Consider an incumbent that is a monopoly currently earning $2 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 $1.2 million annually.To keep potential entrants out of the market,the incumbent lowers its price to the point where it is earning $1.6 million annually for the indefinite future.If the interest rate is 10 percent,does it make sense for the incumbent to limit price to prevent entry?
A) No, since $4 million $400,000.
B) Yes, since $4 million $400,000.
C) No, since $2 million $200,000.
D) Yes, since $2 million $200,000.

Question

Consider an incumbent that is a monopoly currently earning $2 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 $1.2 million annually.To keep potential entrants out of the market,the incumbent lowers its price to the point where it is earning $1.6 million annually for the indefinite future.If the interest rate is 10 percent,does it make sense for the incumbent to limit price to prevent entry?
A) No, since $4 million > $400,000.
B) Yes, since $4 million > $400,000.
C) No, since $2 million > $200,000.
D) Yes, since $2 million > $200,000.

Quizplus · Accepted Answer

By limiting the price and earning $1.6 million annually, the incumbent is sacrificing $400,000 ($2 million - $1.6 million) in profits. However, if a new entrant were to enter the market and reduce the incumbent's profits to $1.2 million annually, the incumbent would lose $800,000 ($2 million - $1.2 million) in profits. Using a discount rate of 10 percent, the present value of sacrificing $400,000 annually indefinitely is $4 million ($400,000 / 0.10), which is greater than the present value of losing $800,000 annually indefinitely, which is $8 million ($800,000 / 0.10). Therefore, it makes sense for the incumbent to limit its price to prevent entry.

Consider an Incumbent That Is a Monopoly Currently Earning $2