Understanding the Economics of Loyalty Programs
 

This is a very newbie (I presume) and random question, but had the bug now for awhile in my head, so figured this is the best place to ask...

How exactly do the economics of FFPs work? I'll give an example of what I'm referring to...

Guy signs up for a Chase United Airlines credit card, spends money wherever and accumulates miles for United. He then uses those miles to book a flight on Lufthansa.
Where does the money come in? Is Chase paying United for those miles? Is United paying Lufthansa to book that flight? How much are the various companies paying each other?
Obviously this is just an example, but there are airline (and hotel) branded credit cards in various countries, various airline alliances and partners, even hotels that include independently-owned hotels that are branded with a national brand.

So I'm just wondering how the economy of that works.

Thanks!

Chase buys miles (points) from United. They earn on interest and annual fees and on consumer fees.
LH is a partner in *A and is obligated to have award inventory with United miles.

by paying card balances in full, a consumer can do well with flying especially if their flight redemptions of Saver awards can work with their schedule. Ditto with the sign up bonuses. Because I rarely fly, plus rarely lodge, I do cash back stuff. Cash back is useless if I ever pay interest and late fees.

The airlines get the cash from the credit card companies which they can use for whatever. Rewards are determined to be a contingent liability on the airlines' books, but by having an expiration date on the accumulated miles/points, a significant portion of the miles purchased by the banks and dispensed to their cardholders never gets redeemed. The technical term for this is "cash cow."

I recall that at one point Air Canada was facing bankruptcy and decided to sell off its Aeroplan mileage scheme. At the time the value of the frequent flyer program was greater than the balance of the airline.

$$$ from the credit card swipe fees paid by the merchants. Chase operates a large payment network aka Chase PaymentTech. The payment network is one reason Capital One has offered to buy Discover.

Thanks!!

Practically, when someone use United miles to book a flight on any non-United airline (whether a *A member or not), is money changing hands? Is United paying Lufthansa (or any other partner airline) whenever someone books with UA miles?

Let me fix the headline:

Understanding the Economics of Loyalty Marketing Programs

The various flavors of credit cards, with their corresponding unique perks (cash back, airline miles, etc.) each have a unique set of transaction fees that are charged to merchants.

So say I eat a $100 meal at Essence Bakery.

- If I use my Citibank AA card, the fee (to pay for the miles I earned) that Citibank charges Essence might be $1.37.
- If I use my Bonvoy AmEx, the fee (to pay for the hotel points I earned) that AmEx charges Essence might be $1.90.
- If I use my Chase Cash Back card, the fee (to pay for the cash back I will claim later) that Chase charges Essence might be $1.04.
- If I use my TruWest Credit Union card, the fee (to pay for the credit union benefits) that TruWest charges Essence might be $0.41.

Since the merchant has customers using all kinds of different cards all day/week/month long, and each card has a different processing fee, the fee structure for their monthly processing of credit cards is incredibly opaque and difficult for the merchant to parse out accurately. This often results in overcharges to the merchant, which is why a lot of mom and pop stores will have a little card or notice at the register mentioning that they prefer payment in cash, which has a processing fee of $0.00.

Also, American credit card processing fees are two or three times larger than the fees charged in Europe or Asia, so the cost to merchants like Essence Bakery here in the States is much higher.

Actually, it's more expensive for merchants to handle cash. These costs include theft and taking the cash to a bank.

There are many dodgy benefits to taking cash.
Sometimes you get caught:

You could gleam quite a bit into from the public financials and presentations on the investor relations section of the credit card issuers and the airliners.
Here's United's MP breakdown
https://ir.united.com/static-files/1...1-cf975348bab9

Right now they hold $7B in liability from the potential redemption, counted as 'frequent flyer deferred revenue'. This is about half of the paid flight revenue for a given quarter. It's worth nothing that the accounting rules regarding FFPs are very lax and the accounting practices vary by company and over time.

I do not think that there are many 'different cards' that subjects the merchant to different fees. For example, a merchant will not see a different fee for the same charge based on a Amex Platinum vs Amex Green vs Amex Blue card.

Certainly there are many components that sum up to the merchant fee, where the largest variability is based on volume, interchange fees, and card network (visa vs mastercard). But there will not be a difference between transacting with a vanilla Chase Freedom vs a premium Chase Sapphire.

This is why credit card surcharges annoy me so much. Their central premise is that cash costs the merchant nothing, which is entirely incorrect. To keep that relevant to the OPs question though, I wonder if the airlines are lobbying to get those fees eliminated given how much they depend on credit cards to generate profitability.

The carriers and banks are lobbying to prevent the swipe fees from being reduced to the debit card fee which is the bigger threat to loyalty programs. Visa and MC are fighting the surcharge/discount for cash.

You are in Australia, as I recall, where there are legal limits on the merchant fees. In the US it is much more of a free for all. It also depends on the deal that the merchant is able to negotiate with their selected payment processor. For a Visa Infinite card it can approach 3% I have heard.

This leads to a separate question, but when a customer swipes a card, how many fees are involved? I imagine at the bare minimum, Chase (the issuer for example), Visa, and the merchant's payment processor are all getting a fee. Does the merchant need to negotiate 3 separate fees?

It less that the merchant, such as Essence Bakery, negotiates the fees, than the many, slightly-differently calculated fees are imposed upon the merchant in their bill from the processor.