Tradeoffs Between Specific Investment and Optimal Resource Allocation: A Comparison of Different Transfer Pricing Policies

Abstract

This paper uses a principal-agent framework to analyze the tension between incentives for specific investment by the agent, and resource allocation that is optimal from the principal’s perspective.  The analysis considers a decentralized firm in which central management can institute different transfer pricing policies to motivate divisional managers to undertake investment and production decisions.  Some well-known properties of the methods are identified: a transfer price that uses a markup over and above actual costs can provide investment incentives but leads to sub-optimal resource allocation; negotiated transfer pricing suffers from the problem of under-investment even though its ex post performance is optimal; and standard cost-based transfer pricing entails over-reporting of standards, which results in inefficient levels of trade as well as low investment.

The paper establishes a clear ranking amongst the three methods studied. It is shown that the overall performance of actual cost-based transfer pricing is superior if the buying division’s investments are important, while negotiated transfer pricing dominates if those of the selling division are important.  The overall performance of standard cost-based method is inferior to that of the actual cost-based method, even though the latter has weaker investment incentives.