In: Economics
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 = 500 -0.001Q, and Barnacle’s cost function is
given by C(Q) = 300Q. 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 $5
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 6 percent,
Marge is considering a limit-pricing strategy.
Instructions: Enter your responses to the nearest
penny (two decimal places).
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?
$ __________________
Solution:
Given
Barnacle has earned more than $160 million over the past decade
P = 500 -0.001Q
C(Q) = 300Q.
Barnacle's profits be if Marge convinces the government to eliminate the subsidy is:
calculation:
Barnacle's product is given by P = 500 -0.001Q
As marginal revenue curve will have twice the slope of the demand curve thus
MR = 500 -0.002Q
Barnacle's cost function is given by C(Q) = 300Q. Thus, the slope of TC = 300, hence MC equals 300
Setting MR = MC
500 -0.002Q = 300
200 = 0.002Q
Q = 1,00,000
Substituting the profit-maximizing quantity into the inverse demand function to determine the price:
P = 500 - 0.001Q = 500 - 0.001 * 100,000 = 400
Profit = Total revenue - Total cost = (400 * 1,00,000) - (300 * 100,000) = 10,000,000
Hence
Barnacle's profits = 10,000,000 - 8,000,000
= 2,000,000
profit of a new entrant if the subsidy is eliminated and Barnacle continues to produce the monopoly level of output is:
calculation:
The (inverse) residual demand curve for entrants would be 400 - 0.001Q
400 -0.002Q = 300
100 / 0.002 = Q
Q = 50,000
P = 400 - 0.001Q = 400 - 0.001 * 50,000 = 350
Profit = Total revenue - Total cost = (350-300) * 50,000 = 2,500,000
Barnacle's profits = 2,500,000 - 8,000,000
= -5,500,000