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 point where it is earning $850,000 annually for the indefinite future.If the interest 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 point where it is earning $850,000 annually for the indefinite future.If the interest 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

To determine if it makes sense for the incumbent to limit price to prevent entry, we need to compare the present value of profits in the two scenarios: with entry and without entry.

If the incumbent does not limit price and a new entrant successfully enters, the incumbent's profits would decrease from $1 million to $750,000 annually. Using a discount rate of 5%, the present value of these profits is:

PV = ($750,000/0.05) = $15 million

If the incumbent limits price and keeps the new entrant out, they will earn $850,000 annually indefinitely. The present value of these profits is:

PV = ($850,000/0.05) = $17 million

Therefore, it makes sense for the incumbent to limit price to prevent entry as the present value of profits is higher compared to the scenario with entry. The correct answer is B.

Consider an Incumbent That Is a Monopoly Currently Earning $1