Cost-Reducing Investments and Transfer Pricing

Abstract

This paper investigates a feature of administered transfer pricing in a decentralized firm with headquarters and two divisions. The upstream division manufactures intermediate products and ships them to the downstream division, which uses them as inputs in its production process and ultimately sells final products externally. Before production and exchange of the intermediate products take place, the upstream division undertakes cost-reducing investments. Under these circumstances, we show that the optimal transfer price exceeds the marginal cost of the intermediate products when upstream division's investment reduces the downstream division's cost of the products. This result is consistent with survey evidence on the transfer pricing practices of firms.