Question

Firm X is the only firm in its industry. Currently, Firm X charges $75 per unit, a price well in excess of its marginal cost of $5 per unit, and earns $70 million per year in profit. According to a trusted source, the manager of Firm X learned that a new firm is contemplating entering the market. This would reduce its profit to $40 million per year. If Firm X expanded its output and lowered its price to $50, the entrant would find it unprofitable to enter the market, and Firm X would earn profits of $50 million per year for the indefinite future. Explain and show your work:

a. What pricing strategy is the manager of Firm X considering?

b. If Firm X was able to credibly commit to maintain a price of $50, would it be a profitable strategy? Explain.

Answer 1

Firm X is the only firm in its industry. Currently, Firm X charges $75 per unit, a price well in excess of its marginal cost of $5 per unit, and earns $70 million per year in profit. According to a trusted source, the manager of Firm X learned that a new firm is contemplating entering the market. This would reduce its profit to $40 million per year. If Firm X expanded its output and lowered its price to $50, the entrant would find it unprofitable to enter the market, and Firm X would earn profits of $50 million per year for the indefinite future.

a. From the above discussions we can see that the manager of firm X is considering a limit pricing strategy. A limit price (or limit pricing) is a price, or pricing strategy, where products are sold by a supplier at a price low enough to make it unprofitable for other players to enter the market. It can be clearly seen that in the above case the manager of firm X is trying to do the same thing.

b. If Firm X was able to credibly commit to maintain a price of $50, it will definitely be a profitable strategy because in this case the firm can earn a profit of $50 million per year.

But if the firm x keeps the price high, than the new firm will enter the market and hence the price will come down to $40 and hence the firm X can earn only $40 million of profit per year. So it will lead to $10 million per year less profit.