CREDIT CARD PRICING
James Carwana, Dana Dubois, Divesh Goyal, John Petry, Sameer Sharma
If the bank could only charge an interest rate, what would it be?
If the bank could only charge interest, then it would at most charge a 10%
interest rate because that is what credit using customers are willing to pay. If
the bank tries to charge any higher rate, these customers would not use the
bank’s credit card service, and the bank’s revenues would suffer.
CREDIT CARD PRICING
Question 1
What is the effect on their revenues from credit users if the bank charges an
annual fee?
We know that in the absence of any fees, the full payers would not provide
any revenue to the bank. The remaining 500 users who do use credit, carry an
average balance of $500 (given that balances are uniformly distributed
between 1 and 1000). A bank could charge these users an interest rate of up
to 10%, thus yielding a revenue per user of $50, and an overall revenue of
$50*500 = $25,000.
If the bank starts charging annual fees, then it will have to lower its interest
rate to 8% so that an average credit using customer still pays $50 (if the bank
does not lower its interest rate, the additional fees will exceed the customer’s
willingness to pay and drive them away). Thus, the bank will still earn a
revenues of $50*500 = $25,000 from these users, but in addition, the bank
will also earn a revenue of $10*500 = $5000 by charging the full payers an
annual fees of $10.
In summary, the banks revenues will increase by $5000.
CREDIT CARD PRICING
Question 2
How would you weigh the pros and cons of charging an annual fee? For this, you can either use an
intuitive argument or you can work with a spreadsheet. Your choice.
There are both pros and cons of charging an annual fees.
Pros
• The bank will be able to generate some revenue from the full payer segment
• The annual fees will guarantee the bank a fixed revenue every period, as opposed to having
only a variable revenue depending upon the amount of credit used by its customers. This will
enable the bank to make better predictions about its earning forecasts
• By charging an annual fees, the bank will have to lower the interest rate in order to remain
within a credit using customer’s willingness to pay. The bank could advertise its lower interest
rate to attract more users. Existing users might start carrying more credit and some full payers
may also begin to use the credit facility. The bank’s revenues and share of wallet may actually
increase due to these factors.
Cons
• The bank may face a backlash from consumer groups or invite scrutiny from industry regulators.
In the absence of competition, this move may make the bank appear monopolistic and like it is
taking advantage of consumers.
• If new competitors enter the market, they may be able to capture the the full payer segment by
not charging an annual fee
• By charging an annual fees, the bank will have to lower the interest rate in order to remain
within a credit using customer’s willingness to pay. If the average credit per customer increases
beyond $1000, say to $1100, the bank’s revenues may actually be lower ( $5000 +
[10+(1100*8%)]*500 = $49,000) than hat they might have been without an annual fees
(1100*10%*500 = $55,000)
CREDIT CARD PRICING
Question 3
How might you design an optimal pricing mechanism for the bank? You may
just make an intuitive argument.
The optimal pricing scheme would generate fixed income from the full payer
segment and high interest income from the credit using segment. To achieve
this, the bank could use the following policy: Customers with an average
outstanding balance of below $100 will be charged an annual fees of $10. The
amount of interest paid by these customer will be deducted from the annual
fees. Annual fees will be waived for customers with balance above $100.
Interest will be calculated at 10%.
CREDIT CARD PRICING
Question 4
PRICING FOR PROFIT
James Carwana, Dana Dubois, Divesh Goyal, John Petry, Sameer Sharma
What are the risks in introducing an annual fee for the banks?
Risks of introducing an annual fee:
• Lose customers to competing banks, if those banks do not follow suit
• Negative reaction from both customers and media
• Full-paying market size may shrink, depending on willingness to pay
• Investigation by Monopolies and Mergers Commission; fines or new
regulations would add new costs
PRICING FOR PROFIT
Question 1
Suppose that the banks make choices simultaneously about whether or not to charge an annual fee.
What are the outcomes (i.e., equilibria) that you might expect?
Nash equilibrium!
PRICING FOR PROFIT
Question 2
Suppose the game is played sequentially. Is there a leader or follower advantage? Who do you expect
to move first, Barclays or Lloyds?
Lloyd vs Barclay’s Customer Base
•Lloyds customer is 5% more likely to convert a transaction into an outstanding balance
• For every pound of outstanding balance, Lloyds is 3% better at collecting revenue on this balance
• Lloyds has fewer write-offs per pound charged
• Generally a first-mover advantage occurs when a company introduces a new desirable product into the market. The
opposite is true when introducing an undesirable product. The first-mover has a disadvantage and will be
remembered for this action.
• Bank of America
• Enron
• Barclays will move first if and only if it exhausted all of the potential cost reductions and it is must gain additional
profits
• Enormous risk of alienation to base
• Credit cards approach commodities except for a small switching cost (emotional not financial). In the 1980’s
automatic billing was not ubiquitous
PRICING FOR PROFIT
Question 3