Think of the divisionalized firm as a type of internal market. Like external markets, the internal markets of divisionalized firms act according to the laws of supply and demand. Supply is offered by various upstream suppliers to meet the demand of downstream users. Goods and services must be transferred and priced each step along the way from basic raw materials to finished products.
For simplicity, consider the problem faced by a vertically integrated firm that has different divisions at distinct points along the various steps of the production process, and assume for the moment that no external market exists for transferred inputs. If each separate division is established as a profit center to provide employees with an efficiency incentive, a transfer pricing problem can occur. Suppose each selling division adds a markup over its marginal cost for inputs sold to other divisions. Each buying division would then set its marginal revenue from output equal to the division's marginal cost of input. This process would culminate in a marginal cost to the ultimate upstream user that exceeds the sum total of marginal costs for each transferring division. All of the markups charged by each transferring division drive a wedge between the firm's true marginal cost of production and the marginal cost to the last or ultimate upstream user. As a result, the ultimate upstream user buys less than the optimal amount of input and produces less than the profit-maximizing level of output.
For example, it would be inefficient if AOL, a major ISP, paid more than the marginal cost of programming produced by its own subsidiaries. If each subsidiary added a markup to the marginal cost of programming sold to the parent company, AOL would buy less than a profit-maximizing amount of its own programming. In fact, AOL would have an incentive to seek programming from other purveyors so long as the external market price was less than the internal transfer price. Such an incentive could create extreme inefficiencies, especially when the external market price is less than the transfer price but greater than the marginal cost of programming produced by AOL's own subsidiaries.
An effective transfer pricing system leads to activity levels in each division that are consistent with profit maximization for the overall enterprise. This observation leads to the most basic rule for optimal transfer pricing: When transferred products cannot be sold in external markets, the marginal cost of the transferring division is the optimal transfer price. One practical means for insuring that an optimal amount of input is transferred at an optimal transfer price is to inform buying divisions that the marginal cost curve of supplying divisions is to be treated like a supply schedule. Alternatively, supplying divisions could be informed about the buying division's marginal revenue or demand curve and told to use this information in determining the quantity supplied. In either case, each division would voluntarily choose to transfer an optimal amount of input at the optimal transfer price.
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