An incumbent firm operates in a local computer market, which is a natural monopo

Question

An incumbent firm operates in a local computer market, which is a natural monopoly. That is, there is room for only one firm to sell profitably in this market. Market demand for the good is estimated to be Q^D = 100-P. Another firm would like to enter this market, but only if the incumbent firm has a higher unit cost than it does. Specifically, there is a 25 percent chance that the incumbent is a low cost firm, with a unit cost equal to 20, and there is a 75 percent chance that the incumbent is a high-cost firm with a unit cost of 30. The entrant's unit cost is 25. The entrant knows its cost but not that of the incumbent. The incumbent does know its unit cost. Market demand is common knowledge to both firms. The entrant, however, does get to observe the current or pre-entry market price at which the incumbent sells its good. If the entrant decides to enter the market it incurs a set-up cost of $1,000. Does the high-cost firm have an incentive to set a low price in order to masquerade as a low-cost firm?

Explanation / Answer

In this case of monopoly , the incumbent firm will use the strategy of limit pricing.  The incumbent will exploit its superior knowledge of the market, and production costs, for its own advantage. Limit pricing means the incumbent firm will set a low price and a high output, so that the entrant cannot make a profit at entrant's low set price. This is best achieved by selling at a price just below the average total costs (ATC) of the potential entrant. This signals to potential entrant that profits are impossible to make. The high cost firm will have an advantage of setting a low price and masquerade as a low cost firm so that it can capture the maximum share of the market demand.

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