External and Internal Pricing in Multidivisional Firms

Stanford GSB Working Paper No. 1825(R)

43 Pages Posted: 2 Feb 2004

See all articles by Tim Baldenius

Tim Baldenius

Columbia Buiness School

Stefan J. Reichelstein

Stanford University - Stanford Graduate School of Business; CESifo (Center for Economic Studies and Ifo Institute)

Multiple version iconThere are 2 versions of this paper

Date Written: November 2004

Abstract

Multidivisional firms frequently rely on external market prices in order to value internal transactions across profit centers. This paper examines the transfer pricing problem in a setting in which 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. We ask whether the imposition of intracompany discounts can alleviate or even eliminate the effects of double marginalization. When the production capacity of the upstream division is effectively unconstrained, we find that discounts will increase the firm's overall profit only under certain conditions. At the same time, it is impossible for any discount rule to induce prices and sales quantities that fully maximize the firm's corporate profit. In contrast, if the production capacity of the selling division is constrained, suitably chosen discounts will always improve the firm's overall profit relative to a policy under which internal transfers are valued at the market price. With constrained capacity, we identify conditions under which discounts set inversely to the external price elasticity of demand can fully eliminate the double marginalization problem and thereby achieve efficient decentralization.

Suggested Citation

Baldenius, Tim and Reichelstein, Stefan J., External and Internal Pricing in Multidivisional Firms (November 2004). Stanford GSB Working Paper No. 1825(R). Available at SSRN: https://ssrn.com/abstract=491662 or http://dx.doi.org/10.2139/ssrn.491662

Tim Baldenius

Columbia Buiness School ( email )

3022 Broadway
New York, NY 10027
United States

Stefan J. Reichelstein (Contact Author)

Stanford University - Stanford Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States
650-736-1129 (Phone)
650-725-7979 (Fax)

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

HOME PAGE: http://www.CESifo.de

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