Specific Investment and Negotiated Transfer Pricing in an International Transfer Pricing Model

Abstract

We study the efficiency of the negotiated transfer pricing mechanism proposed by Edlin and Reichelstein (1995) for solving a bilateral holdup problem in a multinational enterprise. Our main finding is that the proposed renegotiation procedure will generally not provide incentives for efficient renegotiations of the initial trade quantity if the same transfer price is also used for minimizing the global tax bill. Moreover, given that efficient renegotiations are expected to fail, the divisions will not make efficient investments in the first place. Nevertheless, we demonstrate that Pareto improving renegotiations are still possible in many cases but the first-best solution can generally not be attained. Finally, we demonstrate that the conflict between the two functions of transfer pricing can be solved by the use of different transfer prices for tax and managerial purposes. Since using a second set of books is costly, the firm faces a cost-benefit trade-off that can only be solved in the context of a particular decision problem.