Studies in the theory of transfer pricing

The transfer of goods between divisions is an integral part of the operation of most decentralized firms. The method used by such a firm for pricing internal transfers is an important instrument for coordinating the activities of its constituent divisions. Research surveys have documented widespread use of various transfer pricing methods in large corporations but there is no systematic theory that relates the performance of alternative methods to economic factors or features of the firm's operating environment.;This dissertation develops a formal model of a decentralized firm and uses it to analyze and compare the performance of the following commonly used transfer pricing policies: (i) actual cost-based, (ii) standard cost-based, and (iii) negotiated. My model adopts an incomplete contract framework that allows divisions to make unverifiable fixed-cost investments that enhance the value of subsequent trade. The performance of a transfer pricing policy is determined both by the incentives it creates for ex ante investment, as well as by its effect on ex post resource allocation.;My first result is that the performance of actual cost-based transfer pricing can be improved by using a markup over and above unit variable cost. This result provides theoretical justification for the observed prevalence of markups, and reflects the intuition that a successful transfer pricing policy must trade off profit maximization against fairness in divisional performance evaluation. My analysis also yields a method for computing the optimal markup in terms of model parameters.;Standard cost-based transfer pricing is shown to lead to over-reporting of standards, which results in inefficient trade levels of trade. The overall performance of this method is inferior to that of the actual cost-based method, even though the latter has weaker investment incentives.;Negotiated transfer pricing leads to efficient trade ex post but suffers from underinvestment. Its performance is inferior to that of actual cost-based transfer pricing if the buying division's investment is more important, while the opposite is true if the selling division's investment is more important. I also find sufficient conditions on the curvature of the firm's marginal revenue function under which negotiated transfer pricing outperforms standard cost-based transfer pricing.