The Arm’s Length Principle and Tacit Collusion

Abstract

The arm’s length principle states that the transfer price between two associated enterprises should be the price that would be paid for similar goods in similar circumstances by unrelated parties dealing at arm’s length with each other. This paper examines the effect of the arm’s length principle on dynamic competition in imperfectly competitive markets. It is shown that the arm’s length principle renders tacit collusion more stable. This is true whether firms have exclusive dealings with unrelated parties or compete for the demand from unrelated parties.

Keywords: Transfer price, arm’s length principle, tacit collusion, stability of collusion

JEL Classification: D43, L13, L41