Nearly everyone takes it for granted that if government did not
protect consumers from fraud, no such protection would be provided.
The free market, however, protects consumers in countless ways,
all without any government intervention. In fact, it does so more
efficiently and effectively than the government can.
One of the most impressive examples of free-market justice
involves something that might be in your pocket right now: your
credit card. Through voluntary contractual arrangements – motivated
by nothing more than a desire for customers and profit – credit-card
companies provide an entirely private means of recourse when a merchant
wrongs a customer.
Visa and MasterCard, the two most popular credit cards, are
brand names jointly used by banks that have gotten together to issue
the cards. Every bank that belongs to the Visa or MasterCard association
can also open accounts for merchants who wish to accept the cards.
The very existence of these organizations is a testament to the
free market’s ability to overcome the challenges of coordination
to deliver to consumers the products they desire.
To understand how credit-card companies provide justice for
consumers, we must first understand how an ordinary credit-card
transaction works. Suppose Jones buys a camera from a merchant for
$500 using his Visa card, which was issued to him by Bank A. The
merchant, however, has a Visa merchant account through Bank B. How
is the payment accomplished?
Today, it is most common for stores to have electronic terminals
for processing credit-card transactions. So Jones would swipe his
card through this terminal. When he does this, the terminal first
determines that it is a Visa card, rather than one of the other
cards the merchant accepts. Then information about Jones’s card
goes to the computers of the bank with which the merchant has his
Visa merchant account, Bank B. Bank B’s computers contact Visa’s
central computer, which looks up Jones in its system and sees that
his card was issued by Bank A. Visa then transmits an inquiry to
Bank A to see if Jones has sufficient credit to buy the camera.
The answer to that inquiry will come back to Visa, which will pass
it back to Bank B, which in turn will pass it back to the merchant.
If the answer is no, because Jones does not have enough credit,
he will not be able to make the purchase. If the answer is yes,
he will sign the familiar slip accepting the charge to his credit
card, and that will complete the sale. Today, this entire process
may take as little as two seconds.
The merchant, of course, still needs to be paid. He transmits
the request for payment to Bank B. That request goes through the
same channels as the authorization request. The cardholder’s bank
pays the merchant’s bank, which then pays the merchant. At that
point, it is up to the cardholder’s bank to collect the amount due
from the cardholder.
The banks make money from this process through the "merchant
discount" they charge. This is often around 2 percent. In the
case of Visa, for example, 1.4 percent goes to the card issuer.
This is called an "interchange fee" and is set by Visa.
The remainder, 0.6 percent, goes to the merchant’s bank.
When Things Go Wrong: The Government Solution
What if Jones’s camera is something other than advertised?
What if he was promised one type of lens and got a different, inferior
one, or the camera just doesn’t work? Because of the free market’s
incentive to satisfy customers, most stores would allow Jones to
make an exchange or get his money back. But surely there are some
disreputable merchants who would not do this for Jones, since they
are out to make a quick buck with no concern for their long-term
reputations. Thus sometimes a consumer must appeal to a third party
If Jones had paid cash for the camera, his only recourse would
be to go to a government court, probably his local small-claims
court. Filing a lawsuit, even in small-claims court, is costly,
cumbersome, and time-consuming. In most jurisdictions, one must
pay a fee just to file a suit. To have a reasonable chance of success,
a defrauded consumer probably would need to hire a lawyer. If the
seller he is suing is large and sophisticated, it might have superior
lawyers who are experienced in fighting consumer lawsuits, perhaps
often killing them quickly through procedural maneuvers and the
like. Alternatively, the merchant might not show up to defend himself
against small claims and the plaintiff would win. But then he would
have to collect a judgment, which might be difficult to impossible.
A large percentage of small-claims-court judgments are never collected
at all, perhaps because the defendant is insolvent or located prohibitively
far away, making the lawsuit a waste of the taxpayer’s time and
effort, as well as a waste of taxpayer dollars.
The cash-paying customer with a complaint may also have problems
with evidence. What if he has lost his receipt? The case might come
down to his word against the seller’s. The customer who pays with
cash or a money order is in even worse shape if he buys something
from someone located in another country. If a customer located in
the United States sues a foreign merchant in an American court,
the court may not have jurisdiction or the ability to enforce a
judgment against the seller even if the customer wins.
If the customer tries to sue in the foreign country, he will
almost certainly have to be present there and will have to hire
a foreign lawyer. Even if this were not a major obstacle, the foreign
country’s legal system might be significantly less accessible than
that of the United States, even for locals, especially in developing
countries. Then, of course, there are the further potential difficulties
of language barriers and court bias against foreign parties, among
other things. As a result, high costs make almost any consumer-fraud
lawsuit across international borders prohibitively expensive.
Chargebacks: The Private Alternative
So government does provide consumers with nominal, if
often useless, opportunities to pursue redress. On the other hand,
credit-card companies know that no one wants to go to small-claims
court. More importantly, they know that the presence of their logos
on merchants’ doors and in advertisements is interpreted as a seal
of approval, even if not intended as such. It is not good for Visa
and other brands to appear to be associated with crooks or anything
unpleasant to consumers.
Thus the card companies have created their own system for pleasing
consumers who have problems with credit transactions. This is called
the chargeback. Under the card companies’ chargeback procedures,
a consumer can inform his card issuer of his dispute and the issuer
will then help him settle things.
To begin chargeback proceedings, a cardholder files a complaint
for free, using a form provided by the card company. (It is often
included on the back of each month’s billing statement.) On receiving
the complaint, the card company may ask the cardholder for documentation
to support his claim. If he appears to have a legitimate grievance,
the bank will then initiate a chargeback against the merchant’s
bank – that is, the cardholder’s bank will take the money back from
the merchant’s bank. The merchant’s bank has no choice but to allow
this, because each bank in each card system has contractually agreed
to these recourse procedures.
The merchant will then be given an opportunity to produce evidence
on his behalf. If his bank believes the transaction was valid, it
will initiate a chargeback against the cardholder’s bank – that is,
it will take the money back from the cardholder’s bank. If the dispute
continues and cannot be resolved between the two banks, it will
be arbitrated by the credit-card organization.
Are chargebacks better for consumers than the government’s
dispute-resolution system? There is no guarantee, of course, that
any system of justice will reach the correct result. But consider
the following advantages of the private system.
Under the chargeback regime, the procedure for an aggrieved
consumer is much simpler and better. When a consumer wants to file
a complaint, his card issuer is available to assist him by phone,
usually toll-free, 24 hours a day, 365 days a year. Once he files
his complaint, he does not need to hire a lawyer – his bank uses its
own resources to go to bat for him and puts him on an equal footing
with the merchant, regardless of how wealthy or powerful the merchant
The bank will be able to reach and process chargebacks against
any of its merchants anywhere in the world – except in a few countries,
such as France, whose governments have abolished chargebacks by
law to protect merchants.
Given these advantages, and the disadvantages of the government
system, what credit-card holder wouldn’t prefer the nongovernmental
This goes to show that the common belief that only government
can provide justice in consumer-fraud cases is false. Indeed, as
we have seen, the government is an inferior provider of justice
in this realm.
Subject to Court Review?
One might argue that the relationships among the banks, merchants,
and cardholders are governed by contracts, and those contracts,
even if they contain private-arbitration clauses, are ultimately
subject to review in government courts. That is true, but not really
What primarily holds these arrangements together is not the
threat of government intervention, but the desire of all involved
to do business with one another. Cardholders want to pay with plastic,
and merchants want to accept it. Thus both cardholders and merchants
agree to the terms set forth by their banks and the card associations.
This would not change even if government stayed out of disputes.
That is, if a card association could not rely on government to enforce
a member bank’s agreement to comply with chargeback procedures,
that would not spell the end of credit cards or doom the chargeback
To minimize risks of noncompliance in the absence of government
enforcement, the parties involved might have to spend more to acquire
knowledge about the trustworthiness of their contracting partners.
For example, more resources might have to be used to investigate
merchants before allowing them to accept credit cards. A well-developed
credit-bureau system would be ready to assist, too.
Under such circumstances the banks would have the right incentives
to spend the optimal amount of resources to determine who will keep
their promises. This is in contrast with government, which has no
incentive to spend an optimal amount – even if it could determine
that amount – in resolving contract cases when things go wrong.
Today over 18 million merchants accept Visa, and MasterCard
runs a close second. In the United States, credit-card acceptance
in certain market segments, such a department stores, supermarkets,
and gas stations, is nearly universal. On the internet, of course,
it is by far the most commonly used form of payment.
has opened up countless new opportunities for trade for individuals
in every part of the world. The credit-card chargeback regime advances
those prospects by letting customers know that they will have an
opportunity for redress if they are wronged, and will not have to
rely on outdated, inefficient, ineffective, and costly government
H. Huebert [send him mail]
is an attorney and a freelance writer. Visit his
website. This article first appeared in the April 2005 issue
of The Freeman, and is based on research he conducted as
a John M. Olin Student Fellow in Law and Economics, 2003–2004,
at the University of Chicago Law School.