Advanced: Setting an optimal transfer price when there Is an Intermediate imperfect market

(a) Memphis pic is a multi-division firm operating in a wide range of activities. One of its divisions, Division A. produces a semi-finished product Alpha, which can be sold in an outside market at a price P5. It can also be sold to Division B, which can use it in manufacturing its finished product Beta. The outside market in which Alpha is traded is perfect in all respects, except in so far as the buying division would have to tncur transportation costs, which are included in the buying price P8 , if it buys Alpha in the open market. The fimshed product of Division B, Beta. can be sold only in another perfect external market. Assume also that the marginal cost of each division is a rising linear function of output, and that the goal for Memphis pic is to maximize its total profits.

You are required to explain how the optimal transfer price for Alpha should be derived in these circumstances, and to outline any rules which should be stipulated by the management of Memphis pic to ensure attaining its goal of profit maximization. (15 marks)

(b) Assume that Divisions A and B operate as above. except (i)

that Divtsion A is a monopolist facing a downward sloping demand curve and (ii) that it can sell Alpha externally at a price higher than the price it charges mternally to Division B.

Relevant information about both divisions is given below.

You are required to calculate the optimal transfer price for Alpha and the optimal activity level for each division

Transcribed Image Text:

Output of Total cost Revenue from outside Net marginal Alpha of Alpha (units) (000) selling of Alpha (000) revenue of Beta (000)