Scenario: Two firms, Firm 1 and Firm 2, make differentiated products and compete in a duopoly market. The firms do not have a fixed cost. Firm 1's cost is $30 per unit, while Firm 2's cost is $25 per unit. (So they are the marginal cost and the average total cost). There are 1,000 consumers in this market. The demand is divided between the two firm in the following way:
• If Firm 1's price is less than twice Firm 2's price, then everyone buys from Firm 1.
• If Firm 1's price is more than twice Firm 2's price, then everyone buys from Firm 2.
• If Firm 1's price is equal to twice Firm 2's price, then half of the consumers buy from Firm 1 and the other half buy from Firm 2.
-Refer to the scenario above.Suppose Firm 2 sets the price at $25.What price should Firm 1 set in response?

Question

Quizplus · Accepted Answer

If Firm 2 sets the price at $25, then according to the demand conditions, everyone will buy from Firm 2 if Firm 1 sets the price higher than $50. 
If Firm 1 sets the price between $25 and $50, then half of the consumers will buy from Firm 1 and half from Firm 2. 
However, if Firm 1 sets the price below $25, then everyone will buy from Firm 1 which is the most profitable outcome for Firm 1. 
Therefore, Firm 1 should set the price at $25 to capture half of the market or set it lower than $25 to capture the entire market. 
The best choice for Firm 1 is to set the price at $25 to maximize its profits.

Scenario: Two Firms, Firm 1 and Firm 2, Make Differentiated