Consider an incumbent that is a monopoly currently earning $1 million annually.Given the declining costs of raw materials, the incumbent believes a new firm may enter the market.If successful, a new entrant would reduce the incumbent's profits to $750,000 annually.To keep potential entrants out of the market, the incumbent lowers its price to the out where it is earning $850,000 annually for the indefinite future.If the interested rate is 5 percent, does it make sense for the incumbent to limit price to prevent entry?
A)No, since $2 million $250,000.
B)Yes, since $2 million $250,000.
C)No, since $5 million $100,000.
D)Yes, since $250,000 $5 million.

Question

Consider an incumbent that is a monopoly currently earning $1 million annually.Given the declining costs of raw materials, the incumbent believes a new firm may enter the market.If successful, a new entrant would reduce the incumbent's profits to $750,000 annually.To keep potential entrants out of the market, the incumbent lowers its price to the out where it is earning $850,000 annually for the indefinite future.If the interested rate is 5 percent, does it make sense for the incumbent to limit price to prevent entry?
A)No, since $2 million > $250,000.
B)Yes, since $2 million > $250,000.
C)No, since $5 million > $100,000.
D)Yes, since $250,000 > $5 million.

Quizplus · Accepted Answer

If the incumbent does not limit the price, the new entrant will enter the market and the incumbent's profits will decrease from $1 million to $750,000 annually. The present value of $750,000 annually forever, discounted at a 5% interest rate, is $15 million (PV = Annual Profit / Interest Rate = $750,000 / 0.05). However, if the incumbent limits the price and earns $850,000 annually forever, its present value is $17 million (PV = Annual Profit / Interest Rate = $850,000 / 0.05). Therefore, by limiting the price, the incumbent is better off by $2 million ($17 million - $15 million).

Consider an Incumbent That Is a Monopoly Currently Earning $1