Question

Discuss Pricing of an Internal Trade between two divisions of a firm. Especially, discuss coordination, when division managers are evaluated as profit centers and the objective of internal pricing is to maximize the firm-wide profit.

Answer 1

Multidivisional firms frequently rely on external market prices in order to value internal transactions across profit centers. This paper examines marketbased transfer pricing when an upstream division has monopoly power in selling a proprietary component both to a downstream division within the same firm and to external customers. When internal transfers are valued at the prevailing market price, the resulting transactions are distorted by double marginalization. The imposition of intracompany discounts will always improve overall firm profits provided the supplying division is capacity constrained. Under certain conditions it is then possible to design discount rules so that the resulting prices and sales quantities are efficient from the corporate perspective. In contrast, the impact of intracompany discounts remains ambiguous when the capacity of the selling division is essentially unlimited. It is then generally impossible to achieve fully efficient outcomes by means of market-based transfer pricing unless the external market for the component is sufficiently larger relative to the internal market.