CHAPTER 11 • Pricing with Market Power 447 $/Q F IGURE A11.3 PA MCE AR PE,M MCA MC E* MR Q E,1 Q E,2 ϭ QE BUYING ENGINES IN A COMPETITIVE OUTSIDE MARKET Race Car Motors’ marginal cost of engines MCE* is the upstream division’s marginal cost for quantities up to QE,1 and the market price PE,M for quantities above QE,1 The downstream division should use a total of QE,2 engines to produce an equal number of cars; in that case, the marginal cost of engines equals net marginal revenue QE,2 − QE,1 of these engines are bought in the outside market The downstream division “pays” the upstream division the transfer price PE,M for the remaining QE,1 engines Quantity NMRE = (MR Ϫ MCA) Figure A11.4 shows the case where Race Car Motors sells engines in the outside market Now the competitive market price PE,M is above the transfer price that the firm would have set had there been no outside market In this case, although the upstream Engine Division produces QE,1 engines, only QE,2 engines $/Q PA F IGURE A11.4 SELLING ENGINES IN A COMPETITIVE OUTSIDE MARKET MCE PE,M MC E* AR MCA MR Q E,2 ϭ QA Q E,1 Quantity NMRE = (MR Ϫ MCA ) The optimal transfer price for Race Car Motors is again the market price PE,M This price is above the point at which MCE intersects NMRE, so the upstream division sells some of its engines in the outside market The upstream division produces QE,1 engines, the quantity at which MCE equals PE,M The downstream division uses only QE,2 of these engines, the quantity at which NMRE equals PE,M Compared with Figure A11.2, in which there is no outside market, more engines but fewer cars are produced