Optimal Transfer Pricing: Competition Mode, Demand and Strategic Characteristics, and Production Technology

Abstract

The objective of this paper is to find the key factors that affect a firm's optimal transfer pricing policy. It examines two minimalist vertical models -- one consisting of a vertically integrated firm monopolizing an intermediate input for its own and rival's downstream division, and the other comprising two vertically integrated firms competing in a final goods market. Four modes of competition are considered -- Cournot, Bertrand, Stackelberg quantity and price. The paper shows that, in addition to the usual tax considerations, the optimal transfer pricing policy depends on competition mode, demand and strategic characteristics, vertical structure, and production technology. For example, under the same demand structure and competition mode, the two models can yield diametrically opposite outcomes; within a given vertical model, different competition modes may yield different optimal strategies; and within a given competition mode, the four pairings of ordinary substitutes/complements and strategic substitutes/complements can also produce quite different results. The general structure analyzed in this paper can be applied to other transfer pricing models involving uncertainty, cost sharing, asymmetric information, etc. that have been mainly studied in the literature under specific competition modes and demand and strategic characteristics.

Keywords: optimal transfer pricing, vertically related models, multinational firms, international taxation, strategic competition, demand characteristics

JEL Classification: D43, D49, L13, L22, M21