An Experimental Examination of Perceptions of Fairness on Transfer Pricing Decisions and Firm Profit

Abstract

Transfer pricing is an important managerial decision in a decentralized firm. Analytical research has proposed that different transfer pricing methods are better for different information circumstances in a firm. For example, when information asymmetry is high, the information advantage of the negotiated method generates higher firm profits than the cost-based method. But, when information asymmetry is low, the cost-based method provides more firm profits. Yet so far little empirical evidence exists that identifies when a particular scheme performs better than others in practice. The main challenge remains that it is difficult to apply analytical prescriptions without proper considerations of managerial behavior issues. For example, perceptions of fairness may influence a manager’s decisions, willingness to trade and thus the firm’s performance. This study develops a model that examines the potential influences on willingness to trade (transfer pricing method, information asymmetry and perceived fairness) and then the influence of willingness to trade on company profit. Overall, we find that transfer pricing methods, information asymmetry and perceived fairness influence willingness to trade and that willingness to trade is positively associated with company profit. Finally, perceived fairness was a significant variable when perceptions of fairness, willingness to trade, transfer pricing method and information asymmetry were regressed on firm profits, indicating that perceptions of fairness had the most significant influence on firm profits in this study.