A monopolist earns $40 million annually and will maintain that level of profit indefinitely, provided that no other firm enters the market. However, if another firm enters the market, the monopolist will earn $40 million in the current period and $10 million annually thereafter. The opportunity cost of funds is 20 percent, and profits in each period are realized at the beginning of each period.
a. What is the present value of the monopolist’s current and future earnings if entry occurs?
b. If the monopolist can earn $8 million indefinitely by limit pricing, should it do so? Explain.