Consider an incumbent that successfully links the pre-entry price and post-entry profit to prevent entry.The incumbent's monopoly profit is $10 million.If a rival successfully enters the market,the incumbent's profits will fall to $4 million.If the incumbent lowers output to 25,000 units,its rival will stay out of the market,resulting in an infinite stream of profits of $8 million annually.Due to a recent loan default,the current interest rate is whopping 210 percent.Is limit pricing profitable for the incumbent?
A) Yes, since $19.05 million is greater than $2 million.
B) No, since $1.905 million is less than $2 million.
C) No since $4 million is less than $4.2 million.
D) Linking the pre-entry price to the post-entry profit is sufficient to guarantee the profitability of limit pricing.

Question

Quizplus · Accepted Answer

Limit pricing is not profitable for the incumbent because the present value of the infinite stream of profits at the high interest rate is less than the profit from a single year without entry. At a 210% interest rate, the present value of $8 million annually is calculated using the formula PV = P / i, where P is the annual profit and i is the interest rate. Thus, PV = $8 million / 2.1 = $3.81 million. Since the incumbent's monopoly profit without entry is $10 million, even a single year's profit without entry is significantly higher than the present value of the reduced profits under limit pricing.

Consider an Incumbent That Successfully Links the Pre-Entry Price and Post-Entry