This chapter reviews the recent economic literature on transfer pricing. As a starting point, we take Hirshleifer's transfer pricing model and discuss the basic structure of the most widely used model extensions. We review transfer pricing models with asymmetric information, transfer pricing models in incomplete contracting settings, strategic transfer pricing models, and international transfer pricing models with firms operating in different tax jurisdictions. The results offer a rich set of different explanations for the wide variety of transfer pricing methods in practice but they also show that it is impossible to give a general recommendation about “the” best transfer pricing method. By contrast, only limited progress has been made in arriving at a sufficient theory of decentralization. The models are either silent about organizational issues, or the advantages of decentralization are based on more or less restrictive informational assumptions. We conclude that the economic transfer pricing research has certainly improved the understanding of the relative usefulness of alternative transfer pricing methods for a carefully selected set of assumptions. Further theoretical and empirical research seems necessary for a better understanding of the economic reasons for decentralization and for explaining some unresolved empirical puzzles.
This paper analyses the use of transfer pricing as a strategic device in divisionalized firms facing duopolistic price competition. When transfer prices are observable, both firms’ headquarters will charge a transfer price above the marginal cost of the intermediate product to induce their marketing managers to behave as softer competitors in the final product market. When transfer prices are not observable, strategic transfer pricing is not an equilibrium and the optimal transfer price equals the marginal cost of the intermediate product. As a strategic alternative, however, the firms can signal the use of transfer prices above marginal cost to their competitors by a publicly observable commitment to an absorption costing system. The paper identifies conditions under which the choice of absorption costing is a dominant strategy equilibrium.
This paper studies qualitative characteristics of accounting systems that are used in debt financing. We consider a financially constrained firm that provides to lenders information on the value of assets that serve as collateral in a financing contract for a risky investment project. We find that the investor prefers an accounting system that provides biased signals about the value of assets. This bias adjusts the information content of the signals to maximize the probability of undertaking the project. Under fair value accounting, low book values are more precise measures of actual value than high book values, which is consistent with conditional conservatism. Next, we study accounting risk to study the effect of institutions that govern the financial reporting policy based on the optimal precision. We find that fair value measurement introduces greater accounting risk and is preferred by financially constrained firms to measurement at historical cost.
Dutta and Reichelstein (2010) study the role of transfer pricing and organizational choice in providing incentives for efficient decisions on the acquisition and subsequent reallocation of capacity within decentralized firms. Their analysis suggests that transfer prices based on the historical cost of capacity facilitate the efficient allocation of resources. They also find that symmetric responsibility center structures are generally better suited for providing efficient investment incentives than hybrid organizations. An important condition for the derivation of the two results is the linearity of the shadow prices of capacity. If shadow prices are nonlinear, transfer prices should be below (above) the historical cost of capacity in order to counteract the managers’ incentives to underinvest (overinvest). Because profit center organizations can use transfer prices for mitigating the inefficiency caused by nonlinear shadow prices, they offer a natural advantage over pure investment center organizations in implementing efficient capacity decisions. Overall, these observations suggest that the curvature of profit functions is an important factor in determining the suitable instruments for decentralized capacity management.
We study the efficiency of negotiated transfer pricing for solving a bilateral hold-up problem in a multinational enterprise. We show that negotiated transfer pricing will generally not provide incentives for an efficient renegotiation of the initial contract and efficient investments because the divisions possess only one instrument for solving two problems. Either they minimize taxes or they redistribute the gains from efficient trade. The second-best solution solves the renegotiation problem under the arm`s length constraint. It entails that the firm either executes the ex-ante contract or entirely ignores tax considerations when making a quantity adjustment. We also find that the optimal investment decision and the optimal ex-ante contract are governed by the nature of the international tax difference.
