Transfer Pricing

Suppose a firm manufactures bicycles in Hong Kong and distribute it in America.
In consumer market, this firm is monopoly.

As shown below, there's an internal price. If the firm set the internal price differ from the optimal one, it can adjust the profit proportion between manufacture department and sales department, which locate in different areas. In this way, it can reduce total taxes due to different tax rates on profit in the two places.

marginal manufacture cost
marginal distribution cost
net marginal revenue
internal price

Case 1, no external market for manufacture department


Case 2, competitive external market for manufacture department

External purchases


External sales


Case 3, monopolized external market for manufacture department


Core idea

To maximize profit, the firm in whole should produce at

\begin{align} marginal\; cost =marginal\; revenue \end{align}
money out from the firm
money into the firm

Case 1

Optimal condition $MMC+MDC=MR$

Case 2

Optimal condition $Pe+MDC=MR$

Case 3

Firm faces two markets, domestic market and foreign market.

In domestic market, the firm faces domestic demand curve, and distribute by sales department, so we have the net marginal revenue

In foreign market, the firm faces foreign distributor's demand curve. And it has a foreign marginal revenue curve ${MR}_{external}$

Totally, ${NMR}_{d}$ curve plus ${MR}_{external}$ horizontally, the firm has a total demand curve. MMC curve cross this total demand curve, we get optimal point.

Note: for the two curves plus or minus vertically, we can interpret as different marginal costs and/or revenues plus or minus, because we always assume basing on the same product amount. But in the case of plus or minus curves horizontally, we cannot simply interpret marginal costs or revenues plus or minus.

Curves caculation

Curve1 : Q=aP
Curve2 : Q=bP
Curve1 + Curve2 vertically: P=Q/a+Q/b (assume Q stay, Q/a and Q/b represent their old P values, so the new P value is the olds sum)
Curve1 + Curve2 horizontally: Q=aP+bP (P stays, Q is the old Qs sum)

Further study

In case 2 external sales, you may ask, while we assume the firm is monopoly in consumer market, why there's external sales?

The graphs in this page are from the study materials from my microeconomics professor at usc.

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