Intra-Firm Pricing: Experimental Evaluation of Alternative Mechanisms.

Abstract This research explores the economic and behavioral effects of transfer pricing in an experimental setting. Two different transfer pricing mechanisms are examined: a direct approach where the transfer price and quantity was negotiated between the divisional managers, and an indirect approach in which the divisions communicated their private information to the central headquarters which determined the transfer price and quantity. The objectives were to evaluate the two mechanisms with respect to their effects on firm profit, and the level of conflict between the two divisional managers. A total of 82 subjects, forming 41 dyads, participated in the experiment. The task for a subject was to role play as the manager of either the selling division or the buying division and to determine the number of motors to be transferred or acquired and the corresponding price using one of the two mechanisms. The results indicate a significant difference in firm profit depending on the mechanism achieving higher firm profit than the indirect mechanism. The results also demonstrate that inter-divisional conflict is significantly less under the direct approach than it is under the indirect approach..