trans_vert_int

trans_vert_int - Overview Transfer Pricing Framework and...

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Overview: Transfer Pricing Framework and Economic Principles Cases Considered No outside market for upstream good Competitive outside market for upstream good Market power in outside market for upstream good Tax considerations Vertical Integration Decision Making in a Large Firm Large firms comprised of divisions (small internal firms), each operating relatively independently How can efficient allocation of inputs/outputs across divisions be achieved? Centralization Problem : communication is often prohibitive. Decentralization : Let divisions decide on quantities and prices Problem : how to make sure local units make decisions that maximize total profits?
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Adam Smith and Alfred Sloan Adam Smith’s great insight: – given proper incentives, each individual pursuing his or her self interest maximizes the performance of the economy. under certain conditions, market prices provide efficient incentives Alfred Sloan used this insight as a principle of organization within a firm Divide into divisions (“profit centers”) Each division maximizes profits Transfer Pricing in a Large Firm Each division decides on its own production and on its own pricing for external parties, but is also responsible for its own profits. Terminology : P&L responsibility, BU's, profit centers This requires a way to value internal transfers (Transfer Pricing) such that divisional profit maximization implies firm profit maximization Prices set by top management Issues
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Optimal Transfers Upstream Division Produces Q Downstream Division Q Π MC(Q) = NMR(Q) Primary Cost C(Q) Requires Q as input Net Revenue = NR(Q) • NR(Q) is revenue from Q less cost of processing Q (in downstream division) • Profits of the firm, in terms of Q, are = NR(Q) - C(Q) • What is the profit maximizing level of Q? . ... (Drum roll . ..)
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Divisional Profit Maximization • Q is priced at p for internal transfers. • Upstream Division:
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This note was uploaded on 10/20/2011 for the course SLOAN 15.010 taught by Professor Berndt during the Fall '04 term at MIT.

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trans_vert_int - Overview Transfer Pricing Framework and...

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