Negotiated Versus Cost-Based Transfer Pricing in Presence of Multiple Internal Buyers and Demand Interdependence

Abstract

We study an incomplete contracting model to compare the performances of alternative transfer pricing mechanisms. The dual purpose of transfer pricing is to guide intra-company transfers of an intermediate good and to provide incentives for upfront investments at the divisional level. While previous studies have generally analyzed transfer pricing between two monopolistic divisions, intermediate products traded internally are frequently drawn upon by multiple downstream divisions. When several internal buyers offer finished product substitutes, their engagement in a differentiated quantity competition affects the internal coordination problem twofold. First, buyer competition reduces curtailed trading induced by double marginalization, a common problem to cost-based transfer pricing. Second, the seller’s hold-up problem diminishes in his ability to play competing buyers off against one another, whereas the buyers’ hold-up problems intensify. Negotiated transfer pricing, in particular, is known to suffer from hold-up problems. In our study we distinguish two scenarios of buyer-seller interaction: one in which all divisions congregate and the other in which the seller deals with each buyer bilaterally, one at a time. While multilateral bargaining ensures trade efficiency from a modeling perspective, it may be infeasible in many practical situations. Bilateral bargaining, however, introduces trade distortions to the negotiated pricing scheme. In contrast, if buyers place orders sequentially under a cost-based scheme, the Stackelberg output helps alleviating the harmful double-marginalization effect. We extend existing results in two ways. First, and most interestingly, cost-based pricing dominates negotiation provided finished products are good substitutes and bargaining proceeds bilaterally. Second, negotiation dominates cost-based transfer pricing given either demand independence or feasibility of multilateral bargaining.