CHAPTER 13

Oligopoly and Monopolistic Competition

MULTIPLE CHOICE Choose the one alternative that best completes the statement or answers the question. 1) Perfect competition and monopolistic competition are similar in that both market structures include A) price-taking behavior by firms. B) a homogeneous product. C) no barriers to entry. D) very few firms. Answer: C Diff: 1 Topic: Market Structures 2) Perfect competition and monopolistic competition are similar in that firms in both types of market structure will A) act as price takers. B) produce a level of output where price equals marginal cost. C) earn zero profit in the long run. D) act as price setters. Answer: C Diff: 1 Topic: Market Structures 3) Oligopoly differs from monopolistic competition in that an oligopoly includes A) product differentiation. B) barriers to entry. C) no barriers to entry. D) downward-sloping demand curves facing the firm. Answer: B Diff: 1 Topic: Market Structures 4) Regardless of market structure, all firms A) consider the actions of rivals. B) maximize profit by setting marginal revenue equal to marginal cost. C) produce a differentiated product. D) have the ability to set price. Answer: B Diff: 1

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Topic: Market Structures Figure 13.1

5) Figure 13.1 shows a payoff matrix for two firms, A and B, that must choose between a highprice strategy and a low-price strategy. For firm B, A) setting a high price is the dominant strategy. B) setting a low price is the dominant strategy. C) there is no dominant strategy. D) doing the opposite of firm A is always the best strategy. Answer: B Diff: 1 Topic: Game Theory 6) Figure 13.1 shows a payoff matrix for two firms, A and B, that must choose between a highprice strategy and a low-price strategy. The Nash equilibrium in this game A) does not exist. B) occurs when both firms set a low price. C) occurs when both firms set a high price. D) occurs when firm A sets a high price and firm B sets a low price. Answer: B Diff: 1 Topic: Game Theory

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7) Figure 13.1 shows a payoff matrix for two firms, A and B, that must choose between a highprice strategy and a low-price strategy. Both firms setting a high price is not a Nash equilibrium because A) setting a high price is the dominant strategy for each firm. B) neither firm can improve its payoff by setting a low price given that the other firm is setting a high price. C) there is no dominant strategy for either firm. D) both firms can improve their payoff by setting a low price given that the other firm is setting a high price. Answer: D Diff: 1 Topic: Game Theory Figure 13.2

8) Figure 13.2 shows a payoff matrix for two firms, A and B, that must choose between selling basic computers or advanced computers. Firm B's dominant strategy A) is to make basic computers. B) is to make advanced computers. C) is to adopt firm A's strategy. D) does not exist in this game. Answer: D Diff: 2 Topic: Game Theory

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9) Figure 13.2 shows a payoff matrix for two firms, A and B, that must choose between selling basic computers or advanced computers. How many Nash equilibria are there? A) 0 B) 1 C) 2 D) 4 Answer: C Diff: 2 Topic: Game Theory 10) Figure 13.2 shows a payoff matrix for two firms, A and B, that must choose between selling basic computers or advanced computers. Which of the following is a Nash equilibrium? A) Both firms make advanced computers. B) Both firms make basic computers. C) Firm A makes basic computers and firm B makes advanced computers. D) There are no Nash equilibria. Answer: C Diff: 2 Topic: Game Theory 11) In a non-cooperative, imperfect information, simultaneous-choice, one-period game, a Nash equilibrium A) will never exist. B) will always include dominant strategies. C) will always result in both players taking the same action. D) may not maximize the sum of the firms' profits. Answer: D Diff: 1 Topic: Game Theory 12) The term prisoners' dilemma refers to a game in which A) there are no Nash equilibria. B) there are no dominant strategies. C) the payoff from playing the dominant strategy is the same for each player. D) the payoff from playing the dominant strategy is not the highest payoff possible. Answer: D Diff: 1 Topic: Game Theory

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13) Collusion is more likely to occur when A) there is fear of punishment for not colluding. B) there is a known finite time horizon. C) there are large gains to be made by cheating on an agreement. D) the game lasts only one period. Answer: A Diff: 1 Topic: Game Theory Figure 13.3

14) Figure 13.3 shows the payoff matrix for two firms, A and B, selecting an advertising budget. The firms must choose between a high advertising budget and a low advertising budget. Firm A's dominant strategy A) does not exist. B) is to do the opposite of firm B. C) is to select a high advertising budget. D) is to select a low advertising budget. Answer: A Diff: 2 Topic: Game Theory 15) Figure 13.3 shows the payoff matrix for two firms, A and B, selecting an advertising budget. The firms must choose between a high advertising budget and a low advertising budget. Firm B's dominant strategy A) does not exist. B) is to copy firm A. C) is to select a high advertising budget. D) is to select a low advertising budget. Answer: C Diff: 2 Topic: Game Theory

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16) Figure 13.3 shows the payoff matrix for two firms, A and B, selecting an advertising budget. The firms must choose between a high advertising budget and a low advertising budget. A Nash equilibrium is that A) firm A selects a high advertising budget and firm B selects a low advertising budget. B) firm A selects a low advertising budget and firm B selects a high advertising budget. C) both firms select a high advertising budget. D) both firms select a low advertising budget. Answer: C Diff: 2 Topic: Game Theory 17) Figure 13.3 shows the payoff matrix for two firms, A and B, selecting an advertising budget. The firms must choose between a high advertising budget and a low advertising budget. A Nash equilibrium A) occurs when both firms select a high advertising budget. B) exists at any of the four possible strategy combinations because there is never an incentive to change strategy. C) is for both firms to choose the low advertising budget because this yields the highest joint profit. D) does not exist because firm A does not have a dominant strategy. Answer: A Diff: 2 Topic: Game Theory 18) A cartel is a group of firms that attempts to A) maximize joint revenue. B) maximize joint profit. C) behave independently. D) increase consumer surplus. Answer: B Diff: 1 Topic: Cooperative Oligopoly Models 19) If a cartel is unable to monitor its members and punish those firms that violate the agreement, then A) the member firms will each act as price setters. B) the cartel will prosper in the long run. C) the market will become a monopoly. D) the cartel will fail. Answer: D Diff: 1 Topic: Cooperative Oligopoly Models

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20) In a sense, a cartel is self-destructive because A) it reduces consumer surplus. B) it sets price above marginal cost. C) each cartel member has the incentive to cheat on the cartel. D) each cartel member earns economic profit. Answer: C Diff: 1 Topic: Cooperative Oligopoly Models 21) Which of the following conditions can help prolong the life of a cartel? A) There are only a few firms in the market and they all belong to the cartel. B) There are many firms in the market that are not members of the cartel. C) It is difficult to know what price any cartel member is actually charging. D) The cartel has no ability to punish members who cheat on the cartel. Answer: A Diff: 1 Topic: Cooperative Oligopoly Models

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Figure 13.4

22) Figure 13.4 shows the reaction functions for two pizza shops in a small isolated town. The Cournot equilibrium is at point A) a. B) b. C) c. D) d. Answer: B Diff: 1 Topic: Cournot Model 23) Figure 13.4 shows the reaction functions for two pizza shops in a small isolated town. Collusion would result in A) each firm producing 25 pizzas. B) each firm producing 40 pizzas. C) each firm producing 50 pizzas. D) firm A monopolizing the market by selling 50 pizzas. Answer: C Diff: 1 Topic: Cournot Model

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24) Figure 13.4 shows the reaction functions for two pizza shops in a small isolated town. The perfect competitive outcome is that A) each firm produces 40 pizzas. B) each firm produces 50 pizzas. C) each firm produces 100 pizzas. D) each firm produces 200 pizzas. Answer: C Diff: 1 Topic: Cournot Model 25) Figure 13.4 shows the reaction functions for two pizza shops in a small isolated town. Firm B producing 100 pizzas and firm A producing 50 pizzas is not a Cournot equilibrium because A) Cournot duopolists agree to share the market equally. B) firm B is not on its best-response function. C) firm A is not on its best-response function. D) neither firm is on its best-response function. Answer: B Diff: 2 Topic: Cournot Model 26) Suppose two Cournot duopolist firms operate at zero marginal cost. The market demand is p = a - bQ. Firm 1's best-response function is A) q1 = (a - bq2)/2b. B) q1 = (a - 2bq2)/2b. C) q1 = a /b. D) q1 = a /2b. Answer: A Diff: 1 Topic: Cournot Model 27) Suppose two Cournot duopolist firms operate at zero marginal cost. The market demand is p = a - bQ. Each firm will produce A) a/b. B) a/2b. C) a/3b. D) a/4b. Answer: C Diff: 1 Topic: Cournot Model

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28) In the Cournot model, a firm maximizes profit by selecting A) its output, assuming that other firms keep their output constant. B) its price, assuming that other firms keep their price constant. C) its output, assuming that other firms will retaliate. D) its price, assuming that other firms will retaliate. Answer: A Diff: 0 Topic: Cournot Model 29) In the Cournot model, the output that a firm chooses to produce increases as A) the total output of other firms increases. B) the number of firms in the market increases. C) the number of firms in the market decreases. D) its marginal cost increases. Answer: C Diff: 1 Topic: Cournot Model 30) Suppose a market with a Cournot structure has five firms and a market price elasticity of demand equal to -2. What is a Cournot firm's Lerner Index? A) .1 B) .2 C) .5 D) 1 Answer: A Diff: 1 Topic: Cournot Model 31) The Stackelberg model is more appropriate than the Cournot model in situations where A) there are more than two firms. B) all firms enter the market simultaneously. C) one firm makes its output decision before the other. D) firms will be likely to collude. Answer: C Diff: 1 Topic: Stackelberg Model

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32) The outcome of the Stackelberg model is A) a Nash equilibrium. B) the same as the Cournot outcome. C) that the follower earns zero profit. D) that the follower cannot be on its best-response curve. Answer: A Diff: 1 Topic: Stackelberg Model 33) Which of the following is a necessary condition for government subsidies to influence a firm to choose an output level as if it were a Stackelberg leader? A) The subsidy must be announced before the firms choose output levels. B) The subsidy must be equal to the firm's marginal cost. C) The subsidy must be equal to the firm's rival's marginal cost. D) The firm does not have any fixed costs. Answer: A Diff: 1 Topic: Stackelberg Model

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Figure 13.4

34) Figure 13.4 shows the reaction functions for two pizza shops in a small isolated down. The Stackelberg leader will produce A) 25 pizzas. B) 50 pizzas. C) 66.7 pizzas. D) 100 pizzas. Answer: D Diff: 1 Topic: Stackelberg Model 35) Suppose two duopolists operate at zero marginal cost. The market demand is p = a - bQ. If firm 1 is the Stackelberg leader, what level of output will it choose? A) q1 = (a - bq2)/2b B) q1 = (a - 2bq2)/2b C) q1 = a /b D) q1 = a /2b Answer: D Diff: 2 Topic: Cournot Model

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36) Which of the following models results in the highest level of output assuming a fixed number of firms with identical costs and a given demand curve? A) Cournot B) Stackelberg C) Monopoly D) Cartel Answer: B Diff: 1 Topic: Comparison of Models 37) Which of the following market models results in the highest price assuming a fixed number of firms with identical costs and a given demand curve? A) Cournot B) Stackelberg C) Monopoly D) Price is the same in all three markets. Answer: C Diff: 1 Topic: Comparison of Models 38) Which of the following market models results in the highest level of consumer surplus assuming a fixed number of firms with identical costs and a given demand curve? A) Cournot B) Stackelberg C) Monopoly D) Cartel Answer: B Diff: 1 Topic: Comparison of Models 39) Which of the following models results in the greatest deadweight loss assuming a fixed number of firms with identical costs and a given demand curve? A) Cournot B) Stackelberg C) Monopoly D) Perfect competition Answer: C Diff: 1 Topic: Comparison of Models

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40) Which of the following models results in the greatest total profit, assuming a fixed number of firms with identical costs and a given demand curve? A) Cournot B) Stackelberg C) Monopoly D) Perfect competition Answer: C Diff: 1 Topic: Comparison of Models 41) In the long run, a monopolistically competitive firm A) earns zero economic profit. B) produces at minimum average cost. C) operates at full capacity. D) All of the above. Answer: A Diff: 1 Topic: Monopolistic Competition 42) Monopolistically competitive firms A) have market power because they can set price above marginal cost. B) have no market power because they earn zero economic profit. C) have no market power because of free entry. D) have no market power because price equals marginal cost. Answer: A Diff: 1 Topic: Monopolistic Competition 43) Minimum efficient scale refers to the lowest level of output at which A) the firm can earn a profit. B) average cost is minimized. C) the firm will operate. D) the average cost curve is downward sloping. Answer: B Diff: 1 Topic: Monopolistic Competition

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44) The number of firms in a monopolistically competitive market will be smaller if A) the market demand curve shifts rightward. B) minimum efficient scale is lower. C) fixed costs are smaller. D) fixed costs are larger. Answer: D Diff: 1 Topic: Monopolistic Competition 45) The Bertrand model is a more plausible model of firm behavior than the Cournot model A) when firms set the quantity to be sold. B) when firms sell a differentiated product. C) because firms that sell a non-differentiated product typically act as price takers. D) because the Bertrand model predicts that firms will price at marginal cost. Answer: B Diff: 1 Topic: Price Setting 46) The Bertrand model of price setting assumes that a firm chooses its price A) independently of what price other firms charge. B) subject to what price rival firms are charging. C) so that joint profits are maximized. D) without considering the shape of the demand curve. Answer: B Diff: 1 Topic: Price Setting 47) Assuming a homogeneous product, the Bertrand duopoly equilibrium price is A) the same as the Cournot equilibrium price. B) less than the Cournot equilibrium price. C) greater than the Cournot equilibrium price. D) equal to the monopoly price. Answer: B Diff: 1 Topic: Price Setting

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48) Assuming a homogeneous product, the Bertrand equilibrium price is A) independent of the number of firms. B) independent of the firms' marginal cost. C) equal to the Cournot equilibrium price. D) equal to the monopoly price. Answer: A Diff: 1 Topic: Price Setting 49) One criticism of the Bertrand pricing model is that A) the model is implausible when there is product differentiation. B) when there is an oligopoly with no product differentiation, the model's prediction is inconsistent with reality. C) the model's predicted price is solely a function of demand conditions. D) the model's predicted price is dependent on the number of firms. Answer: B Diff: 2 Topic: Price Setting 50) In a Bertrand model, graphically, the intersection of all firms' best-response curves determines A) the Nash equilibrium prices. B) the dominant strategy for each firm. C) the degree of product differentiation. D) the price of the market leader. Answer: A Diff: 1 Topic: Price Setting 51) In a Bertrand model, if one firm has a dominant strategy, its best-response function A) does not exist. B) is identical to its rival. C) is a constant. D) is to respond to its rival's price increase with a price decrease. Answer: C Diff: 2 Topic: Price Setting

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52) In a Bertrand model, market power is a function of A) marginal cost. B) the number of firms. C) price elasticity of demand. D) product differentiation. Answer: D Diff: 2 Topic: Price Setting 53) In a Bertrand model with identical firms and a non-differentiated product, price will increase in response to A) an increase in the number of firms. B) a decrease in the number of firms. C) an increase in marginal cost. D) a decrease in marginal cost. Answer: C Diff: 2 Topic: Price Setting 54) In a Bertrand model with differentiated products, A) firms can set price above marginal cost. B) firms set price at marginal cost. C) price is independent of marginal cost. D) firms set price independently of one another. Answer: A Diff: 2 Topic: Price Setting 55) Product differentiation allows a firm to charge a higher price because the residual demand curve facing the firm A) is more elastic than the residual demand curve without product differentiation. B) is less elastic than the residual demand curve without product differentiation. C) is horizontal. D) shifts to the left. Answer: B Diff: 1 Topic: Price Setting TRUE/FALSE/EXPLAIN QUESTIONS 1) In comparing monopolistic competition to perfect competition, one can conclude that the lack of free entry is the key to having the ability to set price.

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Answer: False. Free entry is the key to driving long-run profit to zero. The key to pricesetting ability is the downward-sloping demand curve. This can result from having few firms, but is mainly due to product differentiation. Diff: 1 Topic: Market Structures 2) If neither firm has a dominant strategy, a Nash equilibrium cannot exist. Answer: False. Even if a firm has no strategy that dominates all others, it may still have a strategy that is the best-given what the other firm is doing. When this is true for both firms for the same strategy pair, a Nash equilibrium exists. Diff: 1 Topic: Game Theory 3) Cartels are inherently self-destructive because each member firm has the incentive to cheat on the cartel agreement. Answer: True. Unless the cartel can establish mechanisms to detect and punish cheaters, the agreement will fail. Diff: 1 Topic: Cooperative Oligopoly Models 4) The Cournot model assumes that firm A maximizes its profit, holding firm B's output constant. Answer: True. Even though firm B does react to changes in firm A's output, firm A assumes that firm B does not react but instead holds its output constant. Diff: 1 Topic: Cournot Model 5) If two firms behave as Cournot duopolists, the level of social welfare is lower than that of a cartel. Answer: False. The Cournot duopolists produce more at a lower price than a cartel. Thus, social welfare is lower with a cartel. Diff: 1 Topic: Comparison of Models PROBLEMS 1) Explain why a monopoly and a perfectly competitive firm do not consider a rival firm's behavior, but an oligopoly and a monopolistically competitive firm do.

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Answer: A monopoly has no rivals. The market price tells a competitive firm everything it needs to know. An oligopoly or a monopolistically competitive firm's strategy will depend on the behavior of its rivals. Diff:1 Topic: Market Structure 2) Why is collusion more likely in a repeated game? Answer: First, a firm can signal other firms that it wishes to cooperate in one period, which could lead to collusion in subsequent periods. Second, a firm can punish a firm for not restricting output. The threat of punishment makes collusion more likely. Diff: 1 Topic: Game Theory Figure 13.2

3) Figure 13.2 shows the payoff for two firms, A and B, that must each choose to produce either an advanced computer or a basic computer. Determine the dominant strategies for each firm (if any) and the Nash equilibria (if any). Answer: Neither firm has a dominant strategy. Each firm is better off doing the opposite of its rival. There are two Nash equilibria. Either firm A makes the basic computer and firm B makes the advanced, or firm A makes the advanced computer and firm B makes the basic. Diff: 2 Topic: Game Theory 4) Suppose that market demand can be represented as p = 100 - 2Q. There are 10 identical firms producing an undifferentiated product, each with the total cost function TC = 50 + q2. Compare the competitive outcome with the cartel outcome. What is the individual firm's incentive to cheat on the cartel? Answer: Each firm has MC = 2q, so that market supply is Q = 5p or joint MC = Q/5. As a cartel, they set joint MR = joint MC yielding 100 - 4Q = Q/5 or 100 = 4.2Q. Q = 23.8, and each firm will produce 2.38 units. The cartel price is 100 - 2(23.8) = $52.38. Each firm has the incentive to cheat because its marginal cost is $4.76 and the market price is $52.38. As a
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competitive market, supply equals demand. p = 100 - 2(5p) or 11p = 100. Price equals $9.09 and output equals 45.45 units. Diff: 1 Topic: Cooperative Oligopoly Models 5) Suppose the demand for pizza in a small isolated town is p = 10 - Q. There are only two firms, A and B, and each has a cost function TC = 2 + q. Determine the Cournot equilibrium. Answer: Firm A's profit is = [10 - (qA+ qB)] qA- 2 - qA. Maximizing with respect to its own output yields qA= 4.5 - qB/2. Similarly, firm B's best response is qB= 4.5 - qA/2. The equilibrium occurs when both firms produce 3 units. Price is 10 - 3 - 3 = 4. Diff: 1 Topic: Cournot Model 6) Explain why the intersection of the best-response functions is the Cournot equilibrium. Answer: On a best-response function, a firm selects the profit-maximizing level of output given the level of output it believes the other firm will produce. At the intersection of the best-response functions, what one firm believes the other firm will produce actually is the amount the other firm produces. Thus, neither firm has an incentive to change the level of output. Diff: 1 Topic: Cournot Model 7) Assuming Cournot behavior, what happens to the market output, the price of the output, and each firm's output as the number of firms in a market increases? Answer: As the number of firms increases, price declines, and each firm produces less, but total market output increases. Diff: 1 Topic: Cournot Model

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Figure 13.5

8) Draw a graph that shows the effect on the equilibrium quantities if the government subsidizes one firm in a Cournot duopoly. Assume that the best-response functions are linear. Explain the new equilibrium quantities. Answer: See Figure 13.5. The subsidized firm, B, produces more output and the nonsubsidized firm, A, produces less. The subsidized firm faces a lower after-subsidy marginal cost, so the profit-maximizing level of output will be higher for every level of output the nonsubsidized firm produces. Diff: 1 Topic: Cournot Model 9) Suppose the demand for pizza in a small isolated town is p = 10 - Q. There are only two firms, A and B. Each has a cost function TC = 2 + Q. Determine the equilibrium quantities of each if firm A is the Stackelberg leader. Answer: Firm B's profit is = [10 - (qA+ qB)] qB- 2 - qB. Maximizing with respect to its own output yields firm B's best response qB= 4.5 - qA/2. Knowing this, firm A substitutes this into demand and maximizes its profit. = [10 - qA- (4.5 - qA/2)] qA - 2 - qA. Maximizing with respect to qA yields qA = 4.5. Firm B responds by producing 2.25. Diff: 2 Topic: Stackelberg Model 10) Suppose the demand for pizza in a small isolated town is p = 10 - Q. The only two firms, A and B, behave as Cournot duopolists. Each has a cost function TC = 2 + Q. If the government wants to subsidize firm A to raise its output to that of a Stackelberg leader, how large should the subsidy be? Answer: Firm B's profit is = [10 - (qA+ qB)] qB- 2 - qB. Maximizing with respect to its own output yields firm B's best response qB= 4.5 - qA/2. Knowing this, firm A substitutes this into demand and maximizes its profit. = [10 - qA- (4.5 - qA/2)] qA - 2 - qA. Maximizing with respect to qA yields qA = 4.5. Firm B responds by producing 2.25. The subsidy (S) must make
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firm A choose 4.5 units while acting as a Cournot firm. Firm A's reaction function as a Cournot firm is qA= [10 - 1 + S - qB]/2. Setting qA = 4.5 and qB = 2.25 yields a subsidy of 2.25 per unit. Diff: 2 Topic: Stackelberg Model 11) What happens in a duopoly if both firms try to act as the Stackelberg leader? Answer: If both firms think they are the leader, they will maximize profits subject to the other firm's response function. Each firm will produce twice what the other firm thinks it is producing. As a result, output and price are driven to the competitive equilibrium. Diff: 1 Topic: Stackelberg Model 12) Suppose the demand for pizza in a small isolated town is p = 10 - Q. There are only two firms, A and B, and each has a cost function TC = 2 + Q. Compare the firms' profits if they behave as Cournot duopolists with their profits if they form a cartel and share the market. Answer: First, the Cournot equilibrium. Firm A's profit is = [10 - (qA+ qB)] qA- 2 - qA. Maximizing with respect to its own output yields qA= 4.5 - qB/2. Similarly, firm B's best response is qB= 4.5 - qA/2. The equilibrium occurs when both firms produce 3 units. Price is 10 - 3 - 3 = 4. Total revenue is 12 and total cost is 5. Profit is 7 for each firm. As a cartel, maximize joint profit by setting marginal revenue equal to their joint marginal cost, or 10 2Q = 1. Q = 4.5, so each firm produces 2.25 units. Price is 5.5. Total revenue is 12.375; total cost is 4.25. Each firm earns a profit of 8.125. Diff: 2 Topic: Comparison of Models

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Figure 13.4

13) Figure 13.4 shows the reaction functions for two pizza shops in a small isolated town. Compare the Cournot, Stackelberg, cartel, and competitive equilibria in terms of total output and welfare. Answer: If both firms are competitive price takers, they both produce 100 units, for a total of 200 units. As a cartel, they jointly produce a total of 100 units. If they behave as Cournot firms, they each produce 66.67 units, for a total of 133.33 units. If one firm is a Stackelberg leader, it produces 100 units and the follower produces 50 units, for a total of 150. In terms of output, and therefore social welfare, the structures are ranked as competitive, Stackelberg, Cournot, cartel. Diff: 2 Topic: Comparison of Models 14) Is it true that in the long run, a monopolistically competitive firm has market power but earns no profit? Explain. Answer: As strange as it sounds, yes. The firm earns zero profit because p = AC. The firm has market power because p > MC. One way to explain this is that the firm has market power to set price, but has no power to prevent entry. Diff: 2 Topic: Monopolistic Competition 15) Suppose the demand for Pepsi is qp = 54 - 2pp + 1p. The demand for Coke is qc= 54 - 2pc + 1pp. Each firm faces a constant marginal cost of $2. Determine the Bertrand equilibrium prices. What happens to the Bertrand equilibrium prices and profits if increased differentiation causes the demand for Pepsi to become qp = 104 - 2pp + 1pc while the demand for Coke remains unchanged?

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Answer: For Pepsi, profit maximization means / pp= 54 - 4pp + pc= 0. For Coke, profit maximization means / pc= 54 - 4pc + pp= 0. Both firms are at equilibrium setting a price of 18. If Pepsi's demand curve shifts, profit maximization for them implies / pp= 104 - 4pp + pc= 0. Both firms are now at equilibrium when Pepsi charges 31.33 and Coke charges 21.33. Diff: 2 Topic: Price Setting 16) Suppose the demand for Pepsi is qp= 50 - 2pp + 1pc. The firm faces a constant marginal cost of m, and pc denotes the price of Coke. Assuming Bertrand behavior, derive Pepsi's bestresponse function and explain how the firm changes price in response to changes in its own marginal cost and changes in Coke's price. Answer: For Pepsi, profit maximization means / pp= 50 + 2m - 4pp + pc= 0. Solving for pp yields Pepsi's best-response function: pp = 12.5 + (1/2)m + (1/4)pc. A $1 increase in marginal cost yields a $0.50 increase in price. A $1 increase in Coke's price yields a $0.25 increase in price. Diff: 2 Topic: Price Setting 17) In a Bertrand duopoly with product differentiation, explain how a change in one firm's marginal cost can have an effect on the price charged by the other firm. Answer: Each firm's price is a function of the other firm's price. If one incurs an increase in marginal cost, it raises its price. This, in turn, causes the other firm to raise its price. Diff: 1 Topic: Price Setting

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