infonet-economy

One of the major functions of transfer pricing is the optimal coordination of internal trade between responsibility centers in decentralized firms. According to standard theory the efficient level of internal trade is achieved by marginal cost pricing. If one of the firm's profit centers faces duopolistic competition on the final product market, the firm's headquarters can gain a strategic advantage when it systematically distorts the transfer price. Because headquarters cannot credibly commit to the equilibrium strategy that is induced by transfer pricing, the market outcome achieved by strategic transfer pricing cannot be replicated by centralized decision making. Since unobservable contracts cannot serve as credible precommitments unless they are employed for other than strategic reasons, the applicability of the basic concept is limited to observable transfer prices. When transfer prices are unobservable and the firms are facing price competition, however, the desired strategic advantages can also be achieved by a commitment to a full-cost system or by the delegation of the authority over the terms of internal trade to the producing division.