Market-Based Transfer Pricing: An Evaluation of Alternative Market Prices

Abstract

We investigate a transfer pricing problem between two divisions within a decentralized firm. An upstream division produces an intermediate good that is transferred to another division within the firm and is also sold in an external market, where the firm competes with a rival who sells a differentiated substitute product. Assuming that headquarters has imperfect information about the upstream division's marginal production costs, we identify conditions under which a market-based transfer price based on the rival's external market price is a viable alternative to a market-based transfer price based on the upstream division's external market price. The two transfer prices differ in their ability to convey private-cost information and in their effect on the upstream division's competitive behavior in the intermediate market. We find that the relative performance of the two transfer pricing regimes depends on the relative levels of internal and external demand for the intermediate product, on the intensity of competition with the rival in the intermediate market, and on the degree of uncertainty about the upstream division's costs. We also extend our main analysis by relaxing our assumptions about information and intermediate market competition and by allowing specific investments. Overall, our analysis provides new insight into how alternative market-based transfer prices can be used to coordinate decentralized decision-making in the absence of a perfectly competitive intermediate market.