Consider the case of two gas stations that are located at two ends of a small town. The population is uniformly distributed from these two gas stations. The cost of traveling from one gas station to the other is 50 cents. The gas stations can buy a gallon of gasoline in the wholesale market at $1.25 per gallon.

a. How does firm 1 set prices given the price p2 of the other firm? That is, what is the reaction function of firm 1.

b. What prices will the firms set in equilibrium?