A monopolist earns $80 million annually and will maintain that level of profit indefinitely,provided no other firm enters the market.If another firm successfully enters the market,the incumbent's profits remain at $80 million the first period,but fall to $35 million annually thereafter.The opportunity cost of funds is 20 percent,and profits in each period are realized at the beginning of each period.If the monopolist can earn $45 million indefinitely by limit pricing,should it do so?
A) Yes, it will earn $225 million in present value if it does this.
B) Yes, it will earn $270 million in present value if it does this.
C) No, it will earn $225 million in present value if it does this.
D) No, it will earn $270 million in present value if it does this.

Question

Quizplus · Accepted Answer

If the monopolist chooses to limit price, it will earn $45 million annually, which is $35 million less than its current profits. However, this strategy will prevent entry and allow the monopolist to maintain its profits indefinitely. The present value (PV) of $80 million per year for perpetuity at a discount rate of 20% is:

PV1 = $80 million / 0.2 = $400 million

The first-year profits with limit pricing would be $45 million, and subsequent years will also be $45 million, resulting in a PV calculation as follows:

PV2 = $45 million + ($45 million / 1.2) + ($45 million / 1.2^2) + ... = $270 million

Therefore, the best choice is B, which states that the monopolist will earn $270 million in present value by choosing to limit pricing.

A Monopolist Earns $80 Million Annually and Will Maintain That