Internal Pricing

This monograph focuses on the use of incomplete contracting models to study transfer pricing. Intrafirm pricing mechanisms affect division managers’ incentives to trade intermediate products and to undertake relationship-specific investments so as to increase the gains from trade. Letting managers negotiate over the transaction is known to cause holdup (underinvestment) problems. Yet, in the absence of external markets, negotiations frequently outperform cost-based mechanisms, because negotiations aggregate cost and revenue information more efficiently into prices. This result is established in a symmetric information setting and confirmed, with some qualification, for bargaining under incomplete information. In the latter case, trading and investment efficiency can be improved by adding non-financial performance measures to a divisional performance measurement system. 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. *The author would like to thank Brian Mittendorf (the reviewer), Neale O’Connor and Stefan Reichelstein for their helpful comments.