Assume a linear market demand curve and a concave average cost curve for the fol

Question

Assume a linear market demand curve and a concave average cost curve for the following questions: (a) Show how an incumbent can keep an entrant out of the market by threatening to produce a large quantity. (b) Why might this behavior be irrational if an incumbent actually faces an entrant? (c) Explain how the purchase of additional capacity (even if it is never used) can make the previous behavior rational. What is meant by additional capacity in practice? It is about regulation of economics, just need to assume the graph of (a) (b) (c) and little explain

Explanation / Answer

a. One way in which the incumbent can deter entry by other participants is to produce a higher quantity at a lower price than the monopoly level, a strategy known as limit pricing. This would reduce the profits being made, making it less attractive for entrants, and this will also mean that the incumbent is meeting more of the market demand, leaving any potential entrant with a much smaller space in the market. This is called limit pricing and will only be an optimal strategy if the smaller profits made by the firm are still greater than those risked if a rival entered the market.

b. This would be an irrational behavior as for any firm the engaging in this kind of behavior, the profits would reduce as more quantity would be produced at a lower price.

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