Economic Theory
The discussion in this section explains an economic theory behind optimal transfer pricing with optimal defined as transfer pricing that maximizes overall firm profits in a non-realistic world with no taxes, no capital risk, no development risk, no externalities or any other frictions which exist in the real world. In practice a great many factors influence the transfer prices that are used by multinational corporations, including performance measurement, capabilities of accounting systems, import quotas, customs duties, VAT, taxes on profits, and (in many cases) simple lack of attention to the pricing.
From marginal price determination theory, the optimum level of output is that where marginal cost 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 (i.e. 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 firm's 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.
It can be shown algebraically that the intersection of the firm's marginal cost curve and marginal revenue curve (point A) must occur at the same quantity as the intersection of the production division's 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.
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.
Read more about this topic: Transfer Pricing
Famous quotes containing the words economic and/or theory:
“... business training in early life should not be regarded solely as insurance against destitution in the case of an emergency. For from business experience women can gain, too, knowledge of the world and of human beings, which should be of immeasurable value to their marriage careers. Self-discipline, co-operation, adaptability, efficiency, economic management,—if she learns these in her business life she is liable for many less heartbreaks and disappointments in her married life.”
—Hortense Odlum (1892–?)
“A theory of the middle class: that it is not to be determined by its financial situation but rather by its relation to government. That is, one could shade down from an actual ruling or governing class to a class hopelessly out of relation to government, thinking of gov’t as beyond its control, of itself as wholly controlled by gov’t. Somewhere in between and in gradations is the group that has the sense that gov’t exists for it, and shapes its consciousness accordingly.”
—Lionel Trilling (1905–1975)