Question

Why should transfer prices equal the marginal cost of the selling division within a company that is selling to a buying , division in the same company when this same selling division has no opportunity to make any sales of what it sells to third parties outside the corporation. In your answer make sure you fully explain the double marginalization issue that arises if transfer prices are set higher in this situation than marginal costs

Answer 1

The goods are generally transferred internally when the minimum price of selling division is equal or less than the maximum price of selling division. With these maximum and minimum prices, the managers can determine on the transfer price. The price to determine the value of internal transfers of goods and services is termed to be transfer price. When the goods are sold outside the firm the market price often determines the transfer price. However when the transfer prices equal the marginal cost of the selling division it indicates double marginalization because in the value chain both divisions exercise monopoly power by output restriction. This manner of pricing will cause the total profits for the firms being less compared to the vertically integrated firm because each firm is behaving as if it were a monopoly, causing a margin over an individual relevant marginal cost. It is termed to be double marginalization; and results to twin instances of deadweight loss, thus reducing greatly the general welfare.