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Omega
journal homepage: www.elsevier.com/locate/omega

Credit card fraud detection strategies with consumer incentives

Deshen Wang a, Bintong Chen a,∗, Jing Chen b
a
Institute for Financial Services Analytics, University of Delaware, Newark, DE 19711, USA
b
Rowe School of Business, Dalhousie University, Halifax, NS B3H 4R2, Canada

a r t i c l e i n f o a b s t r a c t

Article history: Credit card fraud increases as ecommerce becomes more prevalent. Current fraud detection techniques,
Received 14 February 2018 however, are far from accurate, and can result in significant financial losses to merchants and card is-
Accepted 8 July 2018
suers. Furthermore, the associated high false positive declines can cause inconvenience and dissatisfac-
Available online xxx
tion for consumers. We introduce a consumer incentive strategy for merchants to adopt more accurate
Keywords: fraud detection (prevention) techniques, such as secondary verification. We further optimize the strat-
Credit card frauds egy by applying secondary verification only to transactions with values higher than certain thresholds.
Optimal detection strategy We identify the conditions under which the strategy is attractive to merchants, and show that it may
Consumer incentives lead to a ‘win-win-win’ for consumers, merchants, and the card issuer, when the consumer’s tolerance
Case study of false declines is low or/and the incentive amount is within a certain range. In addition, we show that
Financial operations management coordinated decisions by the merchant and the card issuer may generate further benefits. Finally, the
effectiveness of various proposed strategies is demonstrated using actual credit card transaction data.
© 2018 Elsevier Ltd. All rights reserved.

1. Introduction
Credit card fraud causes significant financial losses to mer-
chants and financial services companies (banks) that issue credit
cards. According to Robertson [40], the worldwide card fraud losses
rose from $7.6 billion in 2010 to $21.81 billion in 2015, or 300%
over 5 years. By 2020, global card fraud losses are expected to
reach to $31.67 billion.
There are two major types of credit card fraud: card present
(CP) fraud, such as counterfeit cards used at the point-of-sale or
an auto teller machine, and card-not-present (CNP) fraud, which
occurs when transactions are made online or via mail, telephone,
or mobile apps [24,40]. With the introduction and adoption of the
Europay, Mastercard, and Visa (EMV) chip card [16], CP fraud has
been reduced dramatically in recent years. According to Robertson
[40], losses due to counterfeit cards in US in the first quarter of
2016 were reduced more than one-third as compared to the same
quarter in the previous year. CNP fraud, on the other hand, has
increased dramatically worldwide in recent years, due to the pop-
ularity of ecommerce and as fraudsters have shifted their attacks
from CP to CNP transactions. In the US market, CNP fraud loss is
expected to grow from $2.8 billion in 2014 to $7.2 billion in 2020
[3]. Overall, the CNP fraud now accounts for more than 70% of card
∗
Corresponding author.
E-mail addresses: dwang@udel.edu (D. Wang), bchen@udel.edu (B. Chen),
jchen@dal.ca (J. Chen).
fraud worldwide [2,45]. It is worth noting that banks typically bear
the losses for CP fraud, while merchants bear the losses for CNP
fraud. It is thus critical for merchants to reduce CNP fraud which
is the focus of this paper.
Card issuers and network providers rely on machine learning
(ML) models for credit card fraud detection. Even though a sig-
nificant amount of research has been done in both industry and
academia to improve ML models, effective solutions remains a
challenge [24] (reasons to be discussed later); current ML mod-
els for credit card fraud generate a high volume of false declines
(false positive). In fact, it has been reported in [47] that every le-
gitimate decline is accompanied by as many as 40 false declines,
which means that 97% of transactions flagged as high-risk could
be legitimate transactions. Other reports, like [31,46], suggest sim-
ilar performance; in order to detect half of the fraud (about 50 0 0
transactions), the ML algorithm generates about 6,0 0 0,0 0 0 false
positives.
The high amount of false declines causes inconvenience, dissat-
isfaction, and negative shopping experiences for consumers. As re-
ported in [35], 61% of cardholders who experience false declines
decrease or even completely stop card use. False declines also lead
to significant revenue loss for merchants [31,46,47] (and thus card
issuers). Indeed, according to the report of [5], falsely declined card
transactions cost US ecommerce merchants an estimated $8.6 bil-
lion in 2016, which is much more than the $6.5 billion savings
from the fraud detection. The unreliable performance of current
ML fraud detection models puts merchants in what [22] calls a

https://doi.org/10.1016/j.omega.2018.07.001
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Please cite this article as: D. Wang et al., Credit card fraud detection strategies with consumer incentives, Omega (2018),
https://doi.org/10.1016/j.omega.2018.07.001
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2 D. Wang et al. / Omega 000 (2018) 1–17
merchant’s dilemma; the merchant must decide whether to accept
the ML models’ false positives or to simply accept all transactions
(and thus absorb the losses due to fraudulent transactions).
While card fraud happens globally, its severity varies by coun-
try. Card fraud is more prevalent in the US than in many other
countries. Among 20 countries surveyed by the [26,45] in 2016,
based on data from the past 5 years, US was ranked the second
highest in card fraud rate; 46% of cardholders in US incurred credit
card fraud, as compared to 8%, 12%, and 17%, respectively, for Hun-
gary, Sweden, and Germany. In fact, the US is responsible for 38.7%
of the world’s card fraud, with only 22.9% of total worldwide card
use volume [6]. The major difference between countries is in the
adoption of more effective secondary verification (2V) techniques.
While this technique, especially a PIN system, is well accepted for
credit card payment in many Asian and European countries, it is
not implemented in US. This is because US consumers are not li-
able for any credit card losses due to fraud, and many of them are
not willing to go through the secondary verification steps in the
checkout process. Indeed, an experiment conducted in the US by
Adyen [1] shows that when a 3D secure step (a type of secondary
verification) is added to the checkout process, 40% of the trans-
actions are abandoned at the secure step. As a result, merchants
worry about potential revenue losses and are reluctant to adopt
the more secure fraud detection technique [12]. It is interesting to
note that card issuers also do not have an incentive to introduce
secondary verification, since they are not liable for CNP fraud; their
revenue depends on transaction volume.
Our research is motivated by the observation that merchants
seem to have the most to gain or lose from the effectiveness of
fraud detection. Given the poor performance of the current ML
credit card fraud detection models, implementing secondary ver-
ification seems to be a relatively effective way of reducing credit
card fraud, and the key to implementing secondary verification is
to incentivize the consumers. In this paper, we propose a consumer
incentive strategy to implement secondary verification for credit
card fraud detection. We are interested in finding out, from a mer-
chant’s perspective, when it is beneficial to accept all transactions,
when the current ML fraud detection is sufficient, and when the
more advanced secondary verification should be adopted. We show
that secondary verification with consumer incentive may benefit
the merchant. We further study the benefits of the proposed strat-
egy of only requesting secondary verification for the small portion
of transactions with high value. The optimal threshold transaction
value, above which the secondary verification is requested, is de-
rived. We show that our proposed strategy with consumer incen-
tive may lead to a ‘win-win-win’ for consumers, the merchant, and
the card issuer. In addition, a coordination method is proposed to
further benefit the merchant and the card issuer. Finally, the ef-
fectiveness of the proposed strategies is demonstrated using actual
bank credit card transaction data.
This paper contributes to the literature and practice in several
areas. First, most of the existing work on credit card fraud detec-
tion focuses on improving ML models and algorithms. This paper,
to the best of our knowledge, is among the first to provide an aca-
demic study of credit card fraud detection from a systems perspec-
tive. By analyzing the roles and incentives of each player in the
credit card transaction network, we find that merchants have more
incentives to improve credit card fraud detection than other play-
ers in the system, including card issuers, who have conventionally
been thought to be more motivated. Second, we identify the con-
ditions under which strategy can be better off for the merchant.
Third, we introduce a consumer incentive strategy, which may lead
to ‘win-win-win’ for consumers, merchants, and card issuers un-
der certain conditions, and could resolve the merchant’s dilemma.
Fourth, we develop a strategy that can further improve the system
by optimally differentiating the values of credit card transactions,
Please cite this article as: D. Wang et al., Credit card fraud detection strategies with consumer incentives, Omega (2018),
https://doi.org/10.1016/j.omega.2018.07.001
[m5G;July 20, 2018;2:29]
Fig. 1. Credit card transaction authorization network.
and by coordinating the merchant and the card issuer. In addition,
we propose an easy-to-implement coordination mechanism to co-
ordinate the system. Finally, we use real data to show the viability
of the proposed consumer incentive strategy, and illustrate its effi-
ciency and implementation in improving the system.
The paper is organized as follows. Section 2 describes the credit
card transaction system and reviews the literature. Section 3 de-
scribes the model, and Section 4 introduces the consumer incen-
tive strategy of implementing secondary verification, and compares
with existing strategies. Section 5 focuses on developing further
improvements of the incentive strategy by optimally identifying
the thresholds between high-value and low-value credit card trans-
actions. The improved strategy is shown to be a ‘win-win-win’ sys-
tem, when the consumer’s tolerance of false declines and the in-
centive amounts are within a certain range. Section 6 shows that
further improvement can be achieved via merchant and card is-
suer coordination. Section 7 is a case study using real data to
test the viability of implementing the consumer incentive strategy.
Section 8 concludes the paper and discusses future research direc-
tions. All proofs are in the Appendix.
2. Industry background and relevant literature
Understanding the credit card transaction system is critical to
the economic analysis carried out in the paper. We start by de-
scribing the typical process and analyzing the role and economic
incentives for each player in the system. We then provide a brief
review of the literature relevant to credit card fraud detection, in-
cluding ML algorithms, and secondary verification.
Fig. 1 provides an overview of the credit card transaction au-
thorization system, including the transaction path and decision-
making process [13]. Five players are involved: consumer, mer-
chant, (merchant) acquirer, network (provider), and (card) issuer. A
consumer purchases product from a merchant (such as Home De-
pot) using a credit card from an issuer (such as Chase Bank) that
is associated with a network provider (such as VISA). The issuer
is typically a bank or a financial institution that offers the net-
work provider branded payment cards directly to consumers. The
merchant acquirer is often also a bank or financial institution, and
processes card payments on behalf of the merchant. It allows mer-
chants to accept credit card payments from the issuer within the
network provider. The network provider, such as VISA and Master-
Card, also known as the card association, provides a branded plat-
form for the execution of payment transactions. A transaction is
authorized by the system through 8 steps: (1) the consumer re-
quests a purchase from the merchant; (2) the merchant submits
the request to the acquirer; (3,4) the acquirer sends the request to
the issuer, through the network provider, to authorize the transac-
tion; (5,6) the issuer sends an authorization code (approve or de-
cline) back to the acquirer; (7) the acquirer authorizes the transac-
tion; (8) the consumer receives the product or service.
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As shown in Fig. 1, the efforts to curb card fraud in the trans-
action authorization system can be classified into two categories:
fraud prevention and fraud detection. While fraud prevention at-
tempts to block fraudulent transactions at the source, fraud de-
tection aims to identify fraudulent transactions that have already
passed through the prevention stage.
Credit card fraud prevention consists of two layers of verifi-
cation; the first layer verification includes widely adopted tech-
nologies such as Address Verification Systems (AVS), which verify
the cardholder’s billing address and ZIP code, and Card Verifica-
tion Method (CVM), which verifies card information, such as card
number, expiration date, and Card Verification Value (CVV) code.
Even though it has been widely adopted in US, with an adoption
rate higher than 90% [13], first layer verification is not effective,
since fraudsters are also likely to have this information. Through
an agreement, a merchant and the network provider may choose
to implement additional more sophisticated and effective but less
convenient second layer verification [4,23,30,33,51], also known as
secondary verification (2V), to be discussed further below. In con-
trast to first level verification, the adoption rate of secondary veri-
fication is very low; only 10% [13] of merchants, mostly from Euro-
pean and Asian countries, have adopted the PIN system. The higher
level of adoption of 2V in Europe and Asia partially explains the
lower credit card fraud rate in those areas versus the US [20,26,45].
The dashed lines around the 2V module in Fig. 1 represent its ab-
sence from current practice in the United States.
Currently available versions of 2V may include 3D secure, two
factor authentication (2FA), and biometric indicators (in order of
increased accuracy and inconvenience to consumers). 3D secure
refers to static password verification, 2FA verifies a dynamic code
(one-time password) sent to a consumer’s default device, and bio-
metric techniques enhance security by adding bio feature verifi-
cation, such as finger print and facial recognition. Studies show
that 2V techniques are very effective in reducing credit card fraud.
Orzechowski and Walker [33] report that the fraud losses associ-
ated with the PIN card are only 1/6 of those associated with the
signature card. Aloul et al. [4] propose a fast and effective mo-
bile one-time-password generation system, which is hard to hack.
Jin et al. [23] propose a hybrid security system, which combines
randomly generated one-time passwords and user bio features,
such as fingerprints. The hybrid system increases the security level,
since it is extremely hard to obtain both the specific code and bio
features at the same time. Liao and Wang [30] propose to com-
plete authentication with dynamic ID verification in a multi-server
system to increase security level. Overall, there are many available
highly advanced and secure secondary verification tools. The adop-
tion rate of 2V is very low, however, especially in the US, due to its
complexity and inconvenience to consumers. Here, therefore, we
propose a consumer incentive mechanism to enable the use of the
secondary verification for high value transactions.
If a transaction passes the fraud prevention step(s) described
above, it is then sent to the card issuer for fraud detection to fil-
ter out fraudulent transactions from legitimate. The fraud detection
model can be an expert rule system, and/or a more sophisticated
and effective data-driven machine learning (ML) algorithm. The lat-
ter captures fraudulent transaction patterns by correlating the sta-
tus of a transaction with associated features based on historical
data. An ML algorithm typically generates a fraud probability (or
score) for each transaction. If the algorithm is sufficiently accurate,
the larger the probability, the more likely that the transaction is
fraudulent. The probability is then compared with a threshold de-
termined by the card issuer. If the probability is higher than the
assigned threshold, the transaction is declined, and otherwise it is
approved. This decision (code) is then sent to the merchant.
Almost all credit fraud detection research by academia and
banks focuses on applying and modifying existing ML algorithms
Please cite this article as: D. Wang et al., Credit card fraud detection strategies with consumer incentives, Omega (2018),
https://doi.org/10.1016/j.omega.2018.07.001
[m5G;July 20, 2018;2:29]
3
to detect credit card fraud [8,14,36,39]. Techniques used include:
logistic regression [32,41], decision tree [9,27,42], random forest
[8,38,49], and artificial neural network [19,31,34,41]. Unlike suc-
cessful applications in other areas, however, the performance of
ML models for credit card fraud detection are far from accurate.
This poor performance can be attributed to several reasons, as ex-
plained in [38]. First, frauds usually represent a very small frac-
tion, typically less than 0.1%, of all transactions [34]. This produces
what is known as a data unbalance problem [21,37], and most
ML algorithms cannot extract patterns accurately from unbalanced
data. Second, in order for an ML algorithm to accurately capture
the transaction behavior of a consumer, the algorithm would need
comprehensive transaction data from other banks, and product and
service data from merchants. The reality, however, is that these
critical data are not shared among banks and merchants, and they
are treated as private assets and business secrets for each bank and
merchant. These transaction data are also not shared with research
community, and as a result, research studies on credit card fraud
are very limited [8,36]. Finally, fraud behaviors also evolve over
time [18,38], and some fraudsters even have consumers’ shopping
behavior and transaction data and can imitate normal transactions,
which makes credit card fraud detection even more challenging.
The present paper therefore focuses on studying and evaluating the
economics of credit card fraud prevention and detection strategies.
We propose a strategy to improve credit fraud detection by opti-
mally differentiating the values of credit card transactions, and by
coordinating the merchant and the card issuer.
To study and evaluate strategies for credit card fraud preven-
tion and detection, it is imperative to understand the roles of each
player and the associated economic incentives. Each of the five
players involved in the credit card system, as shown in Fig. 1, bears
a different level of risk in the face of card fraud. While consumer
risks vary from country to country, US consumers hold zero lia-
bility for any unauthorized transactions [10]. As a result, they are
not interested in adopting more complicated verification methods,
and are more concerned with their shopping experience, which is
negatively impacted by a high rate of false declines of their credit
card transactions. A merchant, on the other hand, is responsible for
losses from all fraudulent CNP transactions [47,48]. Both the card
issuer and the merchant suffer from false positive declines, since
rejected consumers may seek customer service or abandon their
purchases. Finally, the card issuer, the merchant acquirer, and the
network provider all profit from charging the merchant transac-
tion fees that are proportional to the volume of transactions, and
they are mostly concerned with the reputation of the brand of the
credit card network. Poor performance of credit card fraud preven-
tion and detection will lead to reduced market share of the credit
card brand and cost them in a long run. Our paper focuses on an
incentive strategy to motivate the merchant, the card issuer, and
consumers to use secondary verification.
Interestingly, we have found very few economic models of
credit card fraud prevention and detection. To the best of our
knowledge, [20] is the only relevant paper; they study a simple
duopoly game in which two merchants adopt 3D secure, one of
the simple 2V strategies. They show that in the equilibrium the
two merchants will both choose to adopt or not adopt 3D secure,
depending on the benefit from 3D secure, net the opportunity cost
of sales lost due to consumer inconvenience from adopting 3D se-
cure. In this paper, we develop economic models by considering an
incentive strategy for merchants to adopt more accurate fraud de-
tection/prevention techniques (secondary verification) and by opti-
mizing the strategy for applying the secondary verification only to
transactions with values higher than certain thresholds.
Incentive systems have been studied and applied in many dif-
ferent domains. Feldmann and Muller [17] design an incentive
scheme for providing true information in supply chains. They ob-
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4 D. Wang et al. / Omega 000 (2018) 1–17
serve that the partners in a supply chain may not reveal true in-
formation, such as production ability, to the supply chain, in or-
der to maximize profit. They propose to incentivize the partners
who provide true information, or penalize those who do not pro-
vide true information. The incentive scheme maximizes the sup-
ply chain overall profit and encourages partners to reveal their
true information. Conversely, Wu et al. [50] study incentives for
sharing information under a Cournot duopoly model with capacity
constraints. Their model considers both demand and cost informa-
tion sharing, and shows that the incentive can be reversed under
boundary solutions. Taylor [43] discusses two common forms of
channel incentives, linear incentive and target incentive. He shows
that a properly designed target incentive can achieve channel coor-
dination and a win-win outcome. Chen [11] discusses an incentive
for the retailer to reveal its information on product return rate.
Consumer incentives have also been examined in the marketing
and operations literature. Thompson et al., Laroche et al., and Liao
et al. [28,29,44] study the effects of different consumer incentive
mechanisms on sales and on consumer response. From the opera-
tions and decision-making perspectives, Demirel et al. [15] propose
a genetic algorithm to determine the consumer incentive amount
for a closed-loop supply chain network. Similarly, Berger and Bech-
wati [7] offer a general approach to the organization’s incentive
budget allocation to maximize customer equity.
In our paper, in addition to developing economic models, we
present an incentive system and propose improved strategies for
easy implementation of 2V by the merchant. To the best of our
knowledge, this is the first study to design an incentive system for
credit card fraud detection. We also optimize the proposed strate-
gies to ensure a win-win-win coordination system. In addition, our
case study using real bank data validates the efficiency and effec-
tiveness of the proposed strategy with incentive system. New man-
agerial insights are discussed.
3. Model description
We consider a credit card transaction network with one mo-
nopolistic ecommerce merchant, one credit card network provider,
one issuing bank, and one acquiring bank. To focus on the profit
analysis for the merchant’s fraud detection strategies, we com-
bine the credit card network provider, the issuing bank, and the
acquiring bank into one ‘aggregated’ bank, since their cost func-
tions to the merchant are similar, being proportional to the value
of each transaction. We consider N consumer transactions that oc-
cur during a given period. Let vi ∈ [0, vmax ], i = 1, . . . , N, represent
the value of ith transaction, where vmax is the largest transaction
value. Each transaction value v is assumed to be an independent
and identically distributed (iid) random variable with a probabil-
ity density function g(v) on a support range [0, vmax ]. We denote

v̄ = vg(v ) dv as the expected value of a transaction.
We refer to transactions made by fraudsters as ‘fraudulent
transactions’ and those by consumers as ‘legitimate transactions’.
To distinguish fraudulent transactions from legitimate transactions,
let r (the fraudulent transaction rate) represent the percentage of
transactions being fraudulent. Then 1 − r is the rate of legitimate
transactions. Most banks adopt ML models to detect fraudulent
transactions. To measure the accuracy of an ML model, we com-
pare the predictions made by the ML model and the actual status
of each transaction. Let f0 represent the false negative rate, which
is the probability that the ML model predicts a transaction to be
legitimate, but it turns out to be fraudulent; let f1 represent the
false positive rate, which is the probability that the ML model pre-
dicts a transaction to be fraudulent, but it turns out to be legiti-
mate. The fraud rate (r), the false negative rate (f0 ), and the false
positive rate (f1 ) capture the uncertainties in detecting fraud. We
Please cite this article as: D. Wang et al., Credit card fraud detection strategies with consumer incentives, Omega (2018),
https://doi.org/10.1016/j.omega.2018.07.001
[m5G;July 20, 2018;2:29]
Fig. 2. A merchant’s decision tree for a transaction.
Table 1
Table of notation.
Indexes
i Subscript, index for strategies, i = 1, 2, 3, 4, 5
Parameters
Si Strategy i
N Total number of transactions in dataset
v Transaction value, a random variable following a distribution
with a probability density function g( · ) in the range [0, vmax ]
vmax modification of p∗ by proposed method
v̄ Expected (average) transaction value
r Fraud rate
α Merchant’s profit margin (percentage)
θ Transaction abandon (incomplete) rate when legitimate
transactions are falsely declined
c Merchant’s unit cost of purchasing the product and processing
a transaction
f0 , f1 False negative and positive rate for machine learning (ML) model
πi , πiI , πiS Net expected profits of merchant, issuer, and system for
Strategy i, respectively, where πiS = πi + πiI
πiC Consumer’s gain for Strategy i
πB , πBI , πBS Net expected profits of merchant, issuer, and system for
benchmark case, respectively, where πBS = πB + πBI and
benchmark case is for f 0 = 0 and f 1 = 0
π ij Net profit difference between π i and π j , where πi j = πi − π j
δ Incentive offered by merchant to compensate consumer for
inconvenience related to secondary verification
ρ Interchange fee, the issuer charges the merchant a proportion
of transaction value
c2v Cost to consumer for using secondary verification
cμ Handling expense of issuer for falsely declined transaction
Decision variables
ti Threshold of transaction value above which secondary
verification is requested for Strategy i, i = 4, 5
Other notation
g(v) Distribution probability density function for transaction value
v(t) Expected transaction value for transaction value larger than t
p(t) Probability of transaction with transaction value larger than t
assume that both f0 and f1 for the bank’s ML model are available
for our analysis. When legitimate transactions are falsely declined
(false positive), some consumers may abandon their purchases and
thus the associated transactions. We assume that the abandon rate
is θ , where 0 ≤ θ ≤ 1. The probabilities of all possible transaction
outcomes of the ML method in detecting frauds are summarized
and illustrated in Fig. 2.
This paper focuses on fraud detection strategies from the mer-
chant’s perspective, since the merchant bears the most significant
economic impact from the outcomes. Let 0 < α ≤ 1 be the mer-
chant’s net profit margin, which is the percentage of net profit
from a transaction of value (v), after the transaction fees are paid
to the (aggregated) bank. Let c be the merchant’s cost, measured
as a percentage of the associated transaction value (v) , and let ρ
be the percentage fee paid to the bank. Then α = 1 − c − ρ , and
the merchant’s net profit is α v. Since all transactions are iid dis-
tributed, our profit analysis will focus on the expected profit/loss
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from one transaction. Table 1 summarizes the notation used in this
paper.
4. Three pure fraud detection strategies for the merchant
In this section, we start our discussion with two fraud detection
strategies that are widely used in practice: no fraud detection for
all transactions (Strategy 1), and applying an ML fraud detection
model for all transactions (Strategy 2). We then introduce a sec-
ondary verification strategy with consumer incentive, for all trans-
actions (Strategy 3). We compare these three strategies by identi-
fying the conditions under which the merchant benefits most from
each strategy.
4.1. Strategy 1: No fraud detection for all transactions
Due to high false positive declines in the current ML fraud de-
tection models, some merchants request that issuers approve all of
their transactions, to provide better shopping experiences to their
customers. This is the so-called ‘merchant’s dilemma’, in which a
merchant voluntarily gives up fraud detection and chooses to bear
all costs of fraudulent transactions to avoid the risk of false de-
clines. This corresponds to an ML model with f0 = 1 and f1 = 0 in
the decision tree (Fig. 2). The expected profit of the merchant for
a transaction under Strategy 1 (π 1 ) is:
π1 = [α (1 − r ) − (1 − α )r]v̄.
The first term in the bracket is the expected profit from a legiti-
mate transaction, and the second term is the fraud loss. Eq. (1) can
be simplified as:
π1 = (α − r )v̄.
It is clear from (2) that the merchant, if choosing no fraud detec-
tion, will be profitable only if its net profit margin is higher than
the fraud rate. We denote r̄1 = α as the maximum fraud rate al-
lowed for Strategy 1 for subsequent comparisons.
4.2. Strategy 2: ML detection model for all transactions
As the fraud rate (r) increases, the performance of Strategy 1
deteriorates. In practice, most merchants still rely on the bank’s
ML fraud detection models to protect their transactions. The per-
formance of an ML model depends on its accuracy, which is mea-
sured by f0 and f1 . In view of the decision tree in Fig. 2, we obtain
the expected profit of the merchant as follows:
π2 = {α (1 − r )[(1 − f1 ) + (1 − θ ) f1 ] − (1 − α )r f0 }v̄,
where the first term represents the expected profit from a legiti-
mate transaction and the second term is the expected loss from a
false negative fraudulent transaction. Eq. (3) can be written as:
π2 = {α (1 − θ f1 ) − r[α (1 − θ f1 ) + (1 − α ) f0 ]}v,
It is clear from (4) that the merchant’s expected profit is nega-
tively impacted by the ML model’s false positive rate (f1 ) and false
negative rate (f0 ), and the impact of f1 is higher than that of f0 ,
especially when the abandon rate θ due to false declines is high.
In addition, the merchant is profitable only when the fraud rate
α (1−θ f )
(r) is lower than the upper bound r̄2 = α (1−θ f )+(11−α ) f , which in-
1 0
creases with the merchant’s profit margin (α ) and the accuracies
(1 − f0 , 1 − f1 ) of the ML model. For most ML models, we have
f1 + f0 < 1, which leads to r̄2 > r̄1 . This implies that the merchant
is more likely to be profitable when it adopts an ML model, espe-
cially when the fraud rate is high.
Please cite this article as: D. Wang et al., Credit card fraud detection strategies with consumer incentives, Omega (2018),
https://doi.org/10.1016/j.omega.2018.07.001
[m5G;July 20, 2018;2:29]
5
4.3. Strategy 3: Secondary verification for all transactions
While Strategies 1 and 2 may work well when the fraud rate
is low, more precise fraud detection techniques are needed to
handle transactions facing a high fraud rate. As mentioned in
Sections 1 and 2, secondary verification is an effective technique
in preventing fraud. In fact, the PIN system, a simple form of sec-
ondary verification, has been widely adopted in most European
and some Asian countries. It faces resistance in the US for two rea-
sons; implementing a secondary verification system requires addi-
tional effort from consumers, and US consumers are not liable for
any credit card fraud. As a result, US consumers have no incen-
tive to cooperate with merchants and banks to implement a more
accurate system associated with additional inconveniences.
On the other hand, banks also have little incentive to imple-
ment secondary verification, since they are not liable for CNP
fraud, which is becoming a major portion of fraud. If a bank
switches to secondary verification, it risks losing its customers to
competitors who do not use the (inconvenient) secondary verifi-
cation. Based on this observation, we propose a consumer incen-
tive system, with compensation offered by merchants, to facilitate
implementation of secondary verification for fraud prevention. The
incentive will be offered for each transaction and could be in the
form of a discount, cash back, bonus points, or other rewards.
Assume that the inconvenience cost associated with each trans-
action for a consumer is c2v . Then the merchant needs to offer an
incentive δ ≥ c2v for each transaction using secondary verification
(1) to keep consumers happy and not switching. We assume that if
the merchant chooses to use secondary verification, it will do so
for all transactions. For simplicity of analysis, we assume that the
secondary verification is perfectly accurate in identifying fraudu-
lent transactions and costs nothing to implement. In reality, sec-
(2) ondary verification is often implemented by the network provider,
who will charge the merchant an additional small percentage of
the transaction fee, proportional to the transaction value. Our ro-
bust test shows that this will not affect the major results and in-
sights in our paper.
In view of the decision tree in Fig. 2, the merchant’s expected
profit is:
π3 = (α v̄ − δ )(1 − r ). (5)
Notice that the merchant’s net expected profit is the profit from
the legitimate transactions minus the incentive that is given to the
consumers for the use of the secondary verification. Clearly, the
merchant is profitable only if the paid incentive δ ≤ δ̄3 = α v̄.
4.4. The merchant’s best strategy
(3) We now identify the merchant’s best option by comparing
three strategies discussed above. The result is summarized in
Proposition 1 and illustrated in Fig. 3.
Proposition 1. Among three pure strategies, Strategies 1, 2, and 3,
the merchant will choose:
(4)
(1) Strategy 1 if and only if (θ ≥ θ 12 , δ ≥ δ 13 , and r ≤ r̄1 );
(2) Strategy 2 if and only if (θ ≤ θ 12 , δ ≥ δ 23 , and r ≤ r̄2 );
(3) Strategy 3 if and only if δ ≤ min(δ13 , δ23 , δ̄3 );
(4) not to do business, as it cannot be profitable, otherwise; where
θ12 = (1−αα(1)−r
r ( 1− f 0 )
, δ13 = r (11−−rα )v̄ , δ23 =
αθ (1−r ) f1 +(1−α )r f0
v̄, r̄1 =
)f1 1−r
α (1−θ f1 )
α , r̄2 = α (1−θ f1 )+(1−α ) f0 , and δ̄3 = α v̄.
Proposition 1 shows that there is no strictly dominant strat-
egy for the merchant. The most beneficial strategy is impacted
by several factors: fraud rate (r), consumer’s abandon rate (θ ), in-
centive for compensation (δ ), the merchant’s margin profit (α ),
the average transaction value (v̄), the probability that a fraudulent
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6 D. Wang et al. / Omega 000 (2018) 1–17
Fig. 3. The merchant’s strategy choice if three strategies are available.
transaction is approved (f0 ), and the probability that a legitimate
transaction is declined (f1 ). Note that f0 and f1 mainly depend on
the prediction accuracy of the ML model, while α is usually pre-
decided by the merchant, and v̄ depends on consumers’ purchase
value. Three parameters, fraud rate (r), consumer’s abandon rate
(θ ) due to a legitimate transaction being falsely declined by the ML
detection model, and the incentive to compensation for the sec-
ondary verification (δ ), directly capture the credit card fraud issue
as well as the detection approaches. Proposition 1 clearly defines
the merchant’s strategy space, which varies with these three pa-
rameters, when there are three strategies available. The implication
of Proposition 1 is that it provides the merchant an easy way to se-
lect its strategy if the three pure strategies are available. It implies
that after the merchant carefully estimates r, θ , and δ from its ex-
perience, or historical data, or industrial reports, and estimates f0
and f1 for the ML detection model, it can calculate the boundaries
(θ12 , δ13 , δ23 , r̄1 , r̄2 and δ̄3 ) given in Proposition 1.
As illustrated by Fig. 3, when both the fraud rate r and sec-
ondary verification compensation rate δ are high, none of the three
pure strategies works well and the merchant cannot make a profit
no matter which strategy it chooses. If the compensation rate (δ ) is
sufficiently low, it is economical for the merchant to choose Strat-
egy 3 and incentivize consumers to do secondary verification for
all transactions. On the other hand, if the fraud rate r is low, the
merchant should consider Strategy 1 or 2, since the benefit of us-
ing secondary verification diminishes. Whether to adopt Strategy
1 or Strategy 2 depends on the consumer’s abandon rate θ in the
face of false positive declines. Strategy 1 is better if the abandon
rate is high, since by accepting all transactions it eliminates all
false positive declines. Strategy 2 is better otherwise.
5. Optimal strategy design
Section 4 shows that none of the three pure strategies dom-
inates, and each has its advantages and disadvantages. Strategies
1 and 2 are less accurate in detecting fraudulent transactions but
are easy to implement. Strategy 3, on the other hand, is accurate
but will be costly to implement, due to the need to offer incen-
tives to the cardholder. Since the value of transactions varies signif-
icantly between 0 and vmax , it is natural to consider mixed strate-
gies that apply more accurate but costly fraud detection for high-
value transitions and less accurate methods for lower-value trans-
actions. We propose two mixed strategies in this section; Strategy
4 applies secondary verification for high-value transactions and no
fraud detection for low-value transactions, and Strategy 5 applies
Please cite this article as: D. Wang et al., Credit card fraud detection strategies with consumer incentives, Omega (2018),
https://doi.org/10.1016/j.omega.2018.07.001
[m5G;July 20, 2018;2:29]
secondary verification for high-value transactions and ML fraud de-
tection for low-value transactions. We are interested in determin-
ing the optimal transaction value thresholds for both strategies.
Furthermore, we show that the mixed strategies dominate the cor-
responding pure strategies for a wide range of transaction value
thresholds, and offer robust performance.
5.1. Strategy 4: Secondary verification for high-value transactions and
no fraud detection for low-value transactions
In Strategy 4, we introduce a threshold (t) such that all trans-
actions with values higher than t are required to go through sec-
ondary verification, and the remaining transactions are automat-
ically approved. The merchant optimizes the threshold to maxi-
v
mize its net profit. We first define v(t ) = t max vg(v ) dv and p(t ) =
 vmax
t g(v ) dv as the average value of transactions that are higher
than t, and the probability of a transaction with value higher than
t, respectively. With the merchant’s decision tree in Fig. 2, the mer-
chant’s net expected profit is given:
π4 (t ) = α (1 − r )v̄ − (1 − α )r[v̄ − v(t )] − δ (1 − r ) p(t ). (6)
The first term on the right-hand side of (6) is the profit from legit-
imate transactions, and the last two terms are the expected fraud
loss generated by the low-value transactions and compensation
costs for the high-value transactions using secondary verification.
Clearly, as the threshold t approaches 0 or vmax , Strategy 4 reduces
to Strategy 3 or Strategy 1, respectively. Eq. (6) can be written as:
π4 (t ) = α v̄ − δ p(t ) − r[v̄ − (1 − α )v(t ) − δ p(t )]. (7)
Eq. (7) suggests that Strategy 4 is profitable if and only if r ≤ r̄4 ,
α v̄−δ p(t )
where r̄4 = v̄−(1−α )v(t )−δ p(t ) . Notice that r̄4 > r̄1 , where r̄1 is the
corresponding threshold for Strategy 1 (Proposition 1). This implies
that when the fraud rate (r) is higher, the merchant is more likely
to be profitable with Strategy 4 rather than the pure Strategy 1.
To maximize the expected profit in (7), the problem can be
rewritten as:
max π4 (t ) subject to t ∈ [0, vmax ]. (8)
t
With (8), we can prove that there exists a unique optimal thresh-
old t4∗ , above which secondary verification is requested by the mer-
chant. We summarize the result in Proposition 2 as follows:
Proposition 2. When the merchant uses Strategy 4, there exists a
unique optimal threshold transaction value (t4∗ ), which is given by:
 
( 1 − r )δ
t4∗ = min , vmax . (9)
r (1 − α )
)δ )δ
Eq. (9) indicates that t4∗ = r((11−r
−α )
if and only if r((11−r
−α )
≤
r (1−α )
vmax , which leads to δ ≤ δ4 = 1−r vmax ; otherwise, t4 = vmax .
∗
Proposition 2 shows that when the merchant must pay a high
compensation for secondary verification (δ > δ 4 ), the best option
is simply not to use the secondary verification with incentive
(t4∗ = vmax ), as the benefit cannot be offset by the high compen-
sation. Instead, using a no-detection policy is more profitable. No-
tice that δ 4 decreases with the merchant’s margin profit (α ), sug-
gesting that when the merchant cannot make a high margin profit
from a transaction, it is less likely to offer an incentive, or it can-
not pay a high incentive, to implement secondary verification for
high-valued transactions by compensating the consumer for incon-
venience. The implication is that low profit-margin merchants may
not be able to offer those consumers who have high transaction
values a high incentive to implement secondary verification. In ad-
dition, δ 4 increases with fraud rate (r), suggesting that as the fraud
rate increases the merchants are more likely to implement sec-
ondary verification, or it is worth offering a high incentive in order
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D. Wang et al. / Omega 000 (2018) 1–17
to implement secondary verification. For the extreme case, if and
only if all transactions are fraudulent (r = 1), the optimal thresh-
old transaction value becomes zero (t4∗ = 0). In such a case, Strat-
egy 4 is reduced to Strategy 3, in which it is optimal for the mer-
chant to implement secondary verification for all transactions. On
the other hand, secondary verification becomes unusual or unnec-
essary when the fraud rate is very low (r → 0).
Interestingly, Proposition 2 indicates that the optimal threshold
t4∗ in Strategy 4 is independent of the distribution of transaction
values. This allows for convenient implementation of Strategy 4;
the merchant can easily determine when it should request sec-
ondary verification, as it only needs to estimate the fraud rate (r),
its margin profit (α ), and the incentive for compensation of each
transaction (δ ). Both the fraud rate and the margin profit can be
estimated from historical data or a careful cost estimate. (9) shows
that the threshold of transaction value (t4∗ ) increases with the mer-
chant’s margin profit (α ) and the compensation fee (δ ), and de-
creases with fraud rate (r), suggesting that when the merchant can
gain a high margin profit or must pay a high compensation, it
should raise the bar for requesting secondary verification. This is
because the high profit margin reduces the risk of the loss from
fraudulent transactions, and the high threshold reduces the com-
pensation costs; when more transactions are fraudulent and the
compensation is cheaper, the merchant should request secondary
verification for more transactions, as fraud becomes a serious is-
sue.
In particular, Strategy 4 may reduce to Strategy 1 (Proposition 2
for the case when t4∗ = vmax ) if it is costly to incent consumers to
use the secondary verification. Strategy 4 may also reduce to Strat-
egy 3 in the case when t4∗ = 0, when the fraud rate (r) approaches
1 or when it is costless to use secondary verification (for example,
no incentive is offered to the consumer. That is δ = 0).
Next, we show that the mixed strategy dominates the corre-
sponding pure strategies if the transaction threshold is optimally
chosen, and furthermore this dominance holds for a wide range of
thresholds. Reorganizing (7), we have:
π4 (t ) = π1 + (1 − α )rv(t ) − δ (1 − r ) p(t ). (10)
)δ
With (10), we see that when vp((tt )) = r((11−r
−α )
, then π4 (t ) = π1 . Let
t4 be the boundary for π4 (t ) = π1 . We also compare (10) to the
merchant’s profit in (5) for Strategy 3, and we have π4 (t ) = π3
−v(t ) (1−r )δ
if 1v̄−p(t ) = r (1−α ) . Let t̄4 be the boundary for π4 (t ) = π3 . Notice
)δ )δ
that r((11−r
−α )
= t4∗ if and only if r((11−r
−α )
≤ vmax (see Proposition 2). We
have the following result that is summarized in Lemma 1.
Lemma 1.
(1) Strategy 4 with the optimal transaction threshold t = t4∗ dominates
both Strategy 1 and Strategy 3;
(2) When δ ≥ δ 13 , Strategy 4 dominates Strategy 3 for any t ≥ 0, and
dominates Strategy 1 for t 4 ≤ t ≤ vmax ;
(3) When δ < δ 13 , Strategy 4 dominates Strategy 1 for any t ≥ 0, and
dominates Strategy 3 for 0 ≤ t ≤ t̄4 , where t 4 < t4∗ < t̄4 .
Lemma 1 indicates that Strategy 4 dominates Strategy 1 and
Strategy 3 when the merchant sets the optimal transaction thresh-
old t = t4∗ . Based on the definition of t4 and t̄4 above, we have
for t 4 < t < t̄4 , then π 4 (t) > π 1 and π 4 (t) > π 3 . Since t 4 < t4∗ < t̄4 ,
point (1) in Lemma 1 holds. Strategy 4 is mixed strategy of Strat-
egy 1 and Strategy 3, and takes advantage of secondary verifica-
tion only for high-value transactions. The intuition is that, as com-
pared to pure Strategy 1, Strategy 4 reduces revenue loss from
high-value fraudulent transactions although the merchant must
pay compensation to the customers; as compared to Strategy 3,
Strategy 4 saves on compensation paid for secondary verification
on low-value transactions (where the compensation would not be
offset by the savings through fraud detection). From Proposition 1,
Please cite this article as: D. Wang et al., Credit card fraud detection strategies with consumer incentives, Omega (2018),
https://doi.org/10.1016/j.omega.2018.07.001
[m5G;July 20, 2018;2:29]
7
we see that when δ ≥ δ 13 , Strategy 1 is strictly better than Strat-
egy 3, while Strategy 3 is strictly better than Strategy 1 if δ < δ 13 .
Points (2) and (3) in Lemma 1 show that even if the merchant
does not use the optimal transaction value threshold (t4∗ ), it can
select a range of t for Strategy 4 that is better than Strategy 1
(t 4 ≤ t ≤ vmax ) and Strategy 3 (0 ≤ t ≤ t̄4 ). Lemma 1 implies that
the mixed Strategy 4 is better for the merchant, as compared to
either of the pure strategies, either Strategy 1 or Strategy 3, for a
wide range of threshold choices (t 4 < t4∗ < t̄4 ).
We now propose and discuss Strategy 5, in which instead of no
prevention for low transactions, the merchant uses the ML detec-
tion model, as compared to Strategy 4.
5.2. Strategy 5: Secondary verification for high-value transactions
and ML detection for low-value transactions
Let t again be the transaction value threshold. With the mer-
chant decision tree in Fig. 2, the merchant’s expected profit is:
π5 (t ) = [α (1 − r )(1 − θ f1 ) − (1 − α )r f0 ][v̄ − v(t )]
+α (1 − r )v(t ) − δ (1 − r ) p(t ). (11)
The first two terms of the right-hand side of (11) are the profit
from transactions of low value and high value, respectively. The
last term is the compensation costs for high-value transactions
due to the request for secondary verification. Similar to Strategy
4, (11) suggests that Strategy 5 is profitable if and only if r ≤ r̄5 ,
α (1−θ f )v̄+αθ f v(t )−δ p(t )
where r̄5 = α v̄[(1−α ) f1 −αθ f ][1v̄−v(t )]−δ p(t ) . Notice that r̄5 > r̄2 , where
0 1
r̄2 is the corresponding threshold for Strategy 2 (Proposition 1).
This implies that the merchant is more likely to be profitable when
it applies Strategy 5 rather than the pure Strategy 2, if both the
fraud rate (r) and the consumer’s abandon rate (θ ) are higher. Eq.
(11) can be written as:
π5 (t ) = γ1 v̄ + γ2 v(t ) − δ (1 − r ) p(t ), (12)
where γ1 = α (1 − r )(1 − θ f1 ) − (1 − α )r f0 and γ2 = r (1 − α ) f0 +
(1 − r )αθ f1 .
The optimal transition threshold can be found by maximizing
the expected profit in (12):
max π5 (t ) subject to t ∈ [0, vmax ]. (13)
t
Proposition 3 summarizes the properties of the optimal threshold
(t5∗ ) for Strategy 5:
Proposition 3. When the merchant uses Strategy 5, there exists a
unique optimal threshold transaction value (t5∗ ) that maximizes its ex-
pected profit and the optimal threshold is given by:
 
( 1 − r )δ
t5∗ = min , vmax . (14)
γ2
where γ 2 is given in (12).
Eq. (14) indicates that t5∗ = (1−r )δ (1−r )δ
γ2 , if and only if γ2 ≤ vmax ,
γ2
which leads to δ ≤ δ5 = 1−r vmax ; otherwise, t5 = vmax . Similar to
∗
Proposition 2, Proposition 3 shows that when the merchant must
pay a high compensation for a high-value transaction (δ > δ 5 ),
the best option is to not use the secondary verification with in-
centive, as the benefit from using secondary verification cannot
cover the high compensation. Instead, the use of the ML detec-
tion model for all transactions can be more profitable, although it
may cause some false declined non-fraudulent transactions or/and
some falsely approved fraudulent transactions. Notice that δ 5 in-
creases with fraud rate (r) and the consumer’s abandon rate (θ ),
suggesting that as r or θ increases, the merchant is more likely to
provide a high compensation to consumers with high-value trans-
actions for implementing secondary verification.
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8 D. Wang et al. / Omega 000 (2018) 1–17

Eq. (14) gives that the threshold of transaction value (t5∗ ) in-
creases with the merchant’s margin profit (α ) if (1 − r )θ f 1 − r f0 <
0; otherwise, it decreases with α ; this suggests that when the
probability that a fraudulent transaction is approved is higher than
the probability that a legitimate transaction is abandoned due to
being falsely declined, the merchant should optimally set a high
threshold (t5∗ ) of transaction values, as long as its margin profit is
large. That is, if the impact of an approved fraud is high relative
to that of a declined legitimate transaction, the merchant should
focus on mitigating these two errors on high value transactions if
it can enhance its margin profit; while the impact of an approved
fraud is low relative to that of a declined legitimate transaction,
the merchant should focus on mitigating these two errors on rela-
tively low value transactions if it can enhance its margin profit. In
addition, t5∗ decreases while δ 5 increases with r, f0 , and f1 , and this
suggests that when fraud rate (r) is higher, or when the probabil-
ity that a fraud is approved (f0 ) is higher, or the probability of a
legitimate transaction being declined is higher (f1 ), the impact of
fraud becomes more serious, and the merchant should request sec-
ondary verification at a lower transaction value, even at the cost of Fig. 4. The merchant’s strategy choice between strategy 4 and strategy 5
a higher incentive (δ ). (‘+’ and ‘−’ represent the merchant’s positive and negative profits, respectively).
(1−r )θ f α
With (9) and (14), we have when r (1− f )1 < 1− ∗
α , then t4 < t5
∗
0
and δ 4 > δ 5 ; otherwise, t4∗ > t5∗ and δ 4 < δ 5 . This implies that in (2) When δ ≥ δ 23 , Strategy 5 dominates Strategy 3 for any t ≥ 0, and
Strategy 5 the merchant should set a high bar for high-value trans- dominates Strategy 2 for t 5 ≤ t ≤ vmax ;
actions for using secondary verification, and probably a compensa- (3) When δ < δ 23 , Strategy 5 dominates Strategy 2 for any t ≥ 0, and
tion lower than that in Strategy 4 (t4∗ < t5∗ and δ 4 > δ 5 ) only when dominates Strategy 3 for 0 ≤ t ≤ t̄5 , where t 5 < t5∗ < t̄5 .
the ratio of the probability that a legitimate transaction is aban-
doned to the probability that a fraud is correctly declined is suf- Lemma 2 indicates that Strategy 5 dominates Strategy 2 and
ficiently low (< 1− α Strategy 3 when the merchant sets the optimal transaction thresh-
α ). In other words, it is not worth it for the
merchant to provide an incentive to compensate the consumer for old t = t5∗ . From the definition of t5 and t̄5 above, we have for t 5 <
inconvenience at relatively low transaction values. t < t̄5 , then π 5 (t) > π 2 and π 5 (t) > π 3 . Since t 5 < t5∗ < t̄5 , point (1)
Interestingly, similar to t4∗ in Proposition 2, t5∗ is independent in Lemma 2 applies. The intuition is that Strategy 5 takes advan-
of the distribution. This implies that to implement Strategy 5, tage of secondary verification only for high-value transactions by
the merchant can easily find out when it should request sec- mixing Strategy 2 and Strategy 3. As compared to pure Strategy 2,
ondary verification, as it only needs to estimate several parameters. by compensating customers with high-value transactions for using
(14) shows that the threshold of transaction value (t5∗ ) increases the secondary verification, Strategy 5 reduces revenue loss from
with the incentive (δ ), and decreases with fraud rate (r) and the high-value fraudulent transitions; as compared to Strategy 3, Strat-
consumer’s abandon rate (θ ), suggesting that when the merchant egy 5 saves the costly compensation for customers with low-value
provides a high incentive it should raise the bar for request of sec- transactions for using the secondary verification (the benefit from
ondary verification, to reduce the possible frequency of use; when using Strategy 3 instead of Strategy 5 cannot offset the compen-
more transactions are fraudulent or consumer’s abandon rate (θ ) sation). In addition, from Proposition 1, we see that when δ ≥ δ 23 ,
for low-value transactions is high, the merchant should request Strategy 2 is strictly better than Strategy 3 and Strategy 3 is strictly
secondary verification when the transaction value is relatively low, better than Strategy 2 if δ < δ 23 . Points (2) and (3) allow the mer-
as the lost sales due to abandoned transactions becomes the con- chant to select a range of t for Strategy 5 that is better than Strat-
cern to the merchant. egy 2 (t 5 ≤ t ≤ vmax ) and Strategy 3 (0 ≤ t ≤ t̄5 ), if the merchant
In particular, Strategy 5 may reduce to Strategy 2 (Proposition 3 does not use the optimal transaction value threshold (t5∗ ).
for the case if t5∗ = vmax if δ > δ 5 ), when the merchant must to pay
a high incentive. Strategy 5 may also reduce to Strategy 3 for the 5.3. Comparison between strategy 4 and strategy 5
case when t5∗ = 0, when the fraud rate (r) approaches 1 or when it
is costless to use secondary verification (no incentive for consumer Notice that the two mixed strategies differ only in the fraud
at all, or δ = 0). detection choices for the low-value transactions. After deriving the
Rewriting (12), we have: optimal threshold transaction values (t4∗ and t5∗ ), we compare the
merchant’s optimal profit π5 (t5∗ ) in Strategy 5 to π4 (t4∗ ) in Strategy
π5 (t ) = π2 + γ2 v(t ) − δ (1 − r ) p(t ). (15) 4. The result is summarized in Lemma 3 and illustrated in Fig. 4,
)δ
which is like the comparison between Strategies 1 and 2.
With (15), we see that when vp((tt )) = (1−r γ2 , then π5 (t ) = π2 . Let
t5 be the boundary for π5 (t ) = π2 . We also compare (15) to the Lemma 3. The merchant chooses:
merchant’s profit in (5) for Strategy 3, and we have π5 (t ) = π3 if (1) Strategy 5 if and only if θ ≤ θ 12 and r ≤ r̄4 ;
v̄−v(t ) )δ
1−p(t )
= (1−r
γ . Let t̄5 be the boundary for π5 (t ) = π2 . Notice that (2) Strategy 4 if and only if θ > θ 12 and r ≤ r̄5 ;
2
(1−r )δ ∗ (1−r )δ r̄4 =
γ2 = t5 if and only if γ2 ≤ vmax (see Proposition 3). Then we
(3) not to process any transaction, otherwise, where
α v̄−δ p(t ) α (1−θ f1 )v̄+αθ f1 v(t )−δ p(t )
have the following result. v̄−(1−α )v(t )−δ p(t ) and r̄5 = α v̄+[(1−α ) f −αθ f ][v̄−v(t )]−δ p(t ) .
0 1

Lemma 2. Notice that the breakeven line θ 12 for choosing a strategy

between Strategy 4 and Strategy 5 is exactly same as that
(1) Strategy 5 with the optimal transaction threshold t = t5∗ dominates of for choosing a strategy between Strategy 1 and Strategy 2
both Strategy 2 and Strategy 3; (Proposition 1). r̄4 and r̄5 ensure the merchant’s positive profits

Please cite this article as: D. Wang et al., Credit card fraud detection strategies with consumer incentives, Omega (2018),
https://doi.org/10.1016/j.omega.2018.07.001
JID: OME
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D. Wang et al. / Omega 000 (2018) 1–17
in Strategy 4 and Strategy 5, respectively. Notice that in Fig. 4,
the regions between the red and black dashed lines are where
the merchant cannot be profitable if either Strategy 1 or Strategy
2 is adopted, implying that either Strategy 4 or Strategy 5 could
be more applicable with a higher fraud rate (r) or/and a higher
consumer’s abandon rate (θ ). The intuition is that when π4 (t4∗ ) =
π5 (t5∗ ), we can find t4∗ = t5∗ , which suggests that it is optimal for
the merchant to require the same portion of high-value transac-
tions for secondary verification for both Strategy 4 and Strategy
5. By requiring secondary verification for high-value transactions,
the merchant can be profitable even with a higher fraud rate (see
r̄4 > r̄1 and r̄5 > r̄2 ), as compared to Strategies 1 and 2. This im-
proves the merchant’s performance in the presence of fraud trans-
actions.
6. ‘Win-Win-Win’ system
Section 5 shows that both mixed strategies, by combining the
consumer-incentivized secondary verification with the currently
used fraud detection practices (no fraud detection or ML fraud de-
tection), lead to profit improvements for the merchant, after more
than compensating the inconveniences for the consumers. There-
fore, Strategies 4 and 5 lead to ‘win-win’ for both the merchant
and consumers. In this section, we show that these mixed strate-
gies are also likely to be winning strategies for the card issuer (the
bank). In addition, we show that when the merchant and the bank
coordinate in their mixed strategy threshold decision, their prof-
its can be improved further. We will focus our study on Strategy
5, since in current practice card issuers do not commonly approve
all transactions (Strategy 1), even when requested by merchants.
Instead, most use ML fraud detection (Strategy 2).1
We start by analyzing the credit issuer’s net profit. The issuer
typically earns an interchange fee from each complete transaction,
which is a fixed percentage (ρ ) of the transaction value (v). If a
consumer’s transaction is declined by mistake (false positive), the
issuer will also incur a cost of cμ for related customer services.
By adding secondary verification for high-value transactions, the
issuer clearly reduces the customer service cost. It remains to be
seen if the added secondary verification has any negative impact
on the interchange fee earned by the issuer. In practice, when
a fraudulent transaction occurs, the card-holding consumer will
claim a chargeback. The chargeback process is complex and is nor-
mally resolved case by case. The chargeback amounts paid back
by the merchant and the bank depend on their liabilities. Some-
times they split the chargeback, based on what they earned from
the transaction. That is, the merchant pays back (1 − ρ )v and the
issuer pays back ρ v. In this case, the net interchange fees earned
by the issuer are simply those from normal transactions. Adding
secondary verification will not change the issuer’s revenue (inter-
change fee) but will save in customer service costs. This makes
the issuer also a ‘winner’, and leads to a “win-win-win” system
for consumers, the merchant, and the issuer.
In case of a fraudulent CNP transaction, however, the merchant
holds the full liability and is responsible to pay the full chargeback.
In this case, by using more accurate secondary verification tech-
niques, the issuer will lose revenue, since less accurate fraud de-
tection translates to more transactions, and even fraudulent trans-
actions result in fees for the issuer. In the remaining section, we
will focus our analysis on this case.
We now calculate and compare the issuer’s expected profits for
Strategy 2 and Strategy 5. If the merchant adopts Strategy 2, the
1
We can show that Strategy 4 also can benefit the issuer and consumers, as com-
pared to Strategy 1.
Please cite this article as: D. Wang et al., Credit card fraud detection strategies with consumer incentives, Omega (2018),
https://doi.org/10.1016/j.omega.2018.07.001
[m5G;July 20, 2018;2:29]
9
issuer’s expected profit (π2I ) is:
π2I = ρ [(1 − r )(1 − f1 ) + (1 − r )(1 − θ ) f1 + r f0 ]
× v̄ − cμ (1 − r )(1 − θ ) f1 . (16)
The first three terms on the right-hand side of (16) are the issuer’s
revenue from approved legitimate transactions, declined legitimate
and complete transactions, and approved fraudulent transactions,
respectively; the last term is the issuer’s handling costs for falsely
declining legitimate transactions. Eq. (16) can be written as:
π2I = ρ [(1 − r )(1 − θ f1 ) + r f0 ]v̄ − cμ (1 − r )(1 − θ ) f1 . (17)
Clearly, (17) represents the issuer’s expected profit which is the
difference between the revenue from all completed transactions
and the handling costs for falsely declining legitimate transactions.
If the merchant adopts Strategy 5, the issuer’s expected profit
(π5I (t )) is:
π5I (t ) = ρ [(1 − r )(1 − f1 ) + (1 − r )(1 − θ ) f1 + r f0 ](v̄ − v(t ) )
+ρ (1 − r )v(t ) − cμ (1 − r )(1 − θ ) f1 (1 − p(t )). (18)
The first three terms on the right-hand side of (18) are the is-
suer’s revenue from approved legitimate low-value transactions,
declined legitimate but complete low-value transactions, and ap-
proved fraudulent transactions with low value, respectively; the
fourth term is the revenue from approved legitimate high-value
transactions; the last term is the issuer’s false decline handling
cost for declined and complete low-value legitimate transactions.
Eq. (18) can be written as:
π5I (t ) = ρ [(1 − r )(1 − θ f1 ) + r f0 ](v̄ − v(t ) )
+ρ (1 − r )v(t ) − cμ (1 − r )(1 − θ ) f1 (1 − p(t )). (19)
Then (19) represents the issuer’s expected profit, the revenue from
all completed transactions (low- and high-value transactions) mi-
nus the handling costs for falsely declined legitimate transactions.
Comparing (19) when t = t5∗ to (17), we have the following re-
sult:
Lemma 4. As compared to Strategy 2, the issuer is more profitable
when the merchant uses Strategy 5, if and only if θ ≥ θ̄ , where θ̄ =
ρ r f0 v(t5∗ )−(1−r )cμ f1 p(t5∗ )
.
(1−r ) (ρv(t5∗ )−cμ p(t5∗ ) ) f1
With Lemma 2, Lemma 4 shows that if the merchant holds
full liability to fraud, the merchant’s optimal Strategy 5 benefits
not only the merchant, but also the credit card issuer, when the
consumer’s abandon rate (θ ) is sufficiently high (θ ≥ θ̄ ). Here θ̄
is solved by setting π2I = π5I (t ) (in (17) and (19)), which is the
breakeven abandon rate when Strategy 2 and Strategy 5 are equiv-
alent for the issuer. As long as the actual consumer abandon rate
is higher than the breakeven value, the issuer is better off with
Strategy 5 than with Strategy 2. The intuition is that as more con-
sumers are unsatisfied with falsely declined transactions and give
up their transactions under the ML detection approach, the issuer
can benefit from Strategy 5 (high-value transactions will not be
falsely declined). The issuer gains more from a high-value trans-
action than a low-value transaction, as it gains ρ portion of the
transaction value. The benefit comes from the loss reduction from
the reduction in truly fraudulent transactions and false positive de-
clines. In addition, for the case in which the bank is requested to
refund the interchange fee to the merchant, the issuer saves han-
dling costs (for contested declines) and no further profit loss, if the
merchant switches from Strategy 2 to Strategy 5. In this case, the
positive profit incremental for the bank is guaranteed.
Lemmas 2 and 4 give the conditions when the merchant and
issuer can benefit from Strategy 5, as compared to Strategy 2. The
consumers whose transaction values are higher than t5∗ will re-
ceive compensation from the merchant, and c2v is the minimum
JID: OME
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10
incentive to compensate the consumers’ inconvenience for the use
of the secondary verification. Lemma 5 gives the condition under
which both the merchant and the consumer can benefit from Strat-
egy 5.
Lemma 5. Both the consumers and the merchant benefit
 from Strat-
γ2
egy 5 as long as c2v ≤ δ ≤ c̄2v , where c̄2v = c2v + 1−r
and t5∗ are given in (12) and (14), respectively.
Lemmas 2, 4, and 5 show that Strategy 5 is a win-win-win
strategy for the merchant, the bank, and the consumer, as long
as c2v ≤ δ ≤ c̄2v and θ ≥ θ̄ . c̄2v is the upper bound of the incen-
tive that a merchant can offer to consumers. Any incentive amount
that is greater than c̄2v will cost the merchant more than the ben-
efit it receives, while any incentive amount below c2v will cause
sales loss for the merchant. Therefore, Lemma 5 implies that as
long as the compensation is within the range (δ ∈ [c2v , c̄2v ]), when
the merchant implements Strategy 5, both consumers and mer-
chant can always benefit.
In addition, although the consumers can always benefit if the
compensation from the merchant is appropriate (c2v ≤ δ ≤ c̄2v ),
from Lemma 4, we see that the issuer can only conditionally ben-
efit from the merchant’s implementation of Strategy 5. To ensure
that the issuer can always benefit from Strategy 5, we now discuss
the system coordination and implementation mechanism between
the merchant and the issuer to ensure an easy-to-implement sys-
tem.
The merchant and the issuer may benefit even further by coor-
dinating their decisions on the transaction threshold (t). With the
merchant’s expected profit in (14) and the issuer’s expected profit
in (19), the system’s profit π5S (t ) = π5 (t ) + π5I (t ) is:
π5S (t ) = [(1 − c )(1 − r )(1 − θ f1 ) − cr f0 ]v̄
+[(1 − c )(1 − r )θ f1 + cr f0 ]v(t )
+(1 − r )[cμ (1 − θ ) f1 − δ ] p(t ) − cμ (1 − r )(1 − θ ) f1 .
Maximizing π5S (t )
in (20), we can have the optimal threshold
transaction value (t∗ ), which is summarized in Proposition 4.
Proposition 4. The merchant will set the optimal threshold transac-
tion value (t∗ ), which can enhance the system’s profit and coordinate
the system. t∗ is given by:
⎧
⎨0, i f δ ≤ δ0,
(1−r )[δ −cμ (1−θ ) f1 ]
t∗ = (1−c )(1−r )θ f1 +cr f0 , i f δ 0 < δ < δ̄0 ,
⎩v , otherwise,
max
where δ 0 = cμ ( 1 − θ ) f 1 and δ̄0 = cμ (1 − θ ) f1 + [(1 − c )θ f1 +
cr f0
1−r ]vmax .
From the proof of Proposition 4 (see Appendix), we see that the
system profit is enhanced (π5S (t ∗ ) ≥ π5S (t5∗ )) by setting t = t ∗ . This
suggests that all members in the system, the merchant and the is-
suer, are likely to benefit. How much each can benefit from the
coordination depends on the bargaining power between the mer-
chant and the credit card issuer, and the effort of the merchant to
incent the consumers whose transactions are of high value.
Eq. (21) shows that when the merchant’s compensation (δ )
for the secondary verification for high-value transactions is lower
than the issuer’s handling cost of falsely declined but completed
low-value transactions, from the system perspective, the merchant
should apply secondary verification to all transactions. When δ is
too high (δ > δ̄0 ), the system is better off when the merchant does
not request the secondary verification at all.
With (14) and (21) by setting t ∗ = t5∗ , we can have the mer-
chant’s coordination mechanism in Proposition 5.
Please cite this article as: D. Wang et al., Credit card fraud detection strategies with consumer incentives, Omega (2018),
https://doi.org/10.1016/j.omega.2018.07.001
[m5G;July 20, 2018;2:29]
D. Wang et al. / Omega 000 (2018) 1–17
Proposition 5. If δ 0 < δ < δ̄0 < δ5 , the merchant can coordinate the
system by offering an interchange fee ρ ∗ to the issuer, where ρ ∗ is
given by:
cμ (1 − θ ) f1 [cr f0 + (1 − c )(1 − r )θ f1 ]
ρ∗ = , (22)
[δ − cμ (1 − θ ) f1 ][r f0 − (1 − r )θ f1 ]
v(t5∗ )
p(t5∗ )−t5∗
; γ2
where δ 0 and δ̄0 are given in Proposition 4.
Offering the interchange fee given in (22), the merchant’s mar-
gin profit becomes, α = 1 − c − ρ ∗ . For a given (1 − c ), ρ ∗ is the
optimal portion that the issuer charges to maximize the system
benefit. Proposition 5 gives the system’s coordination condition
(δ 0 < δ < δ̄0 < δ5 ). Proposition 4 shows that δ 0 and δ̄0 are lower
and upper bounds to ensure t∗ to be valid, and Proposition 3 gives
the upper bound (δ 5 ) to ensure t5∗ to be valid, for implementing
Strategy 5. The coordination conditions ensure that the optimal in-
terchange rate (ρ ∗ ) is paid by the merchant to the issuer when
both t∗ and t5∗ are valid for implementing Strategy 5. In addition,
when δ̄0 ≥ δ5 , t ∗ = t5∗ = vmax , implying that the merchant should
not use secondary verification at all from both perspectives, maxi-
mizing its own profit and maximizing the system’s profit.
We now discuss the implementation of system coordination.
From (22), we see that ρ ∗ is positive only when both the proba-
bility of the approved fraud is higher than the probability of de-
clined and incomplete legitimate transactions, and the merchant’s
compensation to the customer is higher than the issuer’s handling
cost for declined and incomplete legitimate transactions, or when
both the probability of the approved fraud is lower than the prob-
ability of the declined and incomplete legitimate transactions, and
the merchant’s compensation to the customer is lower than the is-
suer’s handling cost for declined and incomplete legitimate trans-
actions. Otherwise, to coordinate the system, the merchant should
negotiate with the issuer for a complementary agreement (ρ ∗ , β )
on how to allocate the system’s profit such that ρ ∗ can be set ac-
cording to (22) to achieve the system coordination, where β is the
(20) portion of system profit that can be allocated to the issuer. In ad-
dition, from (22), we see that ρ ∗ may be small, and in fact smaller
than the interchange rate that the merchant gives to the issuer be-
fore coordination. In such a case, the issuer is not willing to accept
this coordination contract (ρ ∗ ). If ρ ∗ set in (22) is too low to be
accepted by the bank issuer, the merchant also should negotiate
such a complementary agreement (ρ ∗ , β ) with the issuer.
(21) 7. A case study
In this section, we use real data to demonstrate the effective-
ness of the fraud detection strategies studied in this paper, es-
pecially the mixed strategies we proposed. The dataset used in
this experiment is a large and well-known dataset on credit card
fraud detection, which is available in [25]. This dataset includes
credit card transactions made in September 2013 in Europe, con-
sisting of 492 fraudulent transactions out of 284,807 transaction
records for a two-day period. The fraud rate of this dataset is
r = 0.0017. This data was acquired from a European bank, so the
fraud rate is far lower than would be expected in the US mar-
ket [6,26]. The dataset contains 30 anonymized numerical features
for each record. The only non-anonymous features are ‘Time’ and
‘Amount’. The feature ‘Time’ contains the seconds elapsed between
each transaction and the first transaction in the dataset. The fea-
ture ‘Amount’ is for each transaction value, and it ranges from $0.1
to vmax = $25, 691.16. Therefore, the average transaction value is
v̄ = $88.35 and the standard deviation is σ = $250 for this dataset.
Table 2 gives an overview of the distribution of the dataset.
From Table 2, we can see that the majority of the transactions
(89.9%) are for values under $200, suggesting that the transac-
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D. Wang et al. / Omega 000 (2018) 1–17 11

Table 2 between Strategy 5 and 2, as illustrated in Fig. 5(b) , where δ 4 and

Dataset overview.
δ 5 are given in Propositions 2 and 3, respectively. As compared to
Transaction value > $2, 0 0 0 ($1, 0 0 0, $2, 0 0 0] ($500, $1, 000] Fig. 5(a), the range of δ significantly increases. The merchant can
Percentage 0.237% 0.795% 2.178% give an incentive of up to $45 and $20 for Strategy 4 and Strat-
Transaction value ($30 0, $50 0] ($20 0, $30 0] ($0, $200] egy 5, respectively, to compensate the consumer’s inconvenience,
Percentage 3.131% 3.784% 89.875% in this dataset. The result implies that as compared to Strategy
Table 3 3, in which all transactions are requested for secondary verifica-
f0 and f1 from different ML models. tion, Strategy 4 and Strategy 5, in which the secondary verification
is only requested for high-value transactions, are easier to imple-
ML models f0 f1
ment, as they allow for reasonable incentive (δ ) for consumers. Us-
Decision tree 0.31 0.0 0 06
ing this dataset, for an incentive δ = $1 cash back for each trans-
Naïve Bayes 0.17 0.025
Logistic regression 0.45 0.0 0 03
action and a profit margin α = 50% for the merchant, if Strategy 4
Random forest 0.27 0.0 0 05 or Strategy 5 is adopted by the merchant, the optimal threshold is
Artificial neural network 0.22 0.0 0 02 t4∗ = $1, 174 (from Eq. (9)) or t5∗ = $2, 183 (from Eq. (14)). This sug-
gests that the merchant should only require secondary verification
for 2218 out of 284,807 transactions (around 1%) for Strategy 4 or
tion distribution in this dataset is significantly skewed to low-value 577 out of total transactions (around 0.2%) for Strategy 5, in this
transactions. dataset. This further implies that our proposed strategies are easy
to implement, as our strategies only request secondary verification
7.1. Machine learning prediction for a very small portion of transactions.

To illustrate the result for Strategy 2, we first run the ML detec-
tion models on the dataset to obtain the value of f0 and f1 . We
divide the dataset into two parts, a training dataset and a test-
ing dataset, each having 50% of the transactions. We train different
ML models using the training data and run the models on the test
data. The value of f0 and f1 are obtained from test results. Five pop-
ular ML models are tested, including Decision Tree, Naïve Bayes,
Logistic Regression, Random Forest, and Artificial Neural Network.
The derived predictions on f0 and f1 are summarized in Table 3.
The dataset described in Table 2 features a large amount of
transaction with very low values as compared to vmax , and the
fraud rate is very low (r = 0.17%). Since f1 reflects the ratio of false
positive declines over the total legitimate transactions, with a very
low fraud rate, f1 is very low even though the number of false de-
clined transactions is large compared to the number of detected
frauds. Even with the very low fraud rate (r) and false positive
rate (f1 ) in this dataset, we are still able to show that our pro-
posed strategies significantly improve the fraud detection perfor-
mance (Section 7.3).
7.2. Implementation of proposed strategies
In implementing secondary verification, the exact incentive (δ )
is critical to the merchant. We now discuss the range of δ for each
of Strategies 3, 4, and 5. Following the reports of [1,35], it is rea-
sonable to assume θ = 0.5 in our study. We also set ρ = 0.02 and
cμ = $5. We first show when the merchant should implement sec-
ondary verification (Strategy 3) using this data by comparing the
three basic strategies we discussed in Section 4. As an example,
we use Logistic Regression as the ML detection model. The Lo-
gistic Regression ML detection model is one of the most popular
approaches, and it performs on average among demoed models.
Fig. 5(a) gives boundaries measured by δ , as α increases; that is,
δ 13 between Strategy 3 and 1 and δ 23 between Strategy 3 and 2
(δ 13 and δ 23 are given in Proposition 1). As we see, secondary ver-
ification with incentive for all transactions is optimal only in the
shadow region under the two boundaries. This implies that the in-
centive for each transaction should be less than 7 cents. For the
given average transaction value v̄ = $88.35 in this dataset, the in-
centive for consumers may be too low to implement secondary
verification. Thus Strategy 3 (secondary verification for all transac-
tions) would be difficult for the merchant to implement for trans-
actions like those in this dataset.
Similarly, by setting t4∗ = t5∗ = 1 for Strategy 4 and Strategy 5,
we can derive the boundaries δ 4 between Strategy 4 and 1 and δ 5
7.3. ‘Win-Win-Win’ system
From Table 3, we see that the Naïve Bayes ML model has the
lowest false negative rate (f0 ) (the probability that a fraudulent
transaction will be approved) but the highest false positive rate (f1 )
(the probability that a legitimate transaction will be declined). In
contrast, Logistic Regression has the highest f0 but a relatively low
f1 . In this case study, we use these two ML models to illustrate the
improved performance in detecting fraudulent transactions using
our proposed Strategy 5. To illustrate, we first introduce a bench-
mark case, a perfect system (with a subscript B), in which f 0 = 0
and f1 = 0. We set θ = 0.5, α = 50%, cμ = $5, and c2v = 0.4. We
also use ρ = 2% for Strategy 2 and Strategy 5 (for a decentralized
system in which the system is not coordinated) in our study.
For the benchmark case, we have: the merchant’s profit πB =
$12, 559, 561, the issuer’s profit πBI = $502, 382, and the system’s
profit πBS = πB + πBI = $13, 061, 943.
7.3.1. Comparison with the Naïve Bayes ML detection model
When the merchant uses the Naïve Bayes ML detection
model for Strategy 2, we can obtain the merchant’s profit π2 =
$12, 405, 151, the issuer’s profit π2I = $479, 443, and the system’s
profit π2S = π2 + π2I = $12, 884, 594. As compared to the bench-
mark case, we have πBS − π2S = $177, 349.
For
 Strategy 5, with Lemma 5, we have δ ≤ c̄2v = c2v +
γ2 v(t5∗ )
1−r p(t5∗ )
− t5∗ . The profits of the merchant and the issuer, and
consumer’s surplus, and the system’s profit with the change of
the incentive (δ ), are summarized in Table 4, for both Strategy 5
and the coordinated system. To illustrate the effectiveness of our
proposed strategy, we focus on the system improvement by defin-
π5S −π2S π S −π S
ing the percentage increase in the system as and S 2S for
πBS −π2S πB −π2
Strategy 5 and the coordinated system, respectively. Percentage in-
crease in the system and percentage of transactions are requested
for secondary verification (% 2V) are also shown in Table 4, as δ
changes.
When the merchant uses the Naïve Bayes detection model,
based on Proposition 5, we cannot have a positive ρ ∗ . To im-
plement system coordination, the merchant should negotiate an
agreement with the issuer on (ρ , β ), such that the system can
achieve coordination.
The profits of the merchant, the issuer, and the system, and the
consumer’s surplus, with the change of the incentive (δ ), are sum-
marized in Table 4, for both Strategy 5 and the coordinated system,
when the Naïve Bayes ML detection model is adopted.

Please cite this article as: D. Wang et al., Credit card fraud detection strategies with consumer incentives, Omega (2018),
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12 D. Wang et al. / Omega 000 (2018) 1–17

Fig. 5. Incentive (δ ) boundaries.

Table 4
Benefit from optimal strategy 5 and system coordination (Naïve Bayes model).

Strategy 5 Coordination

δ t5∗ c̄2v π5 π5I π5C π5S % increase in system % 2V t∗ πS % increase in system % 2V

0.4 $65 $1.7 $12, 505, 880 $489, 289 $0 $12, 995, 169 62.3% 28.2% $53 $12, 995, 589 62.6% 32.1%
0.8 $130 $2.5 $12, 481, 856 $486, 467 $18, 143 $12, 968, 323 47.2% 16.0% $116 $12, 968, 552 47.3% 17.8%
1.2 $195 $3.3 $12, 467, 122 $484, 988 $24, 105 $12, 952, 110 38.07% 10.6% $179 $12, 952, 249 38.15% 11.6%
2 $325 $4.7 $12, 449, 414 $483, 356 $26, 172 $12, 932, 770 27.16% 5.77% $304 $12, 932, 866 27.22% 6.26%
6 $976 $10.7 $12, 420, 188 $480, 938 $17, 917 $12, 901, 126 9.32% 1.13% $930 $12, 901, 162 9.34% 1.21%
10 $1, 627 $16.6 $12, 412, 582 $480, 223 $10, 820 $12, 892, 805 4.63% 0.40% $1, 558 $12, 892, 830 4.64% 0.44%
12 $1, 952 $19.7 $12, 410, 749 $480, 032 $8, 453 $12, 890, 781 3.48% 0.26% $1, 871 $12, 890, 804 3.50% 0.29%

Table 4 shows that our proposed Strategy 5 can significantly en- δ > $2, the negative effect of the decrease in the number of trans-
hance the system’s performance when the merchant’s incentive (δ ) actions that are requested for secondary verification outweighs the
to compensate the consumer’s cost of inconvenience is not high, positive effect of the increase in δ , thus the consumer’s surplus de-
as compared to Strategy 2, in which only the Naïve Bayes ML de- creases. If the merchants strategy focuses on its relationship with
tection model is used. Notice that this performance improvement the consumer, it may be a good option for the merchant to select a
occurs when only a small portion of high-value transactions are δ that can maximize the consumer’s surplus, when it implements
requested for secondary verification by our proposed strategy with Strategy 5.
incentive system.
Table 4 also shows that as δ increases, the merchant should in-
7.3.2. Comparison with Logistic Regression ML detection model
crease the optimal threshold transaction values for both Strategy
For Strategy 2, we have the merchant’s profit π2 =
5 and the coordinated system, resulting in a significant decrease
$12, 547, 897, the issuer’s profit π2I = $502, 485, and the sys-
(with small increase in δ ), and a slight decrease (with a high δ ),
tem’s profit π2S = π2 + π2I = $13, 050, 382. As compared to the
in the profits of the merchant and issuer for Strategy 5. As a re-
benchmark case, we have πBS − π2S = $11, 561. The profits of the
sult, the effectiveness of our proposed Strategy 5 decreases as δ
merchant, the issuer, and the system, and the consumer’s surplus,
increases. The reason is that as δ increases, either t5∗ or t∗ increases
with the change of the incentive (δ ) are summarized in Table 5,
significantly, the merchant should pay an increased incentive to
for both Strategy 5 and the coordinated system, when the Logistic
consumers (in total amount) to compensate for their inconvenience
Regression ML detection model is adopted. With Proposition 5,
in using secondary verification, because more transactions are re-
we have δ̄0 = 11.6 < 11.9 = δ5 in this case study if the Logistic
quested, and this results in losses for the merchant and the issuer.
Regression model is used. We calculate and list ρ ∗ in Table 5.
For the consumers, when δ is small, although the consumer’s
Table 5 also shows that as δ increases, the merchant should in-
surplus (δ − c2v ) from the request of secondary verification for
crease the optimal threshold transaction values for both Strategy
each transaction is low, the number of transactions that are re-
5 and the coordinated system, resulting in a significant decrease
quested for secondary verification is high, the total consumer’s sur-
in the merchant’s profit and a slight increase in the issuer’s profit
plus (π5C ) increases with δ ; however, as δ continues to increase,
for Strategy 5. As a result, the effectiveness of our proposed Strat-
the effect of the decrease in the number of transactions for which
egy 5 decreases as δ increases. The reason is that as δ increases,
secondary verification is requested outweighs the effect of the
either t5∗ or t∗ also increases significantly. The merchant may pay
increase in the consumer’s surplus, and therefore the total con-
less to consumers in compensation because fewer transactions are
sumer’s surplus (π5C ) decreases.
requested for secondary verification, but the loss from the increase
Interestingly, from Table 4, we see that as δ increases, although
in frauds approved by the Logistic Regression ML detection model
the profits of the merchant and the issuer decrease, the consumer’s
significantly increases, resulting in loss for the merchant. Since the
surplus does not always increase. When δ increases slightly, the
total number of approved transactions increases, the issuer’s profit
consumer’s surplus increases quickly, until it peaks (δ = $2 in this
increases. Notice that the issuer’s profit is lower than that in Strat-
example) and then gradually decreases. The reason is that as δ
egy 2. To motivate the issuer, the merchant should negotiate with
increases, t5∗ increases, implying that secondary verification is re-
the issuer for an agreement to allocate the additional profit from
quested for fewer transactions. The positive effect of the increase
the merchant’s Strategy 5 or implement the coordination mecha-
in δ outweighs the negative effect on the consumer’s surplus of the
nism discussed in Proposition 5. The consumer’s total surplus in-
decrease in the number of transactions for which secondary verifi-
creases only when δ is small, and then decreases (as discussed in
cation is requested, therefore, the consumer’s surplus increases. As
Section 7.3.1).

Please cite this article as: D. Wang et al., Credit card fraud detection strategies with consumer incentives, Omega (2018),
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D. Wang et al. / Omega 000 (2018) 1–17 13

Table 5
Benefit from optimal strategy 5 and system coordination (Logistic Regression model).

Strategy 5 Coordination

δ t5∗ c̄2v π5 π5I π5C π5S % increase in system % 2V t∗ ρ∗ πS % increase in system % 2V

0.4 $861 $0.74 $12, 549, 221 $502, 410 $0 $13, 051, 631 10.8% 1.37% $884 0.135% $13, 051, 632 10.81% 1.33%
0.8 $1, 723 $1.32 $12, 548, 411 $502, 450 $397 $13, 050, 861 4.14% 0.35% $1, 769 0.067% $13, 050, 862 4.15% 0.33%
1.2 $2, 584 $1.85 $12, 548, 160 $502, 465 $325 $13, 050, 625 2.10% 0.14% $2, 654 0.045% $13, 050, 626 2.11% 0.13%
2 $4, 307 $2.99 $12, 547, 989 $502, 477 $148 $13, 050, 466 0.73% 0.033% $4, 425 0.027% $13, 050, 467 0.73% 0.029%
6 $12, 921 $9.95 $12, 547, 909 $502, 484 $16 $13, 050, 393 0.1% only 3 $13, 279 0.009% $13, 050, 393 0.1% only 3
10 $21, 535 $11.9 $12, 547, 899 $502, 484 $10 $13, 050, 383 0.01% only 1 $22, 133 0.005% $13, 050, 383 0.01% only 1

We also notice that the coordinated system produces only lim-
ited improvement in this case study. The intuition is that when
Strategy 5 uses the Logistic Regression ML detection model for
low-value transactions, the optimal t5∗ is very close to the optimal
t∗ , suggesting that the decentralized decision is not much different
from the centralized decision. In addition, to coordinate the sys-
tem, the merchant gives the issuer a lower interchange rate as it
gains more margin profit (α = 1 − ρ ∗ − c) for a given c. As we dis-
cussed in Section 6, the merchant should negotiate with the issuer
with a complementary agreement with (ρ ∗ , β ). Besides offering a
lower interchange rate (ρ ∗ ) to the issuer, it should also share a por-
tion of the systems profit (β ) with the issuer. The magnitude of β
depends on the bargaining power of the merchant and the issuer.
Comparing Table 5 to Table 4, we see that the enhancement
of the system’s performance using the Naïve Bayes ML detection
model is more significant than that of using the Logistic Regression
ML detection model. The reason is that as compared to the Logis-
tic Regression ML detection model, to mitigate the negative impact
of falsely declined transactions (remember that the Naïve Bayes
ML detection model has a high f1 ), the merchant (represented in
Table 4) must reduce the optimal threshold transaction values (for
t5∗ and t∗ ), leading to many more transactions being requested for
the secondary verification. As a result, the merchant must incent
consumers more in compensation. This significantly reduces the
merchant’s profit, although the total consumers’ surplus is signif-
icantly higher with Naïve Bayes than with the Logistic Regression
ML detection model for low-value transactions. Since the difference
between t5∗ and t∗ is higher when the Naïve Bayes ML detection
model is used for low-value transactions in Strategy 5, the differ-
ence between the decentralized system and coordinated system is
also larger. Therefore, the coordinated system thus has a larger per-
formance improvement.
In addition, this case study also illustrates the robustness of
threshold value (t) between the low-value transactions and the
high-value transactions for Strategy 5 if the merchant does not set
the optimal t5∗ . Here, we take the compensation δ = 0.4 = c2v as an
example. If the Naïve Bayes ML detection model is adopted, then
we have δ < δ23 = 0.45. As discussed in Lemma 2, Strategy 5 dom-
inates Strategy 2 for any t > 0 (Lemma 2). By calculation, we ob-
tain that for t = 0, π52 = $40, 683, and for t = vmax , π52 = $157.
Similarly, if the Logistic Regression ML detection model is adopted,
then δ > δ23 = 0.04, and we find that Strategy 5 dominates Strat-
egy 2 for t 5 ≤ t ≤ vmax . With Lemma 2, we can obtain t 5 = $386 <
t5∗ = $861 (see t5∗ in Table 5 for δ = 0.4). The dominating ranges
that are used in practice: no prevention (Strategy 1) and using the
ML detection model for all transactions (Strategy 2). We also dis-
cuss Strategy 3, in which secondary verification is requested for all
transactions, with an incentive for consumers. We find that three
parameters (fraud rate, consumers’ rate of abandoning legitimate
transactions that are falsely declined by an ML detection model,
and the incentive required to compensate the consumer for the in-
convenience of secondary verification) can capture the issues in-
volved in fraudulent credit card transactions. By carefully estimat-
ing three parameters from experience, or historical data, or indus-
trial reports, the merchant can easily choose a strategy.
We find that when both the fraud rate and the secondary ver-
ification compensation rate are high, none of the three strate-
gies works well, as the merchant cannot make a profit using any
of strategies. If the required compensation is sufficiently low, the
merchant should choose Strategy 3 and incentivize consumers to
accept secondary verification for all transactions. If the fraud rate is
low, the merchant should consider Strategy 1 or 2, since the ben-
efit of using secondary verification diminishes. Whether to adopt
Strategy 1 or Strategy 2 depends on the rate at which consumers
abandon transactions due to false positive declines. Strategy 1 is
better if the abandon rate is high, since by accepting all transac-
tions, it eliminates all false positive declines. Strategy 2 is better
otherwise.
In current practice in the United States, secondary verification is
rarely adopted, because it is inconvenient to consumers. In this pa-
per, we propose consumer incentive strategies to facilitate the im-
plementation of secondary verification. In particular, we introduce
two mixed strategies, in which secondary verification is applied to
high-value transactions, and either no fraud detection (Strategy 4)
or an ML detection model (Strategy 5) is used for low value trans-
actions. These mixed strategies set the optimal transaction value
thresholds by balancing the effectiveness of secondary verification
against compensation to consumers for associated inconveniences.
As compared to common strategies currently used in practice, our
proposed optimal strategy can lead to a win-win-win for the mer-
chant, the credit card issuer, and consumers, with the appropri-
ate incentive provided to consumers. The mixed strategies can be
further improved by introducing an easy-to-implement coordina-
tion mechanism between the merchant and the card issuer. This
study provides new insights to the merchant, who acts as a deci-
sion maker, and who can easily choose an optimal mixed strategy
by estimating the parameters in our models from industry experi-
ence, historical data, and other market conditions. Consumers and
 vmax −t 5
take 100% and 98.5% of the whole range of transactions
vmax
values and cover 100% and 4.7% of the whole transactions for the
Naïve Bayes and Logistic Regression ML models, respectively. The
high skewness of the dataset produces these different dominating
ranges for the two ML detection methods.
8. Conclusion
In this paper, we discuss a strategy for a merchant to prevent
fraudulent credit card transactions. We first examine two strategies
Please cite this article as: D. Wang et al., Credit card fraud detection strategies with consumer incentives, Omega (2018),
https://doi.org/10.1016/j.omega.2018.07.001
the card issuer, the two other major players in the transaction net-
work, can also benefit from the merchant’s optimal mixed strategy,
and this makes implementation practical.
We use a real dataset to conduct a case study to illustrate and
verify the major results discussed in our paper. We show that
our proposed optimal strategies only request secondary verification
for a small number of high-value transactions, while they signifi-
cantly enhance the efficiency of credit card fraud detection, and
this has important practical implications. This research shows that
our proposed optimal strategies can not only enhance the mer-
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14 D. Wang et al. / Omega 000 (2018) 1–17

chant’s profit, the issuer’s profit, and the consumer’s surplus (un- (7) w.r.t. t:
der certain conditions), but also significantly reduce the negative
∂ 2 π4 (t )  
impact of fraudulent transactions on the system. The evidence of = −(1 − α )r[g(t ) + tg (t )] + δ (1 − r )g (t ). (A5)
testing our proposed strategies using a real dataset suggests that
∂t2
these optimal strategies can perform well to resolve issues of false Substituting t4∗ into (A5):
decline of transactions using the ML detection model, or of con- ∂ π4 (t )
2
(1 − r )δ  ∗
= −(1 − α )rg(t4∗ ) − (1 − α )r g (t4 )
sumer inconvenience in requests for secondary verification. ∂t2 r (1 − α )
Our paper has a limitation that we assume a monopolistic mer- 
chant and issuer in the card transaction network. This study can + δ (1 − r )g (t4∗ ) = −(1 − α )rg(t4∗ ) < 0.
be extended to address the problem in which multiple merchants Therefore, t4∗ is proved to be the optimal threshold for Strategy 4.
)δ −α )
and card issuers compete for consumers. While card issuers cur- Since t ∈ [0, vmax ], t4∗ = r((11−r
−α )
if and only if δ ≤ δ4 = r (11−r vmax ;
rently compete on card offerings to attract consumers, it would be
otherwise, t4∗ = vmax . The optimal threshold can be summarized as
interesting to study a competition model, in which the merchants  
(1−r )δ
offer different incentives to consumers based on both the trans- t4∗ = min r (1−α )
, vmax . 
action values and the card issuers’ fraud detection accuracy, and
consumers can switch between multiple card issuers. Another lim- Proof of Lemma 1. Eqs. (7) and (2) give:
itation of our model is that we assume that fraudsters’ behavior π41 = π4 (t ) − π1 = (1 − α )rv(t ) − δ (1 − r ) p(t ). (A6)
is static, as described by an aggregate probability of fraud. A fu-
Eqs. (7) and (5) give:
ture study could consider the fraudster’s gaming behavior in the
competition model as fraudsters may constantly game the credit π43 (t ) = π4 (t ) − π3 = δ (1 − r )[1 − p(t )] − (1 − α )r[v̄ − v(t )].
card fraud detection system by dynamically changing their behav-
(A7)
iors and transaction values.
r (1−α ) ∗
For (1), When setting t = t4∗ , (A6) and δ = 1−r t4 gives:
Acknowledgment π ( ) = ( 1 − α ) r v ( ) − δ ( 1 − r ) p( )
∗
41 t4 t4∗ t4∗
 ∗ 
v(t4 )
The authors gratefully acknowledge financial support from = (1 − α )r p(t4 )∗ ∗
− t4 .
the National Natural Science Foundation of China (Grants Nos. p(t4∗ )
71331004 and 71671081) and the Natural Sciences and Engineer- Let h(t ) = v(t ) − t p(t ) and take the first order derivative to
 v
ing Research Council of Canada (Grant No. RGPIN/05008). h(t) w.r.t t, we obtain: h (t ) = −tg(t ) − t max g(v ) dv + tg(t ) =
 vmax
− t g(v ) dv < 0. Therefore, h(t) is monotonic decreasing, and
Proof of Proposition 1. With the merchant’s net profits in (1)–(5),
h(t ) ≥ h(vmax ) = 0. Therefore, π41 (t4∗ ) > 0.
we derive the first breakeven condition by setting π1 = π2 : −α ) ∗
In addition, (A7) and δ = r (11−r t4 gives:
(α − r )v̄ = {α (1 − r )[(1 − f1 ) + (1 − θ ) f1 ] − (1 − α )r f0 }v̄. (A1)
π43 (t4∗ ) = (1 − α )r[t4∗ (1 − p(t4∗ )) − (v̄ − v(t4∗ ))]
Solving (A1) w.r.t. θ and letting θ 12 be the breakeven solution,  t4∗
(1−α )r (1− f )
we have θ12 = α (1−r ) f 0 . Therefore, π 1 ≥ π 2 if θ ≥ θ 12 , otherwise = ( 1 − α )r (t4∗ − v )g(v ) dv > 0.
1 0
π 1 < π 2.
Therefore, π43 (t4∗ ) > 0.
We then derive the second breakeven condition by setting π1 =
For (2) and (3), Taking the first order derivatives of
π3 : ∂ π41 (t )
(A6) w.r.t t: ∂t = −(1 − α )rt g(t ) + δ (1 − r )g(t ) = [δ (1 − r ) −
(α − r )v̄ = (α v̄ − δ )(1 − r ). (A2) (1 − α )rt ]g(t ). We see that when δ (1 − r ) − (1 − α )rt ≤ 0, which
)δ ∂ π41 (t )
leads to t ≥ r((11−r = t4∗ , ≤ 0. Since π 41 (t) decreases with
Solving (A2) w.r.t. δ and letting δ 13 be the breakeven value, we −α ) ∂t
have δ13 = r (11−−rα )v̄ . Therefore,π 1 ≥ π 3 if δ ≥ δ 13 , otherwise π 1 < π 3 . t, π41 (t ) ≥ π41 (vmax ) = 0. Therefore, Strategy 4 dominates
Finally, we derive the third breakeven condition by setting π2 = Strategy 1 if t ≥ t4∗ .
∂ π (t )
π3 : Taking the first order derivative of (A7) w.r.t t: 43
∂t =
−(1 − α )rt g(t ) + δ (1 − r )g(t ) = [δ (1 − r ) − (1 − α )rt ]g(t ). If δ (1 −
{α (1 − r )[(1 − f1 ) + (1 − θ ) f1 ] − (1 − α )r f0 }v )δ ∂ π43 (t )
(A3) r ) − (1 − α )rt > 0, we have t < r((11−r −α )
= t4∗ and ∂t > 0. Since
= (αv − δ )(1 − r ). π 43 (t) increases with t, then π43 (t ) ≥ π43 (0 ) = 0. Therefore,
Solving (A3) w.r.t. to δ and letting δ 23 be the breakeven value, we Strategy 4 dominates Strategy 3 if t < t4∗ .
αθ (1−r ) f1 +(1−α )r f0 When δ ≥ δ 13 , Proposition 1 gives Strategy 1 dominates Strategy
have δ23 = v̄. Therefore, π 2 ≥ π 3 if δ ≥ δ 23 , other-
1−r 3, where π 1 ≥ π 3 . Therefore, Strategy 4 dominates Strategy 3 for
wise π 2 < π 3 .
any t.
Combining the profitable conditions for each strategy and the
In addition, setting π41 (t ) = 0, which leads to:
above breakeven conditions, we obtain: Strategy 1 is optimal and
profitable if θ ≥ θ 12 , δ ≥ δ 13 , and r ≤ r̄1 ; Strategy 2 is optimal and v(t )
− t4∗ = 0. (A8)
profitable if θ ≤ θ 12 , δ ≥ δ 23 , and r ≤ r̄2 ; Strategy 3 is optimal and p(t )
profitable if δ ≤ min(δ13 , δ23 , δ̄3 ). Otherwise, there is no profitable Let t4 be the solution for (A8), we can obtain π 41 (t) ≥ 0 if t 4 ≤
strategy for the merchant.  v(t ∗ )
t ≤ vmax . Since vp((tt )) increases with t, and p(t4∗ ) > t4∗ , any t satisfies
4
Proof of Proposition 2. For given π 4 (t), taking the first order v(t )
− t4∗ = 0 must be less than t4∗ . Therefore t 4 < t4∗ .
p(t )
derivatives of (6) w.r.t. t:
Similarly, when δ < δ 13 , Proposition 1 gives Strategy 3 domi-
∂π4 (t ) nates Strategy 1, where π 3 > π 1 . Therefore, Strategy 4 dominates
= −(1 − α )rt g(t ) + δ (1 − r )g(t ). (A4)
∂t Strategy 1 for any t.
∂π4 (t ) Furthermore, setting π43 (t ) = 0, which leads to:
Setting ∂ t = 0 and solving (A4) equals to 0, we obtain the only
)δ v̄ − v(t )
solution t4∗ = r((11−r
−α )
. Then, taking the second order derivatives of − t4∗ = 0. (A9)
1 − p(t )
Please cite this article as: D. Wang et al., Credit card fraud detection strategies with consumer incentives, Omega (2018),
https://doi.org/10.1016/j.omega.2018.07.001
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D. Wang et al. / Omega 000 (2018) 1–17 15

Let t̄4 be the solution for (A9). We can obtain π 43 (t) ≥ 0 if 0 ≤ Similarly, when δ < δ 23 , Proposition 1 gives Strategy 3 domi-
t ≤ t̄4 . Similarly, t̄4 > t4∗ .  nates Strategy 2, where π 3 > π 2 . Therefore, Strategy 5 dominates
Strategy 2 for any t.
Proof of Proposition 3. For given π 5 (t), taking the first order Furthermore, setting π53 (t ) = 0, which leads to:
derivative of (12) w.r.t. t:
v̄ − v(t )
∂π5 (t ) − t5∗ = 0. (A15)
= −γ2 t g(t ) + δ (1 − r )g(t ). (A10) 1 − p(t )
∂t
Let t̄5 be the solution for (A15). We can obtain π 53 (t) ≥ 0 if 0 ≤
Since g(t) > 0, solve (A10) equals to 0, we obtain the only solution
)δ t ≤ t̄5 . Similar to Lemma 1, t 5 < t5∗ < t̄5 . 
t5∗ = (1−r
γ2 . Then, taking the second order derivatives of (12) w.r.t.
t: Proof of Lemma 3. For given the net profits of the merchant (π 4
∂ 2 π5 (t )  
and π 5 ) for Strategy 4 and Strategy 5, we solve the breakeven con-
= −γ2 [g(t ) + tg (t )] + δ (1 − r )g (t ). (A11) dition by setting π45 = π4 (t4∗ ) − π5 (t5∗ ) = 0:
∂t2
Substituting t5∗ into (A11): π45 = (α − r )v + (1 − α )rv(t4∗ ) − δ (1 − r ) p(t4∗ )
(A16)
∂ 2 π5 (t ) ( 1 − r )δ  ∗ −γ1 v + γ2 v(t5∗ ) − δ (1 − r ) p(t5∗ ).

= −γ2 g(t5∗ ) − γ2 g (t5 ) + δ (1 − r )g (t5∗ )
∂t2 γ2 Reorganizing (A16), we have:
= −γ2 g(t5∗ ) < 0. π45 = [αθ (1 − r ) f1 − (1 − α )r (1 − f0 )][v̄ − v(t5∗ )]
Therefore, t5∗ is proved to be the optimal threshold for Strategy +(1 − α )r[v(t4∗ ) − v(t5∗ )] + δ (1 − r )[ p(t5∗ ) − p(t4∗ )]. (A17)
)δ γ
5. Since t ∈ [0, vmax ], t5∗ = (1−r
γ2 if and only if δ ≤ δ5 = 1−r
2
vmax ; (1−α )r (1− f0 )
The only solution for π45 = 0 is when θ = θ12 = α (1−r ) f1 .
otherwise, t5∗ = vmax . The optimal threshold can be summarized as
  Since when θ = θ12 and = t4∗ t5∗ ,
all three terms in (A17) are equal
)δ
t5∗ = min (1−r
γ2 , vmax .  to 0. Therefore, the breakeven condition for Strategy 4 and 5 is
equivalent to the breakeven condition for Strategy 1 and 2.
Proof of Lemma 2. Eqs. (12) and (4) give: To discuss the profitability condition for Strategy 4, we set:
π52 = π5 (t ) − π2 = γ2 v(t ) − δ (1 − r ) p(t ). (A12) π4 (t ) = (α − r )v̄ + (1 − α )rv(t ) − δ (1 − r ) p(t ) = 0. (A18)
Eqs. (12) and (5) give: Let r̄4 be the breakeven value. Solving (A18), we obtain: r = r̄4 =
α v̄−δ p(t )
π53 (t ) = π5 (t ) − π3 = δ (1 − r )[1 − p(t )] − γ2 [v̄ − v(t )]. (A13) v̄−(1−α )v(t )−δ p(t ) . To ensure r̄4 ≥ 0, α v̄ − δ p(t ) must be nonnegative,
γ2 ∗ thus δ ≤ pα(tv̄) . The numerator can be rewritten as v̄ − (1 − α )v̄ −
For (1), When setting t = t5∗ , (A12) and δ = 1−r t5 gives:
  δ p(t ) ≤ v̄ − (1 − α )v(t ) − δ p(t ), thus r̄4 is guaranteed smaller than
v(t5∗ )
π52 (t5∗ ) = γ2 p(t5∗ ) p(t5∗ )
− t5∗ > 0 (see the proof for Lemma 1). 1. Therefore, π 4 (t) ≥ 0 if and only if r ≤ r̄4 . Further comparing r̄4
(1−α )[α v̄−δ p(t )]
γ2 ∗ and r̄1 , we have r̄4 − r̄1 = v̄− (1−α )v(t )−δ p(t ) ≥ 0.
(A13) and δ = 1−r t5 gives:
Similarly, to discuss the profitability condition for Strategy 5, we
π53 (t5∗ ) = γ2 [t5∗ (1 − p(t5∗ )) − (v̄ − v(t5∗ ))] set:
 t5∗
= γ2 (t5∗ − v )g(v ) dv > 0. π5 (t ) = γ1 v̄ + γ2 v(t ) − δ (1 − r ) p(t ) = 0. (A19)
0
Let r̄5 be the breakeven value. Solving (A19), we obtain:
For (2) and (3), Taking the first order derivatives of (A12) w.r.t
∂ π52 (t ) α (1 − θ f1 )v̄ + αθ f1 v(t ) − δ p(t )
t: ∂t = −γ2 t g(t ) + δ (1 − r )g(t ) = [δ (1 − r ) − γ2 t ]g(t ). r = r̄5 =
[α (1 − θ f1 ) + (1 − α ) f0 ]v̄ + [αθ f1 − (1 − α ) f0 ]v(t ) − δ p(t )
.
We see that when δ (1 − r ) − γ2 t ≤ 0, which leads to
Similar to the proof for r̄4 , r̄5 is also guaranteed smaller than 1.
Therefore, π 5 (t) ≥ 0 if and only if r ≤ r̄5 . In addition,

(1 − α ) f0 [α v̄ − δ p(t )]
r̄5 − r̄2 = ≥ 0.
[α (1 − θ f1 ) + (1 − α ) f0 ]{[α (1 − θ f1 ) + (1 − α ) f0 ]v̄ + [αθ f1 − (1 − α ) f0 ]v(t ) − δ p(t )}

)δ ∗ ∂ π52 (t ) ≤ 0. 
t ≥ (1−r
γ2 = t5 , ∂t Since π 52 (t) decreases with t,
π52 (t ) ≥ π52 (vmax ) = 0. Therefore, Strategy 5 dominates Proof of Lemma 4. For given the issuer’s profit (π2I and π5I (t )), if
Strategy 2 if t ≥ t5∗ . the merchant chooses Strategy 2 and Strategy 5, we have:
∂ π (t )
Taking the first order derivative of (A13) w.r.t t: 53
∂t = π5I (t5∗ ) − π2I = ρ [(1 − r )θ f1 − r f0 ]v(t5∗ )
−γ2 t g(t ) + δ (1 − r )g(t ) = [δ (1 − r ) − γ2 t ]g(t ). If δ (1 − r ) − γ2 t > 0, (A20)
)δ ∂ π53 (t ) +cμ (1 − r )(1 − θ ) f1 p(t5∗ ).
we have t < (1−r ∗
γ2 = t5 and ∂t > 0. Since π 53 (t) increases
with t, then π53 (t ) ≥ π53 (0 ) = 0. Therefore, Strategy 5 domi- Let θ̄ be the breakeven value. Solving (A20) = 0 with respect to θ ,
nates Strategy 3 if t < t5∗ . ρ r f0 v(t5∗ )−(1−r )cμ f1 p(t5∗ )
we obtain θ̄ = . Then we have π5I (t5∗ ) − π2I ≥ 0
When δ ≥ δ 23 , Proposition 1 gives Strategy 2 dominates Strategy (1−r )[ρv(t5∗ )−cμ p(t5∗ )] f1
3, where π 2 ≥ π 3 . Therefore, Strategy 5 dominates Strategy 3 for if and only if θ ≥ θ̄ . 
any t.
Proof of Lemma 5. Let δ = c2v +  be the consumers’ incentive,
In addition, setting π52 (t ) = 0, which leads to:
where  ≥ 0 indicating the extra incentive. Therefore, the total ex-
v(t ) tra incentive is  (1 − r ) p(t5∗ ) for Strategy 5. In order to keep a non-
− t5∗ = 0. (A14)
p(t ) negative profit for the merchant who switches from Strategy 2 to
Strategy 5, we have:
Let t5 be the solution for (A14), we can obtain π 52 (t) ≥ 0 if t 5 ≤
t ≤ vmax . π52 −  (1 − r ) p(t5∗ ) ≥ 0. (A21)

Please cite this article as: D. Wang et al., Credit card fraud detection strategies with consumer incentives, Omega (2018),
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