Transfer Pricing with Imperfectly Competitive External Markets

The typical case of vertical integration involves firms with inputs that can be transferred internally or sold in external markets that are not perfectly competitive. Again, it never pays to use inputs internally unless their value to the firm is at least as great as their value to others in the external market. This observation leads to a third and final fundamental rule for optimal transfer pricing: When transferred products can be sold in imperfectly competitive external markets, the optimal transfer price equates the marginal cost of the transferring division to the marginal revenue derived from the combined internal and external markets. In other words, when inputs can be sold in imperfectly competitive external markets, internal input demand must reflect the opportunity to supply input to the external market at a price in excess of marginal cost. If upstream suppliers wish to offer more input than downstream users desire to employ when input MC = MR from the combined market, excess supply can be sold in the external market. If downstream users want to employ more than upstream suppliers seek to furnish when MC = MR, excess internal demand can be met through added purchases in the external market. In both cases, an optimal amount of input is transferred internally.

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