Question

Suppose that the optimal transfer price between one business and all other business activities in a firm is the market price. What does this condition say about whether this firm should own this business?

Answer 1

When the optimal transfer price between one business and all other business activities in a firm is the market place it means that the receiving units can purchase the product or service from the market. There is no economic logic for the business to perform the activity internally.

For example, if one unit of an automotive firm transfers brake pads to another unit at price of $6 each and buying unit can buying unit can procure brake pads from the outside vendors for the same price, then maybe the firm should not be in the business of making brake pads. The logic of economy of scope is missing in this case. Bringing this same activity in-house creates an additional level of bureaucracy inside the firm. It is fine if this increase in bureaucracy is more than offset by an increase in the efficiency in the form of lower costs for producing the product/service. In the case of the firm manufacturing the brake pads, this rationale is not present.

On the other hand, if the selling division has a cost advantage over the other outside vendors, the firm may realize an economy of scope and gain more than normal returns.