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 costs of service differ across consumer groups. Cost-based differential pricing is shown to increase total welfare and consumer welfare relative to uniform pricing for broad classes of demand functions, even though total output can still fall or the output allocation between consumers can worsen. We discuss why cost-based differential pricing tends to be more beneficial for consumers than its demandbased counterpart, third-degree price discrimination, and provide suffi cient conditions for welfare-improving differential pricing when both costs and demands differ across consumer groups.