Problem.

Two identical firms produce an identical product, and they are the only firms in this market. Their total annual costs are given by TC1 = 300+15q1 and TC2 = 200+25q2, where q1 is the output of firm 1, and q2 is the output of firm 2.

Price is determined by the following industry demand curve: P = 110 - Q where Q = q1 + q2.

Each firm decides how much to produce taking as given the output decision of the other

a) Which type of competition do the two firms engage in? [A quantitative answer is not needed.]

b) Derive the reaction function for each firm.

c) Find the equilibrium quantities and the price. Calculate the profit of each firm in equilibrium.

d) It turns out that the land on which firm 2 has been built is legally owned by Donald T. He offers to rent the land to firm 2 for 500 per year. That is, this cost would occur in addition to all previously mentioned costs of firm 2. How would this be represented in firm 2's total cost function?

e) A court rules that firm 2 has to pay the rent for this year regardless whether or not it produces. Will firm 2 still produce this year? If so, what is the optimal quantity produced? f) The court also rules that starting next year, the firm would not have to pay the rent if it declared bankruptcy. Thus, 'next year' can be considered the long run, when no fixed costs occur if the firm goes out of business [this includes all fixed costs, not only the rent]. Will the firm produce next year or instead shut down?

g) Suppose that we are in the second year now and firm 2 exits the market, so that firm 1 is the only producer. Calculate its optimal output Q1*, the new market price, and profits.

h) Compare consumer surplus under the scenario with two firms (c.) and only firm 1 (g.). Did Donald T. do consumers a favor by demanding high land rental payments and pushing firm 2 out of business? Explain.