Slide 1 Pricing of Joint Products and Transfer Pricing Appendix 14B Interdependencies in costs occur in products that are produced simultaneously or jointly. E.g., Beef & Hides in steers and Natural Gas & Crude Oil in oil well drilling are ‘jointly produced’. Suppose beef & hides are produced in FIXED PROPORTIONS in production: 500 lbs. of Beef + 10 square yards of hides for 1 steer. Two cases: (1) No excess of either product and (2) one product has an excess.  2005 South-Western Publishing Joint Products

Slide 2 Steers: The Case with No Excess of Either Hides or Beef steers (T) DHDH DBDB MR H MR B Two Demand Curves: Hides (H) & Beef (B) Two MR Curves: Hides & Beef

Slide 3 steers (T) DHDH DBDB MC T 2 MR H MR T Find where MR T = MC T to find the optimal of steers.

Slide 4 steers (T) DHDH DBDB MC T 3 MR H MR T At the optimal number of steers, find the prices of beef & hides on their respective demand curves T PBPHPBPH

Slide 5 Suppose the Adkin’s Diet encourages more demand for beef Demand for beef shifts up and out MR for steers shifts up and out The optimal number of steers rises The price of beef rises, but… the price of hides declines. Inverse movement in the prices for joint products is seen in natural gas and oil prices as well.

Slide 6 Excess of One of the Joint Products Excess means the price would be ZERO The solution is to hold back some of the excess to reach the Unit Elastic Point on the Demand Curve. This Maximizes Total Revenue.

Slide 7 Transfer Pricing Vertically integrated firms “sell” intermediate goods from one division to the other. The internal price used is called the transfer price. Fisher Body automobile Frames (a division of GM) sells to Chevrolet (another division of GM) Car Frames Transfer prices paid GM Chevy Division Fisher Body GM Chevrolet Division Buys Fisher Body Car Frames

Slide 8 Transfer Pricing serves two functions: 1.It measures of the marginal value of the resource 2.It provides a performance measures of resources used, including the total value of resources Each division can be a profit center. For International Firms, transfer pricing may assist in reducing worldwide taxation, although the ability to reduce taxation is limited since the IRS requires arm’s length prices.

Slide 9 Create Transfer Prices Similar to Competitive Market Prices Disagreements across divisions are common »“Selling” Division wants a HIGH transfer price! »“Buying” Division wants a LOW transfer price! When External Markets exist, use those prices for transfer (a market-based competitive price) motor assembly final car assembly sell to “P” purchase motors from “P”

Slide 10 Transfer Pricing With No External Markets When no external markets exist, use the MC of the transferred good. Often, however, the MC is a function of output. Marketing and Production steps (M & P) Transfer price is P T = MC P on following figure

Slide 11 Find Where MC M+P = MR D MC M MC P MC M+P MR P PTPT Q 0 MC M + P T Figure 14B.5

Slide 12 Transfer Pricing and Profit Maximization Once a firm uses the transfer price, either from external markets or from analysis of the MC as in P T, the whole firm maximizes profits. Suppose a firm uses a higher price than P T, call it P Higher to make the production group happier. The sum of the MC M plus P Higher is given at the next slide, creating the appearance of a cost increase. Quantity declines from Q 0 to Q 1 and price is artificially increased from P 0 to P 1.

Slide 13 Using a higher transfer price hurts profits as quantity declines and price rises D MC M MC P MC M+P MR P0P0 PTPT P Higher P Higher + MC M P T + MC M Q 1 Q 0 P1P1