Question

Barnacle Industries was awarded a patent over 15 years ago for a unique industrial strength cleaner that removes barnacles and other particles from the hulls of ships. Thanks to its monopoly position, Barnacle has earned more than $160 million over the past decade. Its customers—spanning the gamut from cruise lines to freighters—use the product because it reduces their fuel bills. The annual (inverse) demand function for Barnacle’s product is given by P = 320 -0.0005Q, and Barnacle’s cost function is given by C(Q) = 180Q. Thanks to subsidies stemming from an energy bill passed by Congress nearly two decades ago, Barnacle does not have any fixed costs: The federal government essentially pays for the plant and capital equipment required to make this energy-saving product. Absent this subsidy, Barnacle’s fixed costs would be about $6 million annually. Knowing that the company’s patent will soon expire, Marge, Barnacle’s manager, is concerned that entrants will qualify for the subsidy, enter the market, and produce a perfect substitute at an identical cost. With interest rates at 4 percent, Marge is considering a limit-pricing strategy. What would Barnacle's profits be if Marge pursues a limit-pricing strategy if the subsidy is in place? What would Barnacle's profits be if Marge convinces the government to eliminate the subsidy? What would be the profit of a new entrant if the subsidy is eliminated and Barnacle continues to produce the monopoly level of output?

Answer 1

First, note that the monopoly price is P = $385.00, the monopoly output is Q =700,000, and monopoly profits are $24,500,000.00. (To see this, note that MR = 420 -0.0001Q and MC = $350, so setting MR = MC and solving yields these results).

Second, notice that with the subsidy the firm’s average cost curve is constant at $350 per unit. Thus, to prevent entry via limit pricing, Barnacle would have to price its product at $350. Doing so would yield zero profits.

Answer B:- A better strategy for Barnacle is to lobby to eliminate the $8 million in subsidies while committing to produce its current (monopoly) level of output. This would reduce Barnacle’s profits to $16,500,000.00 per year.

Answer C:- However, the (inverse) residual demand curve for entrants would be P = 385.00 -0.00005Q after Barnacle commits to the monopoly output. Solving MR = MC yields the entrant producing 350,000, a market price of $367.50, and profits for the entrant of $-1,875,000.00, making it unprofitable for an entrant to enter the market.