Compatibility , Competition , and Investment in Network Industries : ATM Networks in the Banking Industry

Pricing in network industries that discriminates between affiliated and unaffiliated consumers is a form of partial incompatibility. This paper measures the magnitude of the effects this incompatibility has on competition, welfare, and investment in the retail banking industry, where banks’ ATM networks are connected to one another and unaffiliated consumers face fees called surcharges. I present a structural model of consumer and bank behavior that allows banks to choose ATM networks and set deposit rates and allows consumers to choose banks. The estimates confirm that network effects are very important in this industry and show that surchargeinduced incompatibility has a significant impact on demand for deposit services. The results also suggest that there is overinvestment in ATMs relative to the social optimum. Counterfactual experiments conditional on network size predict that a move to compatibility through the elimination of surcharges would substantially decrease market concentration, raise average deposit interest rates, raise consumer surplus, lower industry profits, and reallocate profits from large-network banks to small-network banks. Banks are also predicted to respond by reducing the number of their ATMs. ∗Stanford University Graduate School of Business, Stanford, CA 94305. Email: ishii joy@gsb.stanford.edu. I am grateful to Ariel Pakes for his advice. I would also like to thank David Blackburn, Eleanor Ericson, Kate Ho, Catherine Jones, Julie Mortimer, Markus Möbius, Marc Rysman, Minjae Song, and seminar participants at the University of California-Berkeley, Brown, Chicago GSB, Harvard University, MIT, NYU Stern, Northwestern Kellogg, the University of North Carolina Kenan-Flagler, the University of Pennsylvania, Stanford GSB, the University of Wisconsin-Madison, and Wharton.