A monopolist earns $80 million annually and will maintain that level of profit i

Question

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? Multiple Choice Yes, it will earn $225 million in present value if it does this. Yes, it will earn $270 million in present value if it does this No, it will earn $225 million in present value if it does this. No, it will earn $270 million in present value if it does this.

Explanation / Answer

Note that with limit pricing the monopoly earns 45/0.2 = 225 million. With no limit pricing, it earns 80 + 35/0.2 = 255 million. Since with limiting price, its profits are reduced in present value it should not use limit pricing.

Third option is correct (No it should not as profits are 225 million if it does)

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