Firm 1 and firm 2 sell a similar but differentiated product, charging market price p1 and p2

, respectively. Suppose fixed costs are equal to zero and each firm has the same constant marginal cost

c, so that in equilibrium, each firm charges the Nash equilibrium price given by:

where a

(b) is the location of firm 1’s (2’s) product, 0

< a < b < 1. Suppose firm 1 changes its location and moves closer to firm b (i.e. a increases).

(a) Will firm 2 respond by increasing or decreasing its price? Does the change in firm 1’s location result in increased or softened price competition?

(b) Suppose instead that Nash equilibrium prices were given by:

where 0<1

– a – b < 1. Would an increase in a result in an increase or softening of price competition? Would firm 2’s response be more or less aggressive than in Exercise 4(a)?