Beyond price discrimination: welfare under differential pricing when costs also differ

We extend the analysis of monopoly third-degree price discrimination to the empirically important case where marginal costs also differ between markets. Differential pricing then reallocates output to the lower-cost markets, hence welfare can increase even if total output does not, unlike under pure price discrimination. To induce output reallocation the firm varies its prices but---again, unlike under pure price discrimination---with no upward bias in the average price. Due to this price dispersion, differential pricing motivated solely by cost differences will increase consumer surplus (and total welfare) for a broad class of demand functions. We also provide sufficient conditions for beneficial differential pricing in the hybrid case where both demand elasticities and marginal costs differ.