Quality differences, third-degree price discrimination, and welfare

We propose a theoretical model to analyze the welfare implications of price discrimination in the presence of differences in quality. The model considers two markets where in each market competition takes place between a local firm that operates in that market only and a global firm that operates in both markets. All firms are assumed to be producing with zero marginal costs. Local firms produce a good that is perceived by consumers to have superior quality than that produced by the global firm. We find that there are parameter values such that welfare increases while total output decreases if the global firm engages in price discrimination. This is due to a positive allocation effect brought about precisely by the global firm engaging in price discrimination