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610-05 - Monday,October6th Topics DecisionMaking:...

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Monday, October 6 th    Topics:  – Decision Making:  Make or Buy and Transfer Pricing – Double Marginalization and Vertical Integration – Relevant Costs   Readings: – Brickley et. al, Chapter 19:562-574;  – Hoyt, Lecture 3:115-126 Monday, October 13 th 1 st  Half:  Review for Exam 2 nd  Half:  Exam
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Vertical Integration The modern corporation is often organized into a number of different divisions that are vertically integrated. Vertical integration implies a structure in which the product  developed  in  the  "upstream"  division  is  an  input  in production in a "downstream" division. Examples: – Automobile production  – Engines are produced in one division of GM and then  purchased  by  another  a  division  that  assembles  the automobile. 
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Why have vertical integration? Enables a corporation to monitor and reward production more  easily by rewarding division based on the "profits"  generated by that division.   Upstream division that "sells" its products to downstream  division needs a price for its product. Reasons: – To accurately measure division profit and evaluate the  overall success of the firm. To motivate divisions by giving them a chance to earn  profits based on their performance.  To ensure the proper production and allocation of  "upstream" products to "downstream" divisions or  external markets. To minimize international tax liabilities.
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An Example with External Market Company  produces  electronic  control  devices  and  specialty microchips.   ATC is $300 and P c  = 550.   – Company uses chips in control devices.   ATC of device (ATC d ) is $500 + 2*ATC c  = $1100 and  P d  = $1,500.  Assume the $500 is variable. Should the company produce control devices? Two Scenarios: – Outside  orders  for  chips  were  insufficient  to  keep capacity utilized. – Suppose  that  $200  of  the  devices  costs  are  fixed  and capacity  could  be  fully-utilized  by  outside  orders.  Should the firm produce chips in the short run?
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Choosing the Transfer Price Example: 2 divisions “upstream" and downstream.   – The upstream produces a component by the downstream division for sale on an external market.   What should the price of the component (p C ) be? To  answer  --  the  overall  objective  of  the  corporation  is  to maximize its profits, not the profits of any single division. – Assume that each division operates independently given the component price: – upstream division can decided how much to produce  – downstream can decide how much to purchase and from whom (possibly outside the firm).
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