Transfer Pricing with Perfectly Competitive External Markets

The transfer pricing problem is only sightly more complicated when transferred inputs can be sold in external markets. When transferred inputs can be sold in a perfectly competitive external market, the external market price represents the firm's opportunity cost of employing such inputs internally. As such, it would never pay 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 second key rule for optimal transfer pricing: When transferred products can be sold in perfectly competitive external markets, the external market price is the optimal transfer price. If upstream suppliers wish to supply more than downstream users desire to employ at a perfectly competitive price, excess input can be sold in the external market. If downstream users wish to employ more than upstream suppliers seek to furnish at a perfectly competitive price, excess input demand can be met through purchases in the external market. In either event, an optimal amount of input is transferred internally.

Of course, it is hard to imagine why a firm would be vertically integrated in the first place if all inputs could be purchased in perfectly competitive markets. Neither Kellogg's nor McDonald's, for example, have extensive agricultural operations to ensure a steady supply of foodstuffs. Grains for cereal and beef for hamburgers can both be purchased at prices that closely approximate marginal cost in perfectly competitive input markets. On the other hand, if an input market is typically competitive but punctuated by periods of scarcity and shortage, it can pay to maintain some input producing capability. For example, ExxonMobil Corp. has considerable production facilities that supply its extensive distribution network with gasoline, oil, and petroleum products. These production facilities offer ExxonMobil some protection against the threat of supply stoppages. Similarly, Coca-Cola has long-term supply contracts with orange growers to ensure a steady supply of product for its Minute Maid juice operation. Both ExxonMobil and Coca-Cola are examples of vertically integrated firms with inputs offered in markets that are usually, but not always, perfectly competitive.

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