Abstract The article provides some interesting results as to optimal transfer pricing activity. It is shown that if communication is costless, centralized decision-making is always preferred to decentralized decision-making. Furthermore, the article analyzes how high the costs of communication need to be before decentralization is optimal. Describing a transfer price, which induces the divisions of a divisionalized firm to act in the firm's best interest, has long been a problem in the accounting literature. This article also examines the equilibrium characteristics of decentralized decision-making so as to provide insights into the design of optimal transfer pricing systems. A two-agent principal-agent model is examined under a more restrictive definition of decentralization. Decentralized decision-making is possible if the optimal contracts defined by the principal-agent model do not require a center to which each division reports its private information. The final, and most important, result shows that the intermediate product is always transferred at the optimal level, even under information asymmetry.
Jeffrey A. Yost (Sat,) studied this question.
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