Intrafirm Resource Allocation and Discretionary Actions

Abstract

The purpose of this paper is to investigate some aspects of intrafirm resource allocation as accomplished through transfer pricing techniques. Existing theories of transfer prices have several deficiencies. In the traditional transfer pricing models, researchers have posited that central management possesses as much information about the production technologies of divisions as do the division managers themselves (see, e.g., Hirshleifer [1956], Gould [1964]). Given this assumption, central management, by specifying what quantities each division should produce, can achieve the same level of profits as can be achieved by taking the more circuitous, but equivalent, route of specifying the prices that will induce individual division managers to select these same quantities. Consequently, while traditional transfer pricing models identify the implicit prices of intrafirm transfers (which may have some intrinsic interest), these transfer prices need serve no allocational role, and so the failure to implement a transfer pricing scheme has no impact on firm profits in such models.

I would like to thank Joel Demski and Jerry Feltham for detailed comments and suggestions on a previous draft of this paper, and Stan Baiman for many illuminating discussions on transfer pricing.