Differential Pricing When Costs Differ: A Welfare Analysis

This paper analyzes the welfare effects of monopoly differential pricing in the important but largely neglected case where marginal costs of service differ across consumer groups. Compared to uniform pricing, cost-based differential pricing generally raises total welfare. Although total output may fall or even its allocation across consumer groups may worsen, under a minor demand curvature condition at least one of these changes must be beneficial and dominate if the other is not. Aggregate consumer welfare also rises (under a mildly tighter condition). The source of consumer gains is not cost savings from output reallocation, which flow to the firm. Rather, to induce output reallocation the firm must vary its prices, thereby creating price dispersion without an upward bias in the average price. This improves consumer welfare even in cases where output falls. We contrast these results with those in the extensive literature on third-degree price discrimination and, furthermore, provide sufficient conditions for beneficial differential pricing when both demand elasticities and costs differ.