Optimal Transfer Pricing in a Vertically-Related and Imperfectly Competitive Market

Abstract

The objective of this paper is tond the signicant factors that crucially affect arm's optimal transfer pricing policy. To achieve such a goal, it sufces to examine three minimalist vertical models— therst one contains a vertically integrated monopoly in both input and output markets, the second one consists of a vertically integratedrm that monopolizes an intermediate input for its own and ri- val's downstream divisions and the third one comprises two vertically integratedrms competing in a �nal goods market. Four modes of competition are considered—Cournot, Bertrand, Stackelberg quan- tity and Stackelberg price. The paper shows that the optimal transfer pricing policy depends on four specications—the vertical structure, the production technology, the demand characteristics and the competition mode. Itnds numerous patterns on optimal transfer pricing: for example, under the same demand structure and competition mode, the two vertical models can yield diametrically opposite trans- fer pricing strategies; within a given vertical model, different competition modes may yield the same or different optimal strategies; and within a given competition mode, the four possible pairings of ordinary substitutes/complements on the demand side and strategic substitutes/complements on therm side can also produce quite different results. In addition, the paper illustrates how the optimal transfer pricing policy is affected when the additional factors of income tax and tariff distortions are considered. With all the signicant factors affecting the optimal transfer pricing delineated, the paper has laid a foundation for further studies in transfer pricing under more general structures. An important implication of our results is that the optimal transfer pricing policy may not be simply determined by the common practice of shifting prots from high- to low-tax jurisdictions.