Information goods and vertical differentiation

Second-degree price discrimination, that is, vertical differentiation, is w idely practiced by firms selling physical goods to consumers with heterogen eous valuations. This strategy leads to market segmentation and has been sh own to be optimal by many researchers. On the other hand, researchers have also demonstrated, under certain restrictive conditions, that vertical diff erentiation may not be optimal for information goods. We analyze vertical d ifferentiation for a monopolist, continuing the practice of modeling consum er valuation as a linear function of product quality and consumer type but generalizing assumptions about marginal costs and consumer distributions. W e show that the firm's optimal product line depends on the benefit-to-cost ratio of qualities in the choice vector. We find that a vertical differenti ation strategy is not optimal when the highest quality product has the best benefit-to-cost ratio. Many information goods satisfy this property.