I. Now let's go back to the case where all firms have the same cost function. In class we saw the Cournot competition model for two firms. Now, we are going to get you through the Cournot model with three firms. Assume that demand for a good is given by P = a - bQ^d , and that there are 3 firms competing in quantity with a constant marginal cost c < a.

Write down the maximization problem of a representative firm in the market. Solve for the reaction function of this firm: how the optimal quantity produced depends on the quantity produced by the other two firms in the market.

To verify that you have found the correct reaction function, compute the optimal q₁ if q₂ = 40, q₃ =60, a = 4, b = 0.01, and c =2. (note that this is not necessarily and equilibrium.)

q₁ =

II. In the three-firm case, what will be the equilibrium price and the total quantity produced in the market?

To Verify that you have found the correct equilibrium, compute p and Q if a = 4, b = 0.01 and c = 2.

P =

Q =

III. How does this equilibrium compare to the perfectly competitive case?

oCournot competition results in an efficiency gain relative to perfect competition

oCournot competition results in an efficiency loss relative to perfect competition

IV. Intuitively, what will happen in this market when the number of firms goes to ?

oThe market converges to perfect competition

oNone of the above

oEfficiency losses become arbitrarily large

oCournot competition will become the more realistic model

oPrice will approach zero