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Suppose the airline industry consisted of only two firms: American and Texas Air Corp. Let the two firms have identical cost functions, C(q) = 40q. Assume that the demand curve for the industry is given by P = 100- Q and that each firm expects the other to behave as a Cournot competitor.
a. Calculate the Cournot-Nash equilibrium for each firm, assuming that each chooses the output level that maximizes its profits when taking its rival"s output as given. What are the profits of each firm?
b. What would be the equilibrium quantity if Texas Air had constant marginal and average costs of $25 and American had constant marginal and average costs of $40?
c. Assuming that both firms have the original cost function, C(q) = 40q, how much should Texas Air be willing to invest to lower its marginal cost from 40 to 25, assuming that American will not follow suit? How much should American be willing to spend to reduce its marginal cost to 25, assuming that Texas Air will have marginal costs of 25 regardless of American"s actions?
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