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Appendix to Chapter 6 Transfer Pricing 277

MCM 200  400 $600. Thus, in the absence of an external market for

microchips, the appropriate transfer price is PTMCM$600. At an output

of 400 chips, the average cost per chip is ACMCM/Q $500. Thus, by sell-

ing its output to the copier division at PT600, the chip division earns an

internal profit of ($600 $500)(400) $40,000 per week. The copier divi-

sion’s average total cost is ACACA/Q $600 $2,500 per copier. At P* 

2,800, the division makes a profit of $300 per copier, implying a total profit of

$120,000 per week. The combined profit of the divisions is 40,000 120,000 

$160,000.

Now, suppose an external market for chips exists and a chip’s current mar-

ket price is PM$900. For each additional chip produced and sold, the chip

division’s marginal revenue equals $900, the current market price. Setting

MR MC implies 900  200 QM, where QMdenotes the quantity of

microchips. The solution is QM700. Next consider the copier division. The

price it pays for chips is now PTPM$900. Thus, its marginal cost (inclu-

sive of the price of chips) is MCT1,000  900 $1,900. Setting MR MC

implies 4,000 6Q $1,900. Thus, Q* 350 and P* $2,950. To sum up, the

chip division’s total weekly output is 700 chips. Half of this output (350 chips)

is transferred to the copier division; the other half is sold on the open market.

Questions and Problems

1. a. A senior manager argues that the chip division’s main purpose is to
   serve the firm’s final-product divisions. Accordingly, these services
   should be offered free of charge; that is, the transfer price for chips
   should be PT0. Explain carefully what is wrong with this argument.
   b. Suppose the chip division treats the copier division as it would an
   outside buyer and marks up the transfer price above marginal cost.
   Explain what is wrong with this strategy.


2. In the numerical example, suppose the firm can purchase chips on the
   open market at a price of $300. What production decisions should the
   divisions make in this case?

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