapidly erode
(Visa’s merchant) acceptance advantage;” and banks issuing a competitor’s cards “would
strengthen (the competitor’s) other products – commercial cards, traveler’s cheques, stored
value cards.”

MasterCard’s internal documents similarly acknowledge the importance of banks to
the effectiveness of competition from other networks. For example, MasterCard documents
state that member banks possess “powerful distribution channel capabilities for new
products” and that, by issuing through banks, competitor networks would “obviously build
revenue . . . to reinvest back into the business, probably continuing to open up new
acceptance channels that they do not perceive Visa or MasterCard to be dominating.”

Competition Has Increased Outside the U.S. Where the Exclusionary Rules Do Not
Apply

In 1996, both Visa and MasterCard responded to American Express’s worldwide
effort to convince banks to issue cards on the American Express network. Both associations
considered whether to adopt a worldwide rule — mirroring Visa U.S.A.’s Bylaw 2.10(e) —
that would prohibit member banks from issuing cards on the American Express and Novus
networks. Visa’s management concluded that Visa could compete effectively without an
exclusionary rule and told Visa’s International Board member banks that it was “not
necessary” to prohibit banks from issuing competitive cards. MasterCard’s management
reached a similar conclusion, and both international boards then delegated authority to each
region to decide for itself whether to prohibit member banks from issuing cards on the
American Express and Discover/Novus networks.

Aside from the United States — and Canada, where each bank may issue only one
card brand — no Visa or MasterCard regional board has adopted a rule prohibiting banks
from issuing other networks’ cards. In several countries where the rule has been considered,
competition authorities have objected to the rule and expressed concern that such a rule
would have anticompetitive effects.

In more than a dozen foreign countries, American Express has successfully contracted
with Visa and MasterCard member banks to also issue cards on the American Express
network. In many of these countries, Visa and MasterCard have responded by introducing
new products and services. For example, Visa International’s European Region implemented
an aggressive set of competitive initiatives shortly after its regional board rejected an
exclusionary rule analogous to Bylaw 2.10(e). These initiatives included product

Page 18 Michael R. Baye

enhancements, increased network support for the Visa Gold card and co-branding deals, and
improved merchant services.

MasterCard responded in a similar fashion after Puerto Rico’s largest bank, Banco
Popular, decided to issue American Express cards. Puerto Rico is part of MasterCard’s Latin
American Region, which rejected a strict prohibition on banks issuing American Express
cards. After Banco Popular informed MasterCard of the bank’s deal with American Express,
the President of MasterCard’s Latin America/Caribbean Region told a Banco Popular
executive “that MasterCard will strive (try even harder) to be competitive by improving the
service and attention provided to Banco Popular in order to assure that [the bank] continue[s]
the expansion of [its] MasterCard business.”

Visa and MasterCard Potentially Impede Other Networks’ Ability to Provide New
General Purpose Card Products

Visa Bylaw 2.10(e) and the MasterCard competitive programs policy also could
reduce network competition in developing new general purpose card products. These
products — which will retain the core characteristics of ubiquitous acceptance and deferred
payment options — will integrate additional functionalities such as debit and stored value. A
strategy document presented to the MasterCard Executive Committee explained that “By
utilizing a multi-application operating system, our members also have the ability to use the
chip technology to create ‘relationship cards’ allowing their customers to have credit, debit
and stored value resident on a single card with a choice of payment type at the point of sale.”
In a 1995 proceeding before the Federal Trade Commission, Visa International’s Executive
Vice President and General Counsel agreed, stating that “The payment engine I foresee is a
chip card which will have all your relationships on it.” As a practical matter, only banks that
hold consumers’ demand deposit accounts can provide this type of general purpose card.
Such a card is likely to play a critical role in network competition in the future.

The associations’ rules might substantially diminish competing networks’ ability to
develop general purpose card products, including products that incorporate debit or stored
value functionality. For example, a consultant for one bank that was considering whether to
issue American Express cards reported that American Express “is not positioned to tap into
the burgeoning debit card market” and it “faces an increasing challenge in the rapidly
evolving payment systems industry, factoring in the reach of thousands of Visa/MasterCard
issuers.” But “With its platform of core deposit relationships,” the report concluded, the
bank “could assist American Express in establishing successful debit card programs.”