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Two firms compete in a homogeneous product market where the inverse demand function is P = 20 - 5 Q (quantity is measured in millions). Firm 1 has been in business for one year, while firm 2 just recently entered the market. Each firm has a legal obligation to pay one year rent of $2 million regardless of its production decision. Firm 1 marginal cost is $2, and firm 2 marginal cost is $10. The current market price is $15 and was set optimally last year when firm 1 was the only firm in the market. At present, each firm has a 50 percent share of the market.
a. Why do you think firm 1 marginal cost is lower than firm 2 marginal costs?
b. Determine the current profits of the two firms.
c. What would happen to each firm current profit if firm 1 reduced its price to $10 while firm 2 continued to charge $15?
d. Suppose that, by cutting its price to $10, firm 1 is able to drive firm 2 completely out of the market. After firm 2 exits the market, does firm 1 have an incentive to raise its price?
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