Transcript 14 Appendix B

Pricing of Joint Products
and Transfer Pricing
Appendix 14B
Joint Products
• Interdependencies in costs occur in products that are produced
simultaneously or jointly.
• E.g., Beef & Hides in steers and Natural Gas & Crude Oil in oil
well drilling are ‘jointly produced’.
• Suppose beef & hides are produced in FIXED PROPORTIONS
in production: 500 lbs. of Beef + 10 square yards of hides for 1
steer.
• Two cases: (1) No excess of either product and (2) one product
has an excess.
2005 South-Western Publishing
Slide 1
Steers: The Case with No Excess
of Either Hides or Beef
Two Demand
Curves:
Hides (H) & Beef (B)
Two MR Curves:
Hides & Beef
MRB
MRH
DH
DB
steers (T)
Slide 2
2
MRT
MCT
Find where
MRT = MCT
to find the
optimal of
steers.
DH
MRH
DB
steers (T)
Slide 3
3
MRT
MCT
At the optimal
number of
steers, find
the prices of beef &
hides on their
respective
demand curves
PB
PH
DH
T
MRH
DB
steers (T)
Slide 4
Suppose the Adkin’s Diet encourages
more demand for beef
•
•
•
•
Demand for beef shifts up and out
MR for steers shifts up and out
The optimal number of steers rises
The price of beef rises, but…
the price of hides declines.
• Inverse movement in the prices for joint
products is seen in natural gas and oil prices
as well.
Slide 5
Excess of One of the Joint Products
• Excess means the price would be
ZERO
• The solution is to hold back some of
the excess to reach the Unit Elastic
Point on the Demand Curve.
• This Maximizes Total Revenue.
Slide 6
Transfer Pricing
• Vertically integrated firms “sell” intermediate goods
from one division to the other. The internal price
used is called the transfer price.
Car Frames
Fisher
Body
Transfer prices paid
Fisher Body automobile
Frames (a division of GM)
sells to Chevrolet (another
division of GM)
GM
Chevy
Division
GM Chevrolet Division
Buys Fisher Body Car Frames
Slide 7
Transfer Pricing serves two functions:
1. It measures of the marginal value of the
resource
2. It provides a performance measures of
resources used, including the total
value of resources
• Each division can be a profit center.
For International Firms, transfer pricing may assist in
reducing worldwide taxation, although the ability to reduce
taxation is limited since the IRS requires arm’s length prices.
Slide 8
Create Transfer Prices Similar
to Competitive Market Prices
• Disagreements across divisions are common
» “Selling” Division wants a HIGH transfer price!
» “Buying” Division wants a LOW transfer price!
• When External Markets exist, use those prices for
transfer (a market-based competitive price)
sell to others @ “P”
motor assembly
final car
assembly
purchase motors from others @ “P”Slide 9
Transfer Pricing
With No External Markets
• When no external markets exist, use the
MC of the transferred good.
• Often, however, the MC is a function of
output.
• Marketing and Production steps (M & P)
• Transfer price is PT = MC P on following
figure
Slide 10
Find Where MCM+P = MR
MCM+P
P
MCM + PT
MCP
MCM
PT
D
Q0
MR
Figure 14B.5
Slide 11
Transfer Pricing and Profit
Maximization
• Once a firm uses the transfer price, either from
external markets or from analysis of the MC as in
PT, the whole firm maximizes profits.
• Suppose a firm uses a higher price than PT, call it
PHigher to make the production group happier.
• The sum of the MCM plus PHigher is given at the
next slide, creating the appearance of a cost
increase.
• Quantity declines from Q0 to Q1 and price is
artificially increased from P0 to P1.
Slide 12
Using a higher transfer price hurts
profits as quantity declines and
PHigher + MCM
price rises
MCM+P
P1
P0
PT + MCM
MCP
MCM
PHigher
PT
D
Q1 Q0
MR
Slide 13