The question is, at what price the parent firm will pay to the entity located at the LCC for procuring the components. This question apparently seems to be very innocent, but determination of the price acceptable by both the governments is extremely difficult. The reason being, the price at which goods are transferred from a LCC to a HCC affects revenue of the governments of both the countries.
For obvious reasons, the government of the LCC will not accept any transfer price less than the price which is generally charged by independent third parties in same or similar transactions. On the contrary, the government of the HCC will be happy if firms located at HCC can procure goods at a lower price than that of the comparable transactions from entities located at LCC.
Therefore, importance of TP lies in the problem of determination of appropriate transfer price for inter-company transfer of goods, since these are not traded in the open market and consequently market price is not available.
First, we will explore the economics behind determination of optimal transfer price and then enumerate the method being followed in practice.
For the purpose of determination of optimal transfer price, we consider two possibilities:
(i) A situation where the component manufacturer is the only supplier of that kind, and
(ii) A situation where perfect competition exists in the component market.
In case of the first possibility, the final product (say, P) is manufactured by the Parent Company (say, XYZ) located at the HCC. For each unit of product P, one unit of its component, say X, is outsourced from a subsidiary (ABC) of the parent company XYZ. The subsidiary ABC is located at a LCC.
It is interesting to note that price of the component is not available, since it is not sold in the open market. Suppose, demand for the final product P is Dp. The marginal revenue of P derived from Dp is MRp. Assume that production process of the final product P consists of two steps – Step I involves conversion of raw materials to component X (denoted by Cx) and Step II refers to that stage of conversion where component X is used to produce the final product P (denoted by Cn). The marginal cost of producing component X is MCX and marginal cost of Step II in isolation is MCn , so that MC„ and MCX constitute marginal cost of the end product P, i.e., MCp.
Price of the end product is determined as P,, which is obtained from fulfilling the f.o.c., i.e., equality between MCp and MRp (see Figure 14.4). Profit maximizing quantity of final product P is obtained as Qr Since Q1 quantity of the final product P will be produced by the parent firm and each unit of the end product requires only one component X, Q, quantity of X will be produced and transferred to the parent company for production of the final product. The MC of component X at Q, output level is P2. Thus, the transfer price of the component X is P2.
The previous case remains unchanged here excepting the assumption that perfect competition exists in the component market. The implication of the assumption is that large number of sellers is selling the product (component) in the LCC at a fixed price.
There can be two variations of this possibility. Let us explore these possibilities one by one. Since all other conditions remain the same regarding the end product, price of the end product i.e., Pl7 also remains the same (see Figure 14.5).
But since perfect competition exists in the component market located at LCC, the price of that component is fixed irrespective of output level. Assume P3 is the market price per unit for ABC (i.e., P3 = MRX). So, P3 is also the MR of ABC. Thus, the profit of the affiliate / subsidiary of XYZ is maximized where MRX = MCX. MRX and MCX intersect at point e, which helps in determining the profit-maximising quantity, i.e, Q3. Since Q^Qj, the subsidiary will supply OQ1 output to the Parent and QtQ3 can be sold in the open market.
The other possibility (Figure 14.6) shows that P4 is too low and consequently, profit-maximising output of subsidiary falls short of OQr As a result, OQ4 quantity should be procured from the subsidiary unit, while the rest, i.e., Q4Q, may be purchased from the market.