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PRICING WITH MARKET POWER IV. Overview Importance & significance of transfer pricing in vertically integrated M-form of firms Transfer pricing with no.

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Presentation on theme: "PRICING WITH MARKET POWER IV. Overview Importance & significance of transfer pricing in vertically integrated M-form of firms Transfer pricing with no."— Presentation transcript:

1 PRICING WITH MARKET POWER IV

2 Overview Importance & significance of transfer pricing in vertically integrated M-form of firms Transfer pricing with no outside market (Fig 1) Transfer pricing with a competitive outside market –Buying (Fig 2) –Selling (Fig 3) Transfer pricing with a non-competitive outside market –Buying (monopsonist: Fig 5 not given in text) –Selling (monopolist: Fig 4) To do numerical example in class, if time permits

3 Importance & Significance of Transfer Pricing Transfer price = Price for inter-divisional transaction in a multi-divisional company, which is a major determinant of the overall financial performance of the company Unless the right transfer price is chosen, the company shall end up having less than maximum profit (can be shown with a simple diagram) Assuming a competitive external market exists for sale/purchase of the intermediate good, choice of any transfer price other than the competitive outside price shall lead to lower profit (can be shown with a simple diagram)

4 Fig 1: Transfer Pricing When There is No Outside Market Quantity (MR – MC A ) MC E AR MC A MR Q A = Q E PEPE PAPA NMR E MC A is the marginal cost of assembling cars given the engines. Since one car requires one engine, the marginal product of engines is 1. Therefore the curve (MR – MC A ) is the net marginal revenue curve NMR E for engines. The transfer price P E correctly values the engines used to produce the cars. The same result is obtained if we take intersection point between MR and MC. MC

5 Fig 2: Buying Engines in a Competitive Outside Market Quantity (MR – MC A ) MC E AR MC A MR Q E,2 = Q E P E,M PAPA NMR E Since the outside market is competitive, the marginal cost of the intermediate good equals the market price of the good, which is the optimal transfer price P E,M. The downstream division uses Q E,2 engines for its cars, but buys only Q E,1 engines from the upstream division and the rest from the open market. If the firm makes all its engines, then MC E will exceed the market price, increasing the engine divisions profits but lowering the total profit of the firm. The same result is obtained if we take intersection point between MR and MC (after adjusting for horizontal MC* E ) Q: Whatll happen if external competitive market is ignored? MC* E Q E,1 MC Sub-optimum Solution at

6 Fig 3: Selling Engines in a Competitive Outside Market MC E AR MC A MR Q E,2 = Q A P E,M PAPA NMR E MC* E Q E,1 Quantity (MR – MC A ) Although engine division produces Q E,1 engines, only Q E,2 engines are used by the car division, the rest being sold at the price P E,M. Some engines are sold in the market because they will earn higher net revenue than if they were used to manufacture cars. Q: What if external competitive market ignored? MC Sub- optimum solution

7 Fig 4: Monopoly Supply of Engines to the Outside Market MC E AR MC A MR Q E,2 = Q A PAPA NMR E Q E,1 (MR – MC A ) NMR E AR E,M MR E,M P E,M P* E Q E,3 The total net marginal revenue curve NMR E is the sum of MR E,M and (MR – MC A ). Optimal transfer price is P* E and the no. of engines is Q E,1. Q E,2 engines are used to make cars (the quantity at which car divisions MR – MC A is equal to the transfer price P* E ) The remaining Q E,3 engines are sold in the outside market at the price P E,M. Case similar to that of a discriminating monopolist. Quantity

8 Fig 5: Monopsony Purchase of Engines from the Outside Market MC E AR MC A MR Q E,2 = Q A PAPA NMR E Q E,1 NMR E AR E,M MR E,M Q E,3 MC E Transfer price (marked green) is above the open market price (in red), because with monopsony power, purchasing additional engine from outside market involves a marginal expenditure MC E greater than the average price of procurement MC E MR-MC A

9 Numerical Example Demand for automobiles: P = 20,000 – Q MR for automobiles: MR = 20,000 – 2Q Down-streams assembling cost: C A (Q) = 8000Q => MC A = 8000 Up-streams cost of production of engines: C E (Q E ) = 2Q E 2 => MC E (Q E ) = 4Q E Because of 1-1 correspondence: Q E = Q

10 Numerical Example: Case 1 – No outside market NMR E = MR – MC A = 20,000 – 2Q – 8,000 = 12,000 – Q E NMR E = MC E => 12, Q E = 4Q E => Q E = 2000 P E = MC E = 4Q E = $8,000

11 Numerical Example: Case 2 – Outside competitive market for engines Let P E,M = 6000 Buying some engines from outside => NMR E = 6000 => 12, Q E = Q E = 6000 => Q E = 3000 Company produces more cars & buys some engines at lower price, given lower cost of engines in outside market Up-stream production: MC E = 6000 => 4Q E =6000 => Q E = 1500 => Rest 1500 are bought from market

12 Numerical Example: Case 3 – Outside non-competitive market for engines Given P E,M = 10,000 – Q E => MR E,M = 10, Q E => Draw this line, noting that MR E,M = 10,000 when Q E = 0; Q E = 5000, when MR E,M = 0 Draw NMR E = 12,000 – 2Q E, noting that NMR E = 12,000 when Q E = 0; Q E = 6,000 when NMR E = 0 Hence, NMR E,total = MR E,M + NMR E for Q E > 10,000, when equated to MC E = 4Q E gives 11,000 - Q E = 4Q E => Q E = 2200 = total # of engines produced Optimal transfer price = MC E = 4Q E = 8800 MR E,M = 10,000 – 2Q E = transfer price = 8800 => Q E = 600 = # of engines to be sold in market NMR E = 8800 gives 8800 = 12,000 – 2Q E => Q E = 1600 = # of engines & cars produced in-house


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