Decentralization and Transfer Pricing Under Oligopoly.

• Author: Zhao, Laixun
• Position: Product Announcement

Laixun Zhao [*]

This paper presents a simple model of a partially decentralized multinational firm (MNF) in competition with a rival firm. It is shown that transfer pricing can be used as a rent-shifting device by the MNF to compete with the rival. This arises because the MNF headquarters uses the transfer price to manage different subsidiaries. The specific value of the transfer price chosen by the MNF depends on whether the rival firm produces the intermediate good, the final good, or both and whether the rival is integrated or not. In particular, both decentralization and competition with a fully integrated rival result in lower transfer prices.

1. Introduction

   Recent studies of transfer pricing in the accounting and management literature emphasize that the problem arises because of decentralization of firm activities (Amershi and Cheng 1990; Grabski 1985; Halperin and Srinidhi 1991; Hansen and Kimbrell 1991). Decentralization brings several benefits, such as overcoming the limited information processing capabilities of the headquarters, reducing the cost of control, providing better incentives for subsidiaries, and so on. However, decentralization brings costs along with benefits, namely, subsidiaries maximize their own branch profits, even if such actions may reduce total firm profitability. Because of these benefits and costs of decentralization, the central management desires decentralized centralization, that is, in order to reap the benefits and alleviate the costly behavior, it uses transfer pricing to manage different subsidiaries and to maximize the total firm profits. Empirical studies such as Tang (1980) and Wu and Sharp (1979) support this view. They fo und that profit maximization of the whole firm and performance evaluation of the subsidiaries were the dominant objectives for transfer pricing.

   Economic analysis of transfer pricing in the decentralized (divisionalized) multinational firm (MNF) includes studies by Hirshleifer (1956), Bond (1980), Katrak (1983), Diewert (1985), and Eden (1995), among others. An important result is that in the absence of tax rate differentials across countries, the transfer price is the marginal cost of the upstream branch; in the presence of tax rate differentials, the transfer price is a corner solution, that is, either the upper bound or the lower bound, exogenously imposed by regulating governments.

   However, multinationals operate in markets that are not perfect. The above analysis treats the upstream branch as perfectly competitive, thus resulting in the transfer prices being equal to the upstream branch's marginal cost in the absence of tax rate differentials. But in order to improve profit performance, the transfer price must be set at the right level so that there are autonomy and incentives in all divisions, because a higher transfer price increases the profits of the upstream branch but at the expense of the downstream branch. Thus, some affiliate control is necessary to induce efficiency.

   Also, the literature on transfer pricing focuses on the interaction between governments and the MNF and between branches of the MNF. The interaction between the MNF and other firms has been largely neglected. Yet it seems reasonable to expect that if the rival is an input supplier or just an output producer, then it relies on the MNF either for final output sales or for input supply. In such cases, the vertically integrated MNF may use transfer pricing to manipulate profit distribution across branches to take advantage of the unintegrated rival. The fact that many unintegrated firms try to become fully integrated illustrates this point. [1]

   This paper studies the problem of transfer pricing in ways that incorporate some of the above missing features. Namely, we consider decentralization of the MNF and competition with a rival, which may be either vertically integrated or unintegrated. With these new features, we see clearly how the MNFs actively use transfer pricing to shift profits between branches to compete against rival firms.

   We assume a partially decentralized MNF, so the headquarters determines the transfer price and the downstream branch determines the level of the final output. Thus, in this model both branches share decision making, and still the headquarters retains control of the transfer price. In determining the transfer price, the headquarters maximizes the total profits of the MNF, not just those of one branch. The governments in the two countries use tax rates to affect firm profits. This setup follows the approach recently emphasized in the accounting and management literature, that is, the transfer price may be used as an incentive scheme to induce efficiency in different divisions in addition to minimizing taxes paid by the MNF. Recent theoretical models that use a similar structure include Elitzur and Mintz (1996) and Janeba (1996), which focused on corporate tax competition between two governments. Zhao (1998) investigated the impact of labor-management bargaining on transfer prices. In more general settings, Bra nder and Spencer (1985) analyzed the government's strategic use of subsidies (taxes) to shift profits between international duopolists, and Fershtman, Judd, and Kalai (1991) demonstrated how principals can use agents strategically by delegating decision making.

   With the above setting, we first show that partial decentralization of the MNF lowers the transfer price. Because from the headquarters' point of view, the downstream branch with market power produces too little output, a lower transfer price lowers the marginal cost of the downstream branch and induces more output. This result contrasts with those in Katrak (1983), who shows that "indigenisation" of ownership under global profit maximization may induce the subsidiary to produce a smaller output in a setting in which the parent and the subsidiary produce similar (and therefore competing) products.

   We add a rival firm to this framework and show that transfer pricing can be used as a rent-shifting device by the MNF to compete against the rival. Special cases in which the rival produces (i) only the final output, or (ii) only the intermediate input are also investigated. One might expect the MNF to charge a lower transfer price compared with the case when the rival is fully integrated, because in case (i) the MNF needs to induce more final output from the downstream branch to compete with the rival, and in case (ii) the MNF needs a lower transfer price to force a lower input price from the rival. However, we find that, surprisingly, the optimal transfer prices are higher for given levels of output, compared with the case when the rival is fully integrated.

   Finally, we demonstrate that because of decentralization and the possibility of profit-shifting by the MNF, the optimal transfer price may be in the interior, in contrast to the boundary prices obtained in the literature.

   Recently, a number of economists have studied trade in vertically related markets, for instance, Holm (1997), Ishikawa and Lee (1997), Ishikawa and Spencer (1999), Madan (1992), Spencer and Jones (1991, 1992), and Ziss (1997). These authors analyze the impact of government policies in shifting rents between a domestic firm and a foreign firm (either or both can be vertically integrated or unintegrated) and between intermediate input producers and final output producers. In contrast, the present paper analyzes competition in vertically related markets from a different perspective; that is, we focus on the MNF's active use of transfer pricing instead of on the strategic trade policies of governments. To the best of our knowledge, the role of transfer prices as a rent-shifting device under oligopoly has not been previously analyzed.

   Section 2 presents the basic model, section 3 analyzes the case in which the rival firm produces only the final output, section 4 considers the case when the rival produces only the intermediate input, and section 5 concludes.

2. The Basic Model

   Consider an MNF consisting of two subsidiaries, with the upstream branch and the headquarters located in the home country and the downstream branch located in the foreign country. The upstream branch produces one intermediate input, with a gross profit function of

   [[pi].sub.u] = mx - c(x), (1a)

   where m is the transfer price of selling the intermediate input to the downstream branch, x is the quantity of the intermediate input, and c(x) is the cost of producing x, with c' [greater than] 0 and c" [greater than or equal to] 0. The downstream branch uses both the intermediate input and labor to produce the final output. Because we do not focus on the substitutability between the intermediate input and labor, we simply assume that one unit of the final output requires one unit of the input and labor, respectively, by a proper choice of units. The downstream branch's gross profit function can be written as

   [[pi].sub.d] = (p - m - w)x, (1b)

   where w is the unit wage cost, p = p(x + y) is the inverse demand function for the final output sold in the foreign country only, and y is the output of the foreign firm, to be explained below.

   In the foreign country, there is also a rival firm, which is initially assumed to be fully integrated. By this, we mean it produces both the intermediate input and the final output in a...