The Effect of Environmental Risk on the Efficiency of Negotiated Transfer Prices

Abstract

This study investigates whether and how environmental risk affects the efficiency (i.e., overall organizational profit) of negotiated transfer prices. We discuss three fairness-based sharing norms and the implications each would have for efficiency in our setting. We conduct an experiment in which a buying division and selling division negotiate over the transfer of a resource at six levels of environmental risk. Because the expected value of the transfer is positive, the transfer should be made from the risk neutral organization perspective. Results show that environmental risk decreases efficiency. That is, the frequency of agreement decreases as environmental risk increases. Supplemental analysis suggests that the cause of the decrease in agreements is differences in the focal points that buyers and sellers use for determining a fair transfer price. Specifically, buyers focus on the downside potential of the transfer and sellers focus on the expected value of the transfer. As environmental risk increases, the range between these focal points increases, resulting in failed negotiations (i.e., inefficiencies). Implications for practice and theory are discussed.

Keywords: Transfer price, negotiations, uncertainty, focal points

JEL Classification: C78, D81, L22, M49, M55