Answer :
Final answer:
Yes, it makes sense for the incumbent to limit pricing to prevent entry. By lowering the price to 850k annually, the incumbent reduces the potential profits for any new entrant and maintains a higher net present value of future profits.
Explanation:
In this scenario, the incumbent is considering limiting pricing to prevent entry by potential competitors. By lowering its price to 850k annually, the incumbent aims to make the market less attractive for new firms. This strategy, known as limit pricing, is a common tactic used by monopolies to deter entry.
Limit pricing involves setting prices below the monopolist's profit-maximizing level. In this case, the incumbent's profit-maximizing level is $1 million annually. However, by lowering the price to 850k, the incumbent reduces its profits but also reduces the potential profits for any new entrant.
To assess whether it makes sense for the incumbent to limit pricing, we need to consider the potential outcomes. If the incumbent does not limit pricing and a new entrant successfully enters the market, the incumbent's profits would decrease to 750k annually. On the other hand, if the incumbent limits pricing and prevents entry, it would continue to earn 850k annually.
To determine the profitability of these scenarios, we need to consider the present value of future profits. The interest rate of 5% is crucial in this analysis. By discounting future profits, we can compare the net present value of each scenario.
If we calculate the net present value of the incumbent's profits under both scenarios, we find that limiting pricing results in a higher net present value. This means that, from a financial perspective, it makes sense for the incumbent to limit pricing to prevent entry.
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