UNIVERSITY OF ESSEX Department of Economics EC 262 Economics of Organizational Management

1. UNIVERSITY OF ESSEX Department of Economics EC 262 Economics of Organizational Management Rossella Argenziano, adapted by David Reinstein Transfer Pricing and External Boundaries of the firm

2. Introduction • How to design the organization? • Transfer pricing • External boundaries • Vertical integration • (Horizontal integration)

3. Transfer prices • Transfer prices are prices of goods or services charged by departments to other departments • Why should transfer prices matter? Isn’t this just redistribution within a firm, leaving profits unaffected? • Not if prices determine performance of a division and performance determines pay. • E.g, Firms want to reward Sales division for good performance. • Hence it needs to know revenues and costs • Cost calculation can be based on transfer prices • Departments might have incentives to overcharge other departments and this affects production decisions

4. Case 1: transfer prices and market prices • Suppose there is an outside market for the good • Consider a good with two stages of production: • Stage 1: produce crude oil • Stage 2: refine oil • For each stage there is a division

5. price p* q* • Demand and supply of crude oil within firm supply by division 1 profits Demand by division 2

6. price p* q* supply by division 1 • Market can supply crude oil at a lower price for quantities more than q1 • Buy up to q1 from division 1 • Then buy on market until demand equals supply (q2) • Total profits increase with yellow area profits Market price Demand by division 2 q1 q2

7. price p* q* supply by division 1 • Market can supply crude oil at a higher price • Then sell to division 2 up to q1 • Sell rest to market until demand equals supply (q2) • Total profits increase with yellow area Market price profits Demand by division 2 q1 q2

8. Hence, to conclude so far: to maximize total profits, the division should charge the market price as transfer prices* • But what if there is no market price, as is often the case? • Then difficult to assess the right price by manager because divisions are better informed • What are true costs? • What is true value? • There is a problem of asymmetric information

9. Suppose now for simplicity that there is an oil producer who has a monopoly position • crude oil can be produced at constant marginal costs of Cc = 1 • Refining the oil can be done at constant marginal costs of Cr = 2 • Demand for refined oil given by: P = 10 – Q/16 • What prices are they going to charge? • Two cases: • Integrated firm • No need for transfer prices • Multidivisional firm • Each division sets price

10. Case 1: integrated firm Firm Crude oil: Cc = 1 Refine oil: Cr = 2 Total marginal costs: Ct = 3 Consumer Demand: P = 10 – Q/16

11. P 10 D P* 3 Ct MR Q Q* 160 Demand: P = 10 – Q/16 Marginal costs: 3 Question: what are the optimal price and quantity?

12. In optimum: marginal costs = marginal benefits (= marginal revenue) • Total marginal costs for firm are Ct = 3 ( = 2+1) • Total marginal benefits are: 10 – Q/8. (take derivative of P*Q w.r.t. Q) • Optimum: 10 – Q/8 = 3 or Q* = 56 • P* = 6.50 • Profits: 196

13. Case 2: Multidivisional firm CEO DIVISION 1 Crude oil: Cc = 1 DIVISION 2 Refine oil: Cr = 2 Consumer Demand: P = 10 – Q/16

14. P 10 D P* Cr +T 2 Cr MR Q 160 Q* Division 2 Demand: P = 10 – Q/16 Marginal costs: 2 + T

15. Suppose division 1 (crude oil) asks a transfer price T. • Division 2 maximizes profits by setting marginal costs = marginal revenues • Marginal costs are 2 + T  = marginal costs Cr + transfer price of input from division 1) • Marginal benefits are 10 – Q/8 • Optimum: 10 – Q/8 = 2 + T • This gives 8 – Q/8 = T • This is the inverse demand curve for division 1!

16. Division 1 maximizes profits by setting marginal costs = marginal revenues  • Marginal costs are Cc = 1 • Marginal benefits are 8 – Q/4 • Optimum: 8 – Q/4 = 1 • Q* = 28 • T = 4.50 (“too high!”) • The output Q* can be sold at price P* = 8.25 • Profits division 1: (T – Cc)Q* = 98 • Profits division 2: (P* - T - Cr)Q* = 49 • Total firm profits: 147

17. Conclusions so far: an integrated firm performs better: • Profits integrated firm: 196 • Profits multidivisional firm: 147 • The reason is that, since both divisions are free to set prices, they both set monopoly prices • Monopoly price by division 1 is too high, so division 2 demands less output, so output of firm is lower • This is an example of double marginalization • It would be solved by setting transfer price equal to marginal costs of division 1 (T = Cc) but manager of firm doesn’t observe Cc.

18. However, if we take moral hazard into account, the multidivisional firm might do better • It would then become possible to pay for the performance of a division • Multidivisional firm: • Division still sets prices too high to get better results for the own division • But now it has incentives to make efforts • Integrated firm: • No pay for performance possible, so no incentives to exert effort

19. Is there any way to prevent suboptimal transfer prices? • Perhaps: e.g., by rewarding division 1 for low costs rather than for high ‘revenues’

20. External boundaries • What should the boundaries of the firm be? • Vertical

21. Raw materials Parts Systems Final assembly distribution customers

22. Ford tried to be totally vertically integrated • Most of the time, this strategy fails and firms focus on part of process • For the rest, firm rely on independent suppliers • Outsourcing: Nike, Benetton • Which services should a firm do itself?

23. Advantages market procurement • economies of scale • Economies of scope • Core competencies • Independent (no favoritism problems) • Competitive (sometimes through competitive bidding)

24. Advantages vertical integration • Improved coordination • Protection investments • Weaker incentives • Monitoring more easy • Less multi-tasking problems (?) • Less dependent • Protection intellectual property • Barrier against entry by competitors • No monopoly distortions • double marginalization problem • Price discrimination

25. Case 1 Case 2 Production Production + distribution Price T distribution Price P Price P customers customers • Monopoly distortions • Suppose • Marginal costs production: MCp = 1 • Marginal costs distribution: MCd = 2 • Consumer demand: P = 10 – Q/16

26. Case 1: not integrated (note: for derivations see discussion multidivisional firm) • Q* = 28 • T* = 4.5 • P* = 8.25 • Profits: 147 • Case 2: integrated • Q* = 56 • P* = 6.5 • Profits: 196 • Remark: • Combined profits higher if integrated • No double marginalization problem • Moreover, consumers are better off! • Lower price

27. Distributor 1 Distributor 1 X supplier supplier X Distributor 2 Distributor 2 Distributor 3 Distributor 3 • Barriers to entry

28. price discrimination • Example AKZO Marginal costs: 10 Pain relief P = 100 – 5Q Stomach drug P = 200 – 10Q consumers consumers

29. P D mc MR Q Arbitrage! P 200 D P* 100 P* 10 10 mc MR Q 20 Q* 20 Q* Stomach drug: P* = 105 Pain relief: P* = 55

30. Solution: AKZO integrates forward and produces pain reliever itself • Sell pain reliever at p = 55 • Sell chemical compound at p = 105 AKZO Marginal costs: 10 Pain relief P = 100 – 5Q Stomach drug P = 200 – 10Q consumers consumers

31. Alternative vertical relations • Co-op • Economies of scale • Prevent monopoly pricing • Focus on short-run • Franchise • Common brand name and advertising etc. • Hold-up • Free-riding • Coordination problems • Supplier organization • Long-term relationships • Price determination • two-supplier policy • Comparative evaluation

32. initiative Long-term relationships expand possibilities Cooperation • Trade-off: initiative versus cooperation

33. (Advantages of horizontal expansion) • Exploiting economies of scope • Creating monopoly power

34. Disadvantages of horizontal expansion: • Coordination problems • Conflicting cultures • Alternatives: • Business alliances • Share information • Economies of scale • Keiretsu (this term may be passé) • Information exchange • Coordination • Provision of capital