Slide 1

Pricing of Joint Products and Transfer Pricing

Appendix 14B

• 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

Joint Products

Slide 2

Steers: The Case with No Excess of Either Hides or Beef

steers (T)

DH DB

MRH

MRB

Two Demand Curves:Hides (H) & Beef (B)

Two MR Curves:Hides & Beef

Slide 3steers (T)

DH DB

MCT

2

MRH

MRTFind whereMRT = MCT

to find theoptimal ofsteers.

Slide 4steers (T)

DH DB

MCT

3

MRH

MRT At the optimal number of steers, findthe prices of beef & hides on theirrespective demand curves

T

PB

PH

Slide 5

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 6

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 7

Transfer Pricing• Vertically integrated firms “sell” intermediate goods

from one division to the other. The internal price used is called the transfer price.

Fisher Body automobileFrames (a division of GM) sells to Chevrolet (another division of GM)

Car Frames

Transfer prices paidGM ChevyDivision

FisherBody

GM Chevrolet DivisionBuys Fisher Body Car Frames

Slide 8

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 reducetaxation is limited since the IRS requires arm’s length prices.

Slide 9

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)

motor assemblyfinal carassembly

sell to others @ “P”

purchase motors from others @ “P”

Slide 10

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 11

Find Where MCM+P = MR

D

MCM

MCP

MCM+P

MR

P

PT

Q0

MCM + PT

Figure 14B.5

Slide 12

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 13

Using a higher transfer price hurts profits as quantity declines andprice rises

D

MCM

MCP

MCM+P

MR

P0

PT

PHigher

PHigher + MCM

PT + MCM

Q1 Q0

P1