Dominick Salvatore Schaums Outline of Microeconomics, 4th edition Schaums Outline Series 2006

264 RECENT AND ADVANCED TOPICS IN MARKET STRUCTURE [CHAP. 11
11.5 COST-PLUS PRICING
When a firm lacks information to set price according to the MR ¼ SMC profit-maximizing rule, it usually
adopts cost-plus pricing. Here, the firm estimates the average variable cost for a “normal” level of output
(usually between 70 and 80% of capacity) and then adds a markup m over average variable cost to determine
the price of the commodity. The markup is set sufficiently high to cover average variable and fixed costs, and
also to provide a profit margin for the firm. That is,
m ¼ P AVC so that P ¼ AVC(1 þ m)
AVC
The markup is usually inversely related to the price elasticity of demand for the commodity and so it is
consistent with profit maximization (see Problem 11.14).
EXAMPLE 5. If a firm’s AVC ¼ $100 and the firm sets m ¼ 0.20 or 20%, the firm would then set P ¼
$100(1 þ 0.20) ¼ $120. Cost-plus pricing is fairly common in oligopolistic industries. Empirical studies have found that
the markup is about 0.2 or 20% in the steel industry in general but is higher for products facing less elastic demand or
in periods of high demand. Similarly, the retailing sector was found to adjust prices on the basis of feedback from the
market and to reduce the markup and price when the demand for the product declines and becomes more elastic.
11.6 TRANSFER PRICING
The rapid rise of the large-scale enterprise has been accompanied by decentralized operations and the need
for transfer pricing. Transfer pricing refers to the determination of the price of the intermediate products sold by
one semiautonomous division of a firm to another semiautonomous division of the same enterprise. Appropriate
transfer pricing is essential in determining the optimal level of output of each division and of the firm as a
whole. In the absence of an external market for the intermediate product, the transfer price of the intermediate
product is given by the marginal cost of production of the production division at the best level of output of the
intermediate product.
EXAMPLE 6. In Figure 11-3, we assume that there is no external market for the intermediate product and that one unit of
the intermediate product is required to produce each unit of the final product. The marginal cost of the firm, MC, is equal
to the vertical summation of MC p and MC m , the marginal cost curves of the firm’s production and marketing divisions. D m is
the external demand for the final product faced by the firm, and MR m is the corresponding marginal revenue curve. The
firm’s best level of output is 40 units and is given by point E m , at which MR m ¼ MC, so that P m ¼ $14. Since each unit
of the final product requires one unit of the intermediate product, the transfer price for the intermediate product, P t ,is
set equal to MC p at Q p ¼ 40 (point E p ). Thus, P t ¼ $6.
($)
18
14
MC = MC p + MC m
10
P m
Fig. 11-3
E m
MC p
D m
MC m
6
E p
D p = MR p = P t
MR m
0 20 40 60 Q