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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
- Issues
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(Q^ *
u) = 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 FC MC (upstream)
Optimal transfer price p*
Upstream Profits (No FC) NMR (downstream)
Q (produced and processed)
Internal Optimal Transfer Pricing (No Outside Market)
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:
C 1 (Q 1 )
C 2 (Q 2 )
NR(Q 1 +Q 2 )
p *^ = MC 1 (Q 1 2 (Q 2 ) = NMR(Q 1 +Q 2 )
2. Multiple Uses:
p *^ = NMR 1 (Q 1 2 (Q 2 ) 1 +Q 2 )
M
NR 1 (Q 1 )
NR 2 (Q 2 )
C(Q 1 +Q 2 )
M 1
M 2
Optimal Transfer Price: ) = MC
Optimal Transfer Price: ) = NMR = MC(Q
Graphically
NMR (downstream)
MC (upstream)
- p(market price) Opt transfer price p
Tr. 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.
- 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 profit
Application: Outside Market Power
intermediate product (M 1 )
=>
NR 2 (Q 2 )
C(Q 1 +Q 2 )
M 1
P* M 2
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*.
Back to Example
Suppose Upstream (chip) division sets price.
- NMR is “Demand for Chips” from downstream division NMR = 2500 - 8 Q, so Chip Revenue = CR = (2500 - 8Q) Q
- Upstream Profit Max: produce chips until MCR = MCu MCR = 2500 - 16 Q = 2Q = MCu 2500 = 18 Q Q = 138.9, Transfer Price = 2500 - 8 (138.9) = 1388.
- Profits:
- Upstream Division: pQ - TCu = 173.7 m > 62.5 m
- Downstream Division: NR - pQ = 77.1 m < 250 m
- Total Company Profits = 173.1 m + 77.1 m = 250.8 m < 312.5 m
- 61.7 m lost due to bad management of transfers
Tax Avoidance
• Suppose your divisions are located in different
countries, with different tax rates.
• Separate books for taxes and for management
- Legal limits on what can be reported for taxes
• Can adjust transfer prices to “move” profits from
high tax countries to low tax countries
- WSJ article for many examples
Tax Avoidance
• High tax for downstream division suggests
raising transfer price, raising downstream
costs and lowering downstream profits
• With common books, tradeoff between
efficient production and tax avoidance
Reasons for Vertical Integration
• Transaction cost economics (TCE)
• Hold-up
• Externalities and synergies
• Information flows stay within the firm
• Ability to decide on incentives
• Price discrimination
Costs of Vertical Integration
• Market discipline (competition) gives strong
incentives.
• Non-integration maximizes flexibility and
improves matching.
Take Away Points
- Transfer pricing brings the market in the firm and
allows the creation of profit centers.
- The optimal transfer price equals the marginal cost.
- With competitive outside market, transfer price
equals market price.
- Transfer prices have tax implications. Separate tax
and internal books are typical.
- Integration is a complex trade-off. Always consider
contracting as an alternative.
