The standard model of monopolistic imperfect quality discrimination involving consumer self-selection has shown that no distortion occurs at the highest quality level, while all lower quality levels are degraded in order to maintain profitable market segmentation. This result flows from the assumption that consumers with a higher total utility of quality also have a higher marginal utility of quality. The paper develops a reasonable model in which the standard assumption is not satisfied, and this alternative model yields vastly different conclusions regarding the form of quality distortion. In particular, quality may be enhanced, not degraded, to maintain profitable market segmentation.

The standard result of the monopoly imperfect quality discriminating model--no distortion at the highest quality level, while lower quality levels are degraded--flows from the assumption that consumers with a higher total utility of quality also have a higher marginal utility of quality. We develop a reasonable model in which the standard assumption is violated. This alternative model yields vastly different results. Specifically, quality may be enhanced, not degraded, to maintain profitable market segmentation.

Advances in Routing Technologies and Internet Peering Agreements by Stanley Besen, Paul Milgrom, Bridger Mitchell and Padmanabhan Srinagesh. Published in volume 91, issue 2, pages 292-296 of American Economic Review, May 2001