Optimal transfer prices and technology in decentralized business groups

Abstract

Decentralized (parent-affiliates) business groups encompass independent firms sharing production resources under common administrative or financial control. Due to the complexity of integrated decision-making, business groups often delegate pricing and technology decisions to separated units. With the growing prevalence of transfer technology in multi-plant operations, there arises a demand for modeling frameworks capturing the joint impact of transfer prices and technology on affiliates’ production. In this paper, we propose an operational methodology to integrate transfer prices and technology, as incentive mechanisms driving affiliates’ production decisions. This consists of a single-leader-multi-follower game where a parent firm (the leader) operates in a single-product market and delegates production to profit-maximizing affiliate firms (the followers). In addition to providing data-driven support for integrated decision-making, our framework reveals how managerial structures respond to the growing significance of intangible technology. In this line, based on the parent’s control of the value chain we present two specifications and solution approaches: full delegation and partial delegation. For the former, we provide an exact characterization of the equilibrium solution; whereas for business groups operating under full delegation, we provide tight lower and upper bounds, computable by state-of-the-art optimization solvers. Our empirical tests rely on a customized version of the Orbis data set. Figures show that our methodology not only integrates the substitutability between transfer prices and technology, as well as their dependency on the parent’s control of the value chain, but also gives rise to a flexible computational approach that is applicable to a wide range of decentralized business groups.