Overview: Transfer Pricing • Framework and Economic Principles • Cases Considered – No outside market for upstream good – Competitive outside market for upstream good – Market power in outside market for upstream good – Tax considerations • Vertical Integration Decision Making in a Large Firm • Large firms comprised of divisions (small internal firms), each operating relatively independently • How can efficient allocation of inputs/outputs across divisions be achieved? – Centralization : Dictate all quantities & transfers Problem : communication is often prohibitive. – Decentralization : Let divisions decide on quantities and prices Problem : how to make sure local units make decisions that maximize total profits?Adam Smith and Alfred Sloan • Adam Smith’s great insight: – given proper incentives, each individual pursuing his or her self interest maximizes the performance of the economy. – under certain conditions, market prices provide efficient incentives • Alfred Sloan used this insight as a principle of organization within a firm – Divide into divisions (“profit centers”) – Each division maximizes profits Transfer Pricing in a Large Firm • Each division decides on its own production and on its own pricing for external parties, but is also responsible for its own profits. • Terminology : P&L responsibility, BU's, profit centers • This requires a way to value internal transfers (Transfer Pricing) such that divisional profit maximization implies firm profit maximization – Prices set by top management – IssuesOptimal Transfers Upstream Division Produces Q Downstream DivisionQ Π MC(Q) = NMR(Q) Primary Cost C(Q) Requires Q as input Net Revenue = NR(Q) • NR(Q) is revenue from Q less cost of processing Q (in downstream division) • Profits of the firm, in terms of Q, are = NR(Q) - C(Q) • What is the profit maximizing level of Q? .... (Drum roll ...)Divisional Profit Maximization • Q is priced at p for internal transfers. • Upstream Division: – Revenues = p Qu, Costs = C(Qu) – (Internal) Profits Πu = pQu -C(Qu) – Maximizing: Produce Qu such that p = MC(Qu) • Downstream Division: – Revenues = NR(Qd), Costs = p Qd – (Internal) Profits Πd = NR(Qd) - pQd – Maximizing: Order Qd such that p = NMR(Qd) Setting the Transfer Price • Optimal Transfer Price: p* such that Qd = Qu *• We have p = MC(Qu) = NMR(Qd) – If wrong transfer price set, either • Qd > Qu (shortage of input) • Qd < Qu (surplus of input) – Much easier to set transfer price with competitive outside markets (follows after example)Graphically ( ) Downstream Profits No FCMC (upstream) Optimal transfer price p* Upstream Profits NMR (downstream)(No FC) Q (produced and processed) Internal Optimal Transfer Pricing (No Outside Market)Example: Firm makes chips & computers (e.g. Apple and the 3 GHz chip)• Upstream division makes chips • Downstream divisions assembles computers • Data: – Upstream: Chip Manufacturing Plant: Q is # of chips in thousands • Total Costs: TCu = Q2 ==> MCu = 2Q – Downstream: Computer Manufacture • Need one chip per machine (Q also represents # computers) • Demand: P = 4000 - 4 Q (Firm monopolizes their demand) • Assembly Costs (all costs except the chip) = 1500 Q: ==> MCa = 1500 Example: continued • NMR is “Demand for Chips” from downstream division R = PQ = (4000 - 4 Q)Q NR = (P - MCa)Q = (2500 - 4 Q)Q NMR = 2500 - 8 Q • Optimal chip production has NMR = MCu NMR = 2500 - 8 Q = 2 Q = MCu 2500 = 10 Q Q = 250 • Transfer Price: p = 2(250) = 500 (= MCu)Example: continued • Profits: Upstream Division: pQ - TCu = 500(250) - (250)2 = 62.5 m Downstream Div: NR - pQ = 1500(250) - 500(250) = 250.0 m Total Company Profits = 62.5 m + 250 m = 312.5 m (Note how transfer revenue/cost cancels out)Various Issues • If there are many divisions, do we need new principles for transfer pricing? • What if there are outside sources of the chip? • Why does each division’s internal “profit” matter? • Are there tax considerations? • Does market power matter? Multiple Sources or Uses 1. Multiple Sources: C1(Q1) C2(Q2) NR(Q1+Q2) p * = MC1(Q1 2(Q2) = NMR(Q1+Q2) 2. Multiple Uses: p * = NMR1(Q1 2(Q2) 1+Q2) M NR1(Q1) NR2(Q2) C(Q1+Q2) M1 M2 Optimal Transfer Price: ) = MCOptimal Transfer Price: ) = NMR = MC(QApplication: Competitive Outside Market • (market is a source) (* = p, market price • (end of story) NR2(Q2) C(Q1+Q2) M1 ) M2 P P Competitive Outside Market – You can buy Q at price p – You can sell Q at price p market is a use) – Set transfer price pEasiest Case: No calculation required – Transfer price = market price (competitiveGraphically NMR (downstream) MC (upstream) p* (market price) Opt transfer price pTr. Price w/o market Additional Profit Q produced Q bought upstream outside Effective MC from upstream division and market Back to the Example Suppose there is a substitute chip available for $ 350 • So ………… Set transfer price p = 350 • Upstream (chip) division produces so that p = MCu, or 350 = 2Q, or Q = 175 • Downstream (computer) division orders chips until p = NMR, or 350 = 2500 - 8 Q, or Q = 268.75 • So, 175 (thousand) produced, 93.75 purchased outside, 268.75 computers made. • Profits = NR(268.75) - TC(175) - 350(93.75) = 319.5 m • Note: 319.5 m > 312.5 m ; 7 m additional profitApplication: Outside Market Power • intermediate product (M1) • * < AR=> • NR2(Q2) C(Q1+Q2) M1 M2P* P You monopolize an outside market for With market power, p= MRoutside outside p* < p, the outside market price for intermediate product Summary: Transfer at MC; the outside market price p is higher than transfer price p*.Divisional Profits and Evaluation • Internal Profits add to Firm Profits • Are division profits useful for evaluating performance? – It depends: Can reflect efficiency gains in production – Yes, with outside competitive market • Raises bargaining issues for prices – Increased p raises upstream profits, lowers downstream profits – This is one reason p is set by top management • If a division can set p, losses typically result – Double Marginalization Double Marginalization NMR MC pUpstream MC NMR p Upstream Q Q Loss to Loss to Downstream Profits Profits Profits Downstream Profits Firm Firm Upstream Division