Hale’s One Stop and Auto Service competes with Murray’s Gas Mart. The

Hale’s One Stop and Auto Service competes with Murray’s Gas Mart. The local demand is: Qd = 25 – 10P  P = 2.50 – 0.1 Qd. Both firms sell exactly the same quality of gasoline.

Thus, if the firms charge a different price, the lower price firm will capture the entire market share. If the firms charge the same price, they will split the market share. The marginal cost functions are both constant at $1.25. If the firms compete by setting price, what is the market output level? What is the market price level?

ANSWER

If the firms compete by setting price, the equilibrium price will be $1.25 per unit. The market output level will be 12.5 units. If both firms attempt to price above $1.25, the firm with the lower price will enjoy the entire market share and earn an economic profit while the higher pricing firm sells no units of output. The higher price firm will have an incentive to undercut the price of the other firm. This behavior will continue until both firms charge $1.25. If the firms offer a price below $1.25, they will lose money and exit the industry or raise prices. Thus, equilibrium occurs where both firms charge $1.25 per unit.