| Abstract: | This paper analyses optimal transfer prices in a firm organized in two divisions. The production costs of the divisions are their respective private information. The objective of headquarters is to determine the transfer pricing method that maximizes total profit less managers' compensation. Managers are interested in their current compensation and in the market evaluation of their experience. In this setting, the paper discusses why particular transfer pricing methods found in practice and literature may induce-inefficiencies, and it identifies conditions under which each method is preferable. Major results are: a market-based transfer price does not implement the first-best solution if there are benefits from internal trade; cost-based transfer,prices may achieve first-best, and they are preferable to negotiated transfer prices if communication is cost-less; dual transfer prices do not implement the first-best solution, as long as collusion cannot be discouraged. ‘There are two truisms in business. Transfer prices are wrong and charges for corporate overhead are too high.‘1 |
