Suppose an industry consists of two competitors that compete in prices. Firm 1 makes and sells product 1, firm 2 makes and sells product 2. The demand for each product

is as follows:

q1 = 25 5p1 + 2p2

q2 = 25 5p1 + 2p1

The cost functions are C(qi) = 2 + qi for i = 1, 2.

Are the goods produced by firms 1 and 2 homogenous or differentiated? Explain.

Find the best response functions for firms 1 and 2.

How does the price Firm 1 would want to set change with the price of Firm 2?

Explain economic intuition.

What is the Lerner index (price minus marginal cost relative to the price) for

products 1 and 2? Do the firms have market power? Why doesn't the "Bertrand

paradox" of no market power apply in this case?