# ColombiaLink.com – TRANSFER PRICING – MICROECONOMICS

See
also: List of Economic Topics

TRANSFER
PRICING
– microeconomics

Transfer
pricing refers to the pricing of goods and services within a multi-divisional
organization. Goods from the production division may be sold to the marketing
division, or goods from a parent company may be sold to a foreign subsidiary.
The choice of the transfer prices affects the division of the total profit among
the parts of the company. It can be advantageous to choose them such that, in
terms of bookkeeping, most of the profit is made in a country with low taxes.

From
marginal price determination theory, we know that generally the optimum level
of output is that where marginal costs equals marginal revenue. That is to say,
a firm should expand its output as long as the marginal revenue from additional
sales is greater than their marginal costs. In the diagram that follows, this
intersection is represented by point A, which will yield a price of P*, given
the demand at point B.

When
a firm is selling some of its product to itself, and only to itself (ie.: there
is no external market for that particular transfer good), then the picture gets
more complicated, but the outcome remains the same. The demand curve remains the
same. The optimum price and quantity remain the same. But marginal cost of production
can be separated from the firms total marginal costs. Likewise, the marginal revenue
associated with the production division can be separated from the marginal revenue
for the total firm. This is referred to as the Net Marginal Revenue in production
(NMR), and is calculated as the marginal revenue from the firm minus the marginal
costs of distribution.

Transfer
Pricing with No External Market

It
can be shown algebraically that the intersection of the firms marginal cost curve
and marginal revenue curve (point A) must occur at the same quantity as the intersection
of the production divisions marginal cost curve with the net marginal revenue
from production (point C).

If
the production division is able to sell the transfer good in a competitive market
(as well as internally), then again both must operate where their marginal costs
equal their marginal revenue, for profit maximization. Because the external market
is competitive, the firm is a price taker and must accept the transfer price determined
by market forces (their marginal revenue from transfer and demand for transfer
products becomes the transfer price). If the market price is relatively high (as
in Ptr1 in the next diagram), then the firm will experience an internal surplus
(excess internal supply) equal to the amount Qt1 minus Qf1. The actual marginal
cost curve is defined by points A,C,D.

Transfer
Pricing with a Competitive External Marke
t

If
the market price is relatively low (as in Ptr2), then the firm will experience
an internal shortages (insufficient internal supply) equal to the amount Qf2 minus
Qt2. The actual marginal cost curve is defined by points A,B,E.

If
the firm is able to sell its transfer goods in an imperfect market, then it need
not be a price taker. There are two markets each with its own price (Pf and Pt
in the next diagram). The aggregate market is constructed from the first two.
That is, point C is a horizontal summation of points A and B (and likewise for
all other points on the Net Marginal Revenue curve (NMRa)). The total optimum
quantity (Q) is the sum of Qf plus Qt.

Transfer
Pricing with an Imperfect External Market

See
also

marketing

pricing
microeconomics
production,
costs, and pricing