Internal Pricing

This monograph focuses on the use of incomplete contracting models tostudy transfer pricing. Intrafirm pricing mechanisms affect division managers'incentives to trade intermediate products and to undertake relationship-specificinvestments so as to increase the gains from trade. Letting managers negotiateover the transaction is known to cause holdup (underinvestment) problems. Yet,in the absence of external markets, negotiations frequently outperform cost-basedmechanisms, because negotiations aggregate cost and revenue information moreefficiently into prices. This result is established in a symmetric informationsetting and confirmed, with some qualification, for bargaining under incompleteinformation. In the latter case, trading and investment efficiency can be improvedby adding non-financial performance measures to a divisional performance measurementsystem. When the intermediate product can also be sold in an imperfectly competitive external market, internal discounts on external market prices are shown often to improve the efficiency of intrafirm trade and of upfront investments.