External and Internal Pricing in Multidivisional Firms

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.