Abstract
A scenario is constructed under which a multinational firm (MNF) faces a threat of a penalty, the probability of which is based on the MNF's transfer price. Given this scenario, the MNF's optimum transfer price could be in the interior, and simultaneous interaction of the transfer price and real variables exists. Increased surveillance of the transfer price makes the MNF move its transfer price towards the arm's length price and checks fiscal abuses. But it worsens the international allocation of resources even though the cost advantage of the exporting country increases. Still, the impact on global welfare is ambiguous.
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