Question

A monopolist makes $20 million a year and will keep this profit level given that no other firm enters the market. However, the entry of another firm will reduce the monopolist’s profits to $10 million a year. The interest rate is 5 percent and profits are realized at the beginning of each period.

2.1 Assume that another firm enters the market, what is the present value of the monopolist’s current and future profits?

2.2 Assume that by using limiting pricing the monopolist makes $12 million indefinitely. Should the monopoly adopt this strategy?

Answer 1

a) Present value of current and future profits = Profit received now (current period) + Profit in later periods / rate of

interest

= 20 million + 10 million / 5 percent

= 20 million + 200 million

= 220 million

b) Limit pricing is profitable when

(Profit from limit pricing - profit from duopoly) / rate of interest > Monopoly profit - Profit from limit pricing

(12 - 10) / 5% > 20 - 12

40 million > 8 million

Since the inequality is true, limit pricing should be accepted.