Do Profit - Based Cost Allocations Encourage Internal Trade ?

In this paper, we study the effect of insulating and non-insulating cost allocations on internal trade in a model of incomplete information. From the perspective of firm-wide profit, the allocation scheme that results in the least amount of rationing (forgone profitable trade) is the optimal one. If one thinks of internal trade as a form of cooperation, one might expect non-insulating allocations to increase trade. As it turns out, non-insulating cost allocations may either encourage or discourage internal trade. This is because while the non-insulating scheme imposes a tax on new trade (as does the insulating allocation) it also provides a subsidy on existing trade. The subsidy varies in a non-linear fashion with the transfer price making the comparison of the allocation methods subtle. The broader point is that, in incomplete information environments, whether or not non-insulating cost allocations encourage cooperation is context-specific.