Consider an industry with a small number of firms with market power. Suppose the

Question

Consider an industry with a small number of firms with market power. Suppose they sell identical products and have identical cost of production. If each firm posts a price without knowing the prices posted by its rivals, and it is impossible for them to collude, then

A. Firms will charge prices equal (or almost equal) to the marginal cost of production.
B. Firms will make zero (or close to zero) economic profits.
C. Firms will have incentives to invest in product differentiation.
D. All of the above.

Explanation / Answer

C. Firms will have incentives to invest in product differentiation. Product differentiation and lowering costs are the only ways to gain a competitive advantage over other firms. In this case, they all have the same costs so they can only benefit by product differentiation. Further, the other choices are false.

Here's why the others are false:
a. These firms have market power, they can set their own prices. The only reason they would do this is if another firm had higher costs than they did and they wanted to eliminate the competition (in this case they all have the same costs of production). Even if the firms do not know the prices posted by their rivals, the will still price above their MC because of product differentiation.
b. This is false because a is false.

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