Academic journal article Economic Perspectives

Payment Instrument Choice: The Case of Prepaid Cards

Academic journal article Economic Perspectives

Payment Instrument Choice: The Case of Prepaid Cards

Article excerpt

Introduction and summary

Technological advances continue to allow more and more individuals and businesses to shift toward the electronic delivery of information instead of the exchange of paper-based documents. Examples of this migration include the use of email instead of traditional mail service, the delivery of real-time news via the Internet instead of a physical newspaper, and the payment of bills using online transfers instead of mailing checks. While electronic delivery is faster, often less costly, and often more reliable and secure, the older paper-based systems have not disappeared. Some users of the older technology prefer it to the newer technology, given the incentives they face today. In this article, we will explore the replacement of paper-based payment instruments by prepaid payment cards--an electronic alternative.

The adoption of electronic payment instruments that are able to access sophisticated and extensive networks to authorize, process, and settle payments with relative ease continues to increase. Today, the total number of electronic transactions made in the United States, which accounts for around 55 percent of non-cash transactions, has surpassed the number of check payments, which accounts for around 45 percent of non-cash transactions (Federal Reserve System, 2004). U.S. consumers used checks for 11 percent of their in-store purchases and used payment cards for 56 percent of their in-store purchases in 2005 (American Bankers Association and Dove Consulting, 2005). This shift to electronic payments suggests that payment participants generally prefer electronic payments to checks.

While cash transactions are more difficult to measure, recent survey evidence of in-store purchases reports that cash transactions have remained stable from 2001 to 2005, suggesting that providers of electronic alternatives have had difficulty in convincing consumers and merchants to decrease their cash usage recently (American Bankers Association and Dove Consulting, 2005). However, considering a longer time horizon, Humphrey (2004) estimates that U.S. legal cash usage as a share of consumer payments fell from 31 percent in 1974 to 27 percent in 2000. He attributes the decrease in cash payments to greater usage of payment cards, mainly credit and debit cards.

Today, the usage of prepaid cards in certain payment segments is growing rapidly and generally replacing paper-based payment instruments. In this article, we will focus on prepaid products for which the purchaser of the card is different than the consumer who uses the value to pay for goods and services. We find that prepaid cards allow purchasers to transfer funds that are accessed electronically when goods and services are bought by recipients. Prepaid cards allow recipients without relationships with financial institutions to make electronic payments. In addition, prepaid cards allow purchasers to restrict the types of merchants or products that can be bought by recipients.

However, even if a payment segment is ideal for prepaid products, adoption of them will depend on the ability of providers of these products to get all transactors on board. In general, each prepaid payment participant should receive at least the same net benefit as the next best payment alternative while one participant receives a higher net benefit. In this article, we will discuss the costs and benefits to payment system participants of using various payment mechanisms. We will specifically explore the costs and benefits of prepaid card applications over existing payment instruments for certain payment segments.

Traditional payment instruments

Each type of payment instrument provides a distinct set of costs and benefits to consumers, businesses, and payment providers. We will focus on payments to and from consumers in this article. (1) In this section, we will discuss the costs and benefits of traditional payment instruments, such as cash and checks, along with their electronic alternatives. …

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