DISCUSSION PAPER SERIES IN ECONOMICS AND MANAGEMENT Market- versus Cost-based Transfer Pricing, Intra-Company Coordination and Competitive Behavior on the Intermediate Market Clemens Löffler & Thomas Pfeiffer Discussion Paper No. 13-17 GERMAN ECONOMIC ASSOCIATION OF BUSINESS ADMINISTRATION – GEABA Market- versus cost-based transfer pricing, intra-company coordination and competitive behavior on the intermediate market Clemens Loe er and Thomas Pfei er, University of Vienna Abstract. This paper examines properties and compares the e ectiveness of market- versus costbased transfer pricing. Transfer pricing provides speci c investment incentives, governs competitive behavior on the intermediate market and guides intra-company trade. In particular, we study market-based transfer prices that are based either on the rm's price (controllable market-based transfer pricing) or the competitor's price (uncontrollable market-based transfer pricing), actual cost-plus and standard cost-based transfer pricing. The optimal controllable market-based and costplus transfer price both entail a markup over (expected) marginal costs and the optimal standard cost-based transfer price equals expected marginal costs, while the optimal uncontrollable marketbased transfer price entails a discount. Re ning routinely made suggestions in textbooks, we nd broadly stated that (i) uncontrollable market-based transfer pricing is optimal for intermediate cost uncertainty when the intensity of competition is not too high, (ii) the controllable marketbased transfer pricing is optimal for high intensity of competition when the cost uncertainty is not too high, (iii) cost-plus transfer pricing is optimal if cost uncertainty is su ciently high, and (iv) standard cost-based transfer pricing is optimal if the intensity of competition is not too high and cost uncertainty is rather low. 1 Introduction A classical research question refers to the e ectiveness of market- versus cost-based transfer pricing to coordinate decentralized companies (e.g. Eccles 1983, 1985). Based on neoclassical analysis (Cook 1955, Hirshleifer 1956), managerial accounting textbooks routinely propose to use marginal actual costs as the transfer price in the case of a monopolistic intermediate market, and the unadjusted market price in the case of a perfect intermediate market (e.g. Drury 1996, Atkinson et al. 2001, Horngren et al. 2009). As indicated by several empirical studies, however, rms deviate from this suggestion using a variety of quite di erent market-based and cost-based transfer pricing methods that are determined by means of adjustments.1 Since in most cases intermediate markets are di erentiated, rms can base the market-based transfer price either on the rm's price (controllable market-based transfer price) or on the competitor's price (uncontrollable market-based transfer price). Besides actual cost-based transfer pricing, standard cost-based transfer pricing is frequently used in practice. Up to now a coherent analysis of these frequently discussed market- and cost-based transfer pricing methods is missing, including uncontrollable and controllable market-based transfer pricing, actual cost-plus and standard cost-based transfer pricing.2 This paper provides systematic insights about properties and the e ectiveness of these transfer pricing methods to alleviate intra-company coordination problems in the presence of an imperfect intermediate market. To elaborate, we use a simple model of a decentralized rm with two divisions. Division 1 produces an intermediate good that is sold externally and which is also used by Division 2 to procure a nal good. While Division 2 acts as a monopolist on the nal market, Division 1 faces di erentiated Bertrand price competition on the intermediate external market. Division 1 can reduce its costs by undertaking speci c investments up-front. Lower costs enhance the value of intracompany trade and make competition on the intermediate market more aggressive. Transfer pricing provides up-front investment incentives, governs competitive behavior on the intermediate market 1 Previous empirical studies have found that a majority of companies apply variants of market- or cost-based transfer prices. According to Ernst and Young (2011), 39% to 44% of the interviewed rms adopt a market-based approach and 30% to 36% adopt a cost-based approach. Emmanuel and Mehafdi (1995) provide a rigorous comparison of various studies. 2 In this vein, for instance, Baldenius (2008, p. 295) states at the end of his survey on internal pricing that it \would be desirable if future research could develop a comprehensive theory of how alternative pricing mechanisms perform in settings that account for various external market environments." 1 and guides intra-company trade. Broadly stated, we synthesize previous transfer pricing literature on incomplete contracting (e.g. Baldenius, Reichelstein and Sahay 1999) with the literature on competitive behavior on the intermediate market (Arya and Mittendorf 2008).3;4 Market-based transfer prices are frequently calculated by adjusting the external market price which serves as a reference price (e.g., Atkinson et al. 2001). Under di erentiated Bertrand competition, the rm can either use the competitor's or Division 1's price as a reference price. Under the uncontrollable market-based transfer price Division 1's pricing decision on the intermediate market does not in uence its pro t from intra-company trade since the competitor's price cannot be in uenced strategically under simultaneous Bertrand competition. In contrast, under the controllable market-based transfer price Division 1's pricing decision on the intermediate market in uences its pro t from intra-company trade which in uences Division 1's behavior on the intermediate market.5 By linking the two markets, controllable market-based transfer pricing induces a competitive advantage on the intermediate market, but derails trade on the internal market. Linking the two markets with the controllable market-based transfer price is quite e ective if the intensity of competition is high, while the uncontrollable market-based transfer price is quite effective if the intensity of competition is low. The controllable market-based transfer price further has the advantage that Division 1's market-based transfer price re ects more accurately Division 1's actual costs for intra-company trade than the uncontrollable market-based transfer price. Summing up, the uncontrollable market-based transfer price dominates the controllable market-based transfer price if both the cost uncertainty and the intensity of competition are not too high. Our analysis provides interesting insights into the determination of additive markups and discounts that are frequently applied in practice to correct for market imperfections (e.g. Drury 1996, 3 Abstracting from an external intermediate market, previous transfer pricing literature on incomplete contracting has analyzed investment and trade incentives of cost-based and negotiated transfer pricing methods (e.g. Baldenius, Reichelstein and Sahay 1999, Baldenius 2000, Sahay 2003, Johnson 2006, Pfei er, Schiller and Wagner 2011, and Baldenius 2008 for an excellent overview). Focusing on strategic delegation, Arya and Mittendorf (2008) have studied the competitive advantage of controllable market-based versus cost-based transfer pricing thereby abstracting from intra-company coordination problems arising from speci c investment problems and cost uncertainty (see Arya and Mittendorf 2010 for an excellent overview on this branch of literature). 4 Consistent with the basic analysis of Arya and Mittendorf (2008), we assume the rm acts as a monopolist on the nal market. In contrast to previous literature, we do not consider strategic considerations on the nal market (e.g. Alles and Datar 1998). Arya and Mittendorf (2008, 2010) provide a discussion of key di erences between the two set-ups and on the strategic delegation literature in general (e.g. Gal-Or 1993, Hughes and Kao 1997) that also applies to our model. 5 For instance, Feinschreiber (2004) notes that controllable market transfer pricing can induce opportunistic pricing behavior. 2 Atkinson et al. 2001). Accounting for Division 1's opportunistic behavior, the optimal controllable market-based transfer price entails a markup over expected marginal costs in order to decrease Division 1's price on the intermediate market. The markup is decreasing with the intensity of competition, since the rm has an incentive to soften competition.6 In contrast, the optimal uncontrollable market-based transfer price entails a discount to increase demand on the nal market and thus investments, since Division 1 has an incentive to underinvest in order to increase the competitor's price and thus its intra-company pro t. The discount is increasing with the intensity of competition, since increasing intensity of competition increases Division 1's incentives for such opportunistic behavior.7 Textbooks frequently suggest using actual marginal cost transfer price for a monopolistic intermediate market, i.e. in the absence of competition. Accounting for the fact that rms frequently use standard cost-based transfer pricing, we provide rst a performance comparison of these two cost-based transfer pricing schemes. The cost-plus transfer price determines the transfer price as actual costs plus a markup, while the standard cost-based transfer price is determined by central o ce ex-ante. The standard cost-based transfer price separates the pricing decisions of the two markets and provides the same investment decisions as an integrated rm. Under the cost-plus transfer price, Division 1's pro t from intra-company trade equals the markup times the traded quantity. Although a positive markup distorts intra-company trade, it is optimal to apply a markup that provides stronger investment incentives to reduce the costs which in turn increase intra-company trade. The optimal markup decreases with increasing intensity of competition since the rm has an incentive to soften competition.8 If costs are deterministic, the cost-plus transfer price induces less e cient investment and trade incentives so that the standard cost-based transfer price always dominates. Since in contrast to the standard cost-based transfer price, the cost-plus transfer price transmits actual cost information to the internal market, cost-plus transfer pricing dominates if 6 Focusing on strategic delegation, Arya and Mittendorf (2008, p. 728) nd that the optimal controllable marketbased transfer price entails a discount over marginal costs in the case of Bertrand competition. Our model comprises a similar strategic e ect as in Arya and Mittendorf (which decreases the markup), but also entails a countervailing stronger e ect from the intra-company coordination problem (which increases the markup). In the absence of competition, the optimal controllable market-based transfer price entails a markup. The markup is decreasing with increasing intensity of competition, since the strategic a ect becomes more important. 7 In the absence of competition, the optimal uncontrollable market-based transfer price equals the expected marginal costs. 8 Abstracting from an external intermediate market, Sahay (2003) has shown that the optimal cost-plus transfer price entails a markup over marginal costs to provide cost-reducing investment incentives. Our analysis complements this nding by showing that the size of the markup should be decreasing with the intensity of price competition. 3 cost uncertainty is su ciently high (and vice versa). To the best of our knowledge, we are the rst to use an incomplete contracting approach and systematically provide insights into the structure and the e ciency of market- versus cost-based transfer pricing combining strategic external competition and intra-company coordination problems.9 Our results re ne suggestions in textbooks to use marginal actual cost-based transfer pricing in the absence of competition on the intermediate market and the unadjusted market price in the case of a perfect intermediate market. Comparing all these transfer pricing schemes, we nd broadly stated that (i) the uncontrollable market-based transfer price is optimal for low up to intermediate intensity of competition and intermediate cost uncertainty, (ii) the controllable market-based transfer price is optimal for high intensity of competition if cost uncertainty is not extremely high, (iii) cost-plus transfer pricing is optimal if cost uncertainty is su ciently high, and (iv) standard cost-based transfer pricing is optimal if the intensity of competition is not too high and cost uncertainty is rather low. In the absence of competition, the two cost-based transfer prices weakly dominate the market-based transfer prices. In the absence of cost uncertainty, the standard cost-based and the controllable market-based transfer prices are the optimal schemes. Our analysis is related to the following work. In the absence of competition, Baldenius and Reichelstein (2006) have analyzed the e ectiveness of controllable market-based transfer prices to coordinate intra-company trade. Abstracting from intra-company coordination problems, Arya and Mittendorf (2008) have shown that the controllable market-based transfer price always dominates actual and standard cost-based transfer prices which are identical in the absence of speci c investments and cost uncertainty.10 Our result complements these ndings by showing that standard cost-based transfer pricing is e ective if cost uncertainty is low and the intensity of competition is not too high. Actual cost-based transfer pricing is e ective if cost uncertainty is rather high, while 9 To provide a non-trivial performance comparison, all components of our model are necessary, i.e. speci c investments, cost uncertainty and competition on the intermediate market. In fact, we nd (i) that in the absence of speci c investments standard cost-based transfer pricing is never superior, (ii) that in the absence of cost uncertainty cost-plus transfer pricing is never superior, and (iii) that in the absence of competition on the intermediate market the two market-based transfer pricing schemes are never superior. 10 Our analysis also extends previous ndings on the structure of controllable market-based transfer pricing. In fact, in the absence of competition Baldenius and Reichelstein (2006) have shown that the optimal controllable marketbased transfer pricing entails no markup over expected costs to coordinate optimally the intra-company coordination problem. In the absence of an intra-company coordination problem Arya and Mittendorf (2008) have shown that the optimal controllable market transfer pricing entails a discount over (expected) costs to facilitate a strategic advantage in the case of Bertrand competition. Somewhat surprisingly, our analysis shows that the interrelation of intra-company coordination and strategic interaction on the intermediate market necessitates a markup. 4 controllable market-based transfer pricing is quite e ective for high intensity of competition and not too high cost uncertainty. Abstracting from competition on the intermediate market, Pfei er (2011) has investigated uncontrollable market-based transfer pricing.11 Abstracting from an external intermediate market, previous literature has studied the e ectiveness of various cost-based transfer pricing methods (Baldenius, Reichelstein and Sahay 1999, Baldenius 2000, Sahay 2003, Pfei er, Schiller and Wagner 2011). Our analysis complements a key nding of this literature that standard cost-based transfer pricing dominates cost-plus transfer pricing if cost uncertainty is not too high.12 In contrast to all these work, in our model the cost-reducing investments generate strategic e ects on the competitor that di er signi cantly depending on the individual transfer pricing schemes.13 In an extension section, we study the case of di erentiated Cournot competition on the intermediate market. In contrast to Bertrand competition, the rm facilitates a competitive advantage by increasing the investments more aggressively. Since the competitor's external price depends on the quantities on the intermediate market, yet uncontrollable market-based transfer pricing also links the two markets.14 Nevertheless, our main results concerning the e ectiveness of the individual transfer pricing schemes are similar to those of the Bertrand case. However, in contrast to Bertrand competition, the controllable market-based transfer price is dominated if the external and intra-company market have the same size.15 11 Modeling the uncontrollable market-based transfer price as a random variable that is correlated with the rm's costs, Pfei er (2011) studies uncontrollable market-based transfer pricing using non-linear demand and transfer pricing functions. While consistent with previous studies our analysis is restricted to simple discounts and linear demand functions. Our setup explicitly considers competition on the intermediate market and strategic e ects of investments on the competitor. In the absence of competition, the rm's costs and the uncontrollable market-based transfer price are uncorrelated in our setting. 12 In particular, our analysis adds the following. (i) In the absence of competition, cost-based transfer pricing is not dominated by market-based transfer prices. (ii) In the presence of an imperfectly competitive market, actual cost-based transfer pricing is optimal if cost uncertainty is su ciently high irrespective of the intensity of competition. (iii) Although standard cost-based transfer prices are the simplest transfer pricing scheme they can be e ective if cost uncertainty is su ciently low and the intensity of competition is not extremely high. 13 From a broader perspective, our paper relates to the industrial organization literature on R&D competition which studies oligopolistic market competition when rms can conduct cost-reducing investments before engaging in competition (e.g. Brander and Spencer 1983, d'Aspremont and Jacquemin 1988, Suzumura 1992). Focusing on intra-company coordination problems in decentralized companies, we nd that depending on the applied transfer pricing scheme the strategic bene t of investments can di er signi cantly. 14 In contrast to our previous analysis, the optimal uncontrollable market-based transfer price entails a markup to facilitate a comparative advantage on the intermediate market. Similarly, the size of the markup for cost-plus transfer pricing is c.p. increasing with the intensity of competition in order to increase the aggressiveness of competition via higher investments. 15 Studies on transfer pricing have documented that the magnitude of intra-company trade can vary greatly across rms (e.g. Emmanuel and Mehafdi 1995, Chapter 3). Our nding predicts that under quantity competition the controllable market-based transfer price should not be prevalent for ancillary intra-company trade. 5 The reminder of the paper is organized as follows. Section 2 presents the basic set-up and investigates as a benchmark the case of an integrated rm. Section 3.1 studies the e ectiveness of market-based transfer pricing. Section 3.2 investigates the e ectiveness of cost-based transfer pricing. Section 3.3 provides a performance comparison between market- and cost-based transfer pricing. Section 4 reports brie y ndings for the case of Cournot competition. Section 5 concludes. 2 Model 2.1 Basic set-up We consider a decentralized rm that consists of two divisions. Division 1 produces a (intermediate) good that can be sold on an external market or used by Division 2 to produce a nal product for its external market. Without loss of generality, one unit of the intermediate good is converted into one unit of the nal product, with the cost of conversion normalized to zero. For simplicity, we refer to Division 1's external market as intermediate market and to Division 2's external market as nal market. Division 1 can reduce the production costs by undertaking speci c investments up-front, when costs are still uncertain. To elaborate, Division 1 faces di erentiated Bertrand competition on the intermediate market from a competitor C. To keep the exposition simple, we normalize C's production costs to zero. From the standard inverse demand function, pi (qi ; qj ) = aI qi qj with i; j = 1; C and i 6= j, (1) we get the demand system on the intermediate external market (e.g. Singh and Vives 1984) qi (pi ; pj ) = aI 1+ pi 1 2 + pj 1 2 with i; j = 1; C and i 6= j; (2) where, p1 and, pC , denote the prices on the intermediate market by Division 1 and C, respectively; q1 (p1 ; pC ), and, qC (pC ; p1 ), denote the quantities sold by Division 1 and C, respectively; a denotes the consumers' maximum willingness to pay. The parameter competition, 2 [0; ] measures the intensity of < 1. A lower value (higher degree of di erentiation) implies a lower intensity of competition (and vice versa). If = 0, Division 1 enjoys monopoly power. Division 2 enjoys monopoly power in the nal market with the demand function 6 q2 (p2 ) = aF p2 ; (3) where q2 denotes the quantity sold for a price of p2 and aF denotes the consumers' maximum willingness to pay. For sake of simplicity, we assume aI = aF = a. The appendix details the exact conditions that guarantee interior solutions for all equilibria, i.e. positive quantities and costs and that all second-order conditions are ful lled. Figure 1 depicts the sequence of events. - Please insert Figure 1 At date 0, the central o ce speci es the transfer pricing method. We discuss the particular methods subsequently. At date 1, Division 1 undertakes speci c investments, I 2 [0; I]. The investments generate non-contractual xed costs of w(I) = I 2 =2. Given the investment level, Division 1's cost per unit is given by: C(I) = (c the productivity of investments I, a > C(I) c 2 [c; c] and c xI), where c denotes basic costs and x denotes 0. The basic costs are uncertain, c = c + ", where denotes the expected costs that are inferred by an uncorrelated noise term ", i.e. E["] = 0 and V ar ["] = 2. At date 2, all parties learn the realization of the costs. At date 3, Division 1 and the competitor C determine their prices for the intermediate market. Finally, at date 4, Division 2 makes its pricing decision at the nal market. The pro t of each division is calculated according to the transfer pricing rule. Each division is run by a risk-neutral manager who seeks to maximize the pro t of its division. Given the transfer price t, the pro ts of Division 1 and 2 and the competitor are given by: 1 = [p1 c(I)] q1 (p1 ; pC ) + [t 2 = [p2 t] q2 (p2 ) C = pC qC (p1 ; pC ): The rm's corporate pro t is given by: 2.2 Benchmark case: integrated = C(I)] q2 (p2 ) w(I) (4) 1 + 2. rm As a convenient benchmark for our subsequent analysis, we rst abstract from intra-company coordination problems and investigate the optimal decisions for the integrated rm that maximizes 7 the expected corporate pro t, = E [(p1 C(I)) q1 (p1 ; pC ) + (p2 C(I)) q2 (p2 )] w(I). (5) Backward induction provides the subgame perfect equilibrium. At date 4, the rm determines the monopoly price yielding the following standard monopoly quantity on the nal market that depends on the realized costs given the investments I, a C (I) : 2 q2 (I) = (6) At the intermediate market, the rm and the competitor determine their prices at date 3, leading to the well-known equilibrium prices in a di erentiated Bertrand duopoly (notice, the reaction functions are given by: p1 = [a (1 p1 (I) = a[2 ) + C(I) + pC ]=2 and pC = [a (1 (1 + )] + 2C(I) 2 4 and pC (I) a[2 = ) + p1 ]=2): (1 + )] + C(I) 2 4 (7) and the corresponding quantities are given by: q1 (I) = a[2 (1 + )] 4 2 2 2 C(I) 2 5 and qC (I) = a[2 (1 + )] + C(I) : 2 2 4 5 (8) The rm and the competitor determine their prices simultaneously given their expectations of the others choice. Since they are not able to strategically in uence each other, the traded quantities on the intermediate and nal market are independent (see (6) and (8)). Anticipating the optimal responses in all subsequent stages, central o ce determines the optimal investment decision that maximizes the expected corporate pro t: w0 (I ) = = @pC @C(I ) @ (q1 (I ) + q2 (I )) + @I @pC @I " # p (I ) C(I ) 1 2 xE q1 (I ) + q2 (I ) : 2 2 4 1 E (9) The rst term, xE [q1 (I ) + q2 (I )], depicts the rm's investment decision without strategic considerations, taking into account the direct marginal bene t of reducing costs. From the competitor's perspective, the rm is a Stackelberg leader who can strategically in uence the competitor's price decision. The second term, x 2 E [p1 (I ) C(I )] =( 4 8 2 1 2 ), re ects the rm's incentive to reduce the investments strategically in order to soften the price competition with the competitor. Accordingly, the investments, I; are decreasing in the intensity of competition, , and thus also the traded quantities, q1 (I ) and q2 (I ). Broadly stated, more intense competition reduces not only the traded quantity on the intermediate market, but also the one on the nal market. The rm's maximum expected corporate pro t, E [ ( )], can be stated in a convenient simple form, consisting of a basic value, B ( ), plus a exibly value, F ( ) E[ ( )] 1 2 2, (I )2 2 q1 (I )2 + q2 (I )2 = E =: B ( )+ =: B ( )+F ( ) 2 2 ] [2 [4 2 2 ] [1 2 ] + 1 4 (10) 2 2: The appendix provides the explicit form for B ( ). The basic value, B ( ), re ects the basic maximum expected corporate pro t that would be attained if the rm ignores the cost information about the realized state " when determining the prices, p1 , and p2 . The basic value is, ceteris paribus, increasing with the traded quantities, q1 and q2 , and the productivity of investments, x. Since trade takes place after costs are known, this generates a exibility value at the intermediate market of [2 3 2 2 2 ] = [4 2 2 ] [1 2 ] and a exibility value at the nal market of 2 =4. Results In the following, we are interested how frequently discussed market- and cost-based transfer pricing schemes provide investment and pricing incentives on both markets. In contrast to previous literature (e.g. Baldenius, Reichelstein and Sahay 1999, Baldenius and Reichelstein 2006, Arya and Mittendorf 2008) we study how external competition a ects intra-company coordination (and vice versa), i.e. transmitting cost information, providing investment and pricing incentives. We rst analyze market-based transfer pricing (Section 3.1), then cost-based transfer pricing (Section 3.2). Finally, we conduct a performance comparison among these methods (Section 3.3). 3.1 Market-based transfer pricing Under market-based transfer pricing, the transfer price equals a reference price less a discount that is determined by the central o ce at date 0. Throughout our analysis, we investigate two 9 market-based transfer pricing methods under which either the competitor's or Division 1's market price serves as reference price. The two methods di er in their implications on the intra-company coordination problem and on their in uence on the price competition on the intermediate market. 3.1.1 Uncontrollable market-based transfer pricing Under the uncontrollable market-based transfer price method, the central o ce uses as reference price the competitor's market price, tu = pC . Although the uncontrollable market-based transfer price method is frequently applied in practice and discussed in managerial accounting textbooks (e.g. Horngren et al. 2009), an investigation of its properties and performance in the presence of market competition is still missing. Under simultaneous Bertrand competition the competitor's price cannot be in uenced strategically by Division 1's price behavior. However, Division 1 can in uence with its cost-reducing investments the competitor's price. As a reaction, the competitor reduces its price which, ceteris paribus, is detrimental for Division 1's pro t on the external and internal market. This in turn reduces Division 1's investment incentives. Balancing these forces, central o ce determines the expected transfer price below the expected marginal costs since a discount increases the demand on the nal market and thus increases Division 1's investment incentives. To elaborate, we determine the subgame perfect equilibrium by backward induction. At date 4, Division 2 determines the monopoly price considering the transfer price, tu , instead of the costs, C(I), yielding a quantity of: q2u (pC ; ) = a tu 2 = a pC + : 2 (11) The quantity equals the one of the benchmark case if the transfer price equals marginal costs, tu = C(I) for all c. At date 3, Division 1 determines its price on the intermediate market, considering C's reaction function, pC (p1 ) = [a (1 ) + p1 ]=2 from (7). Division 1's reaction function equals the one of the benchmark case since Division 2's quantity, q2u , depends only on the competitor's price decision that cannot be in uenced by Division 1's price decision in the simultaneous Bertrand setting. Accordingly, the prices and the corresponding quantities are identical to the ones of the benchmark case, (7) and (8), and do not depend on the discount , 10 pu1 (I) = p1 (I) ; puC (I) = pC (I) ; q1u (I) = q1 (I) and u (I) = q (I) : qC C (12) At date 1, Division 1 determines the speci c investments as follows (abbreviating tu (I u ; ) = puC (I u ) ): w0 (I u ) @ 1 @puC @ 1 @pu2 @puC @C(I u ) u u (q1 (I ) + q2u (I u ; )) + + @I @pC @I @p2 @pC @I # " u (I u ) u) u) u (I u ; ) p C(I a + C(I 2t 1 2 : xE q1u (I u ) + q2u (I u ; ) 2 2 2 2 4 4 1 (13) = E = The rst term, xE [q1u ( ) + q2u ( )], depicts Division 1's investment decision without strategic considerations, accounting for that Division 1 perfectly bene ts from the cost reduction. As Stackelberg leader, Division 1 can strategically in uence the competitor's price which in turn a ects the price competition on the intermediate market as well as Division 1's pro t from internal trade. The second term, x 2 E [pu1 (I u ) C(I u )] = 2 4 1 2 , represents the strategic e ect of the investments on the price competition on the intermediate market which is identical to the one of the benchmark case. The third term, x E [a + C(I u ) 2tu (I u ; )] =(2 4 2 ), re ects Division 1's incentive to increase its pro t from internal trade. If the transfer price is below the monopoly price of the nal market, tu (I u ; ) < [a + C (I u )]=2, Division 1 has an incentive to reduce its investments in order to increase the competitor's price which in turn increases the transfer price. In equilibrium, the transfer price never exceeds the monopoly price of the nal market. The investment level, I u ( ) ; is increasing in the discount, @I u ( ) =@ discount, @q2u ( ) =@ 0, which exceeds Division 1's incentive to increase its pro t from internal E [a + C(I u ) trade, @( 0, since Division 2's demand is increasing in the 2 2tu (I u ; )] =(2 4 ))=@ . At date 0, considering the decisions of the subsequent stages central o ce determines the optimal discount, u , that maximizes the expected corporate pro t. Using E [tu (I u ; u )] = E[puc (I u )] u reveals that the expected transfer price comprises a cost minus structure, E [tu (I u ; u )] = E [C(I u ) with the expected discount of 11 mu ( )] (14) E [mu ( )] = x2 (1 2 2 ) [4 (2 + )] E[q2u ( )] x2 [8 + (4 [9 + ([5 (3 + )])])] (1 2 2 ) )(4 0: (15) The discount is, ceteris paribus, increasing in the intensity of competition, , and in the productivity of the investments, x. The reason is that, by increasing the discount, central o ce increases demand of Division 2, and in addition increases investment incentives for Division 1. In the absence of competition, = 0 (similarly, in the absence of speci c investments, x = 0), the optimal transfer price equals the expected marginal costs, inducing the same investments and expected quantities as in the benchmark case. The maximum expected corporate pro t, E [ a exibility value, F u ( ) E[ u( )] u( )], can be stated as a basic value, B u ( ), plus 2, 2 1 q1u ( )2 = E = Bu( ) + =: Bu( ) + F u( ) 8 + [4 mu ( )q2u ( ) + q2u ( )2 (9 + [5 2 2 2[4 ] [1 I u ( )2 2 (3 + )])] + ] 4[4 2 2 2 (16) 2 2 ] 2: The intra-company coordination problem yields that the basic value of the uncontrollable marketbased transfer price is always below the one of the benchmark case, B u ( ) exibility value is also below the one of the benchmark situation, F u ( ) B ( ) for all . The F ( ) for all , since the uncontrollable market-based transfer price transmits only imperfectly cost information to Division 2. In fact, in the absence of competition the transfer price transmits no cost information to Division 2. The associated exibility value at the nal market is increasing with competition. The following lemma summarizes key characteristics of the uncontrollable market-based transfer price method. For didactical reasons, we modify slightly our notation emphasizing that the equilibrium values depend on the level of competition : Lemma 1 Under the uncontrollable market-based transfer price method, (i) the expected transfer price is below the expected costs, E[tu ( )] E[C(I u ( ))] for all : (ii) The induced investments and the expected quantities on both markets are below the ones of the benchmark case, I u ( ) I ( ), E[q1u ( )] 12 E [q1 ( )] and E[q2u ( )] E [q2 ( )] for all . (iii) The maximum expected corporate pro t is given by: E [ B ( ) and F u ( ) u] = B u ( )+F u ( ) 2 where B u ( ) F ( ) for all : Our analysis complements Pfei er (2011) who has shown in the absence of competition at the intermediate market that the optimal uncontrollable market price equals the conditional expected marginal costs (plus a potential markup that diminishes for linear demand functions). Complementing this nding, our analysis shows that due to the interrelation between competition and speci c investments the optimal uncontrollable market-based transfer price entails a discount that is increasing with the intensity of competition. 3.1.2 Controllable market-based transfer pricing A disadvantage of the uncontrollable market-based transfer price is that it transmits imperfectly cost information to Division 2 yielding ine cient internal trade. As an alternative, the rm can use Division 1's market price which might re ect better Division 1's costs. Using the controllable market-based transfer price, the central o ce ties the transfer price to Division 1's market price, tc ( ) = p 1 ( ) . By linking the external and internal market, the controllable market-based transfer price provides for Division 1 a strategic opportunity to soften the competition on the external intermediate market on the expense of the internal market. The controllable market-based transfer price provides also the advantage to lower competition on the external market through the investments and the discount. To elaborate, at date 4, Division 2 determines the monopoly price given the transfer price, tc , yielding the following quantity q2c (p1 ; ) = a tc 2 = a p1 + : 2 (17) In contrast to the uncontrollable market-based transfer price, the transfer price is directly in uenceable by Division 1. At date 3, Division 1 determines its price, considering C's response, pC (p1 ) = [a (1 from (6) and Division 2's response q2 (p1 ; ) from (17), 13 ) + p1 ]=2 d 1 dp1 = = The rst term, [a (1 @ [p1 C(I)] q1 (p1 ; pC ) @ [tc (p1 ) + @p1 a (1 ) 2p1 + pC 2 1 ) 2p1 + pC C(I)] q2c (p1 ; ) @p1 C(I) a + C(I) + 2 2 C(I)]= 1 2tc (18) : , represents the standard reaction function of 2tc ] =2, represents the impact of Division 1's the Bertrand duopoly. The second term, [a + C(I) pricing decision on internal trade. Increasing the price, p1 , decreases internal trade, q2 , but in turn increases the transfer price, tc . The second term is positive as long as the transfer price is below the monopoly price of the nal market, tc < [a + C (I)] =2. In equilibrium the transfer price is always below the monopoly price of the nal market. Compared to the benchmark case Division 1 has always an incentive to increase the market price, p1 , even in the absence of competition, = 0. The equilibrium prices and corresponding quantities are given by: pc1 (I; ) = pcC (I; ) = [1 2 ] [a + 2 (1 + ) (a + )] + 3 3 2 a [1 ] [6 + (3 C(I) 2 ) ]+ 2 3 C(I) + 2 1 2 2 6 2 (19) q1c (I; ) c qC (I; ) = = [1 )] [a(3 + ) 2 (1 + )] 6 1 [1 ] a [(6 + (3 3 2 C(I) 2 ) ) + 2 (1 + )] + 6 2 2 3 + 2 3 C(I) 4 : In contrast to the uncontrollable market-based transfer price, the prices and quantities depend on the discount, , since the controllable market-based transfer price connects the two markets. At date 1, anticipating the optimal responses at the previous stages Division 1 determines the optimal investments as: w0 (I c ) = = E @C(I c ) c c (q1 (I ; @I " xE q1c (I c ; c c ) + q2c (I c ; ) + q2c (I c ; c ) 2 c )) + 3 @ 1 @pC 2 @pcC @I pc1 (I c ; 6 2 c 2 C(I c ) ) 1 2 # (20) : The rst term, xE [q1c ( ) + q2c ( )], depicts Division 1's investment decision without strategic considerations, accounting for Division 1's direct bene t of reducing the costs. As Stackelberg leader, 14 Division 1 can strategically in uence the competitor's price, which is re ected by the second term, x 2 3 2 E [pc1 ( ) C( )] =(6 2 2 2 1 ). Since increasing investments increase the in- centives for distorting the subsequent pricing decision, the strategic e ect is less pronounced than under the controllable market-based transfer price (and the benchmark case).16 In contrast to the uncontrollable market-based transfer price, Division 1 has no additional incentive to in uence the competitor's price in order to increase its pro t from internal trade, (@ (@pc2 =@pC ) 1 =@p2 ) (@pcC =@I) = 0. Finally, at date 0, central o ce determines the optimal discount, , that maximizes the expected c corporate pro t. Using E [tc ( )] = E[pc1 ( )] plus a positive markup, mc ( ) E [tc ( )] = = with Dc ( ) = term, 4 1 2 2 [3 E[C( )] + , the expected transfer price equals expected costs 0, i.e. 4 1 2 3 2 2 + 2 2 c x D ( ! ) 2 E [q2c ( )] 2E [pc1 ( ) 3[2 C( )] ] 2 (21) E[C( ) + mc ( )] 4 2 + 4 E [q2c ] =(3 2 ]=[27[2 2 2 3 ] 2 1 3x2 [3 2 2 ]2 6 ), re ects the e ect of the discount (@ =@p2 ) (@p2 =@ ). The second term, 2 2 c x D ( 5 2 + 4 ] 0. The rst on internal trade distortions, )E [q2c ], re ects the e ect of the discount on the investments, (@ =@p1 ) (@p1 =@I) (@I=@ ). The third term, 2 2 E [pc1 C(I)] =(3 2 2 ), re ects the strategic e ect of the discount on the competitor, (@ =@pC ) (@pC =@ ). In contrast to the uncontrollable market-based transfer price, the expected transfer price entails a positive markup over expected marginal costs. Even in the absence of competition, = 0, the optimal transfer price entails an expected markup of 4E [q2c ( )] =6 in order to mitigate Division 1's incentives to distort its price to gain from internal trade. The markup is increasing in E [q2c ( )], as this increases Division 1's incentives for overpricing. Finally, the associated maximum expected corporate pro t, E [ 16 c( )], can be stated in terms of 2 The strategic e ect under the controllable market price, x 2 3 E [pc1 (I c ) C(I c )] =(6 2 2 c 2 equals the strategic e ect under the uncontrollable market price, x E [p1 (I c ) C(I c )] =( 4 1 4 c c c 2 2 positive term, x E [p1 (I ) C(I )] =(6 4 1 ): 15 2 2 2 1 ); ); less a a basic plus a exibility value, E[ c( )] = E 2 1 q1c ( )2 + 3 =: Bc( ) + =: Bc( ) + F c( ) 2 2 2 18[2 2tc ( ) a + C( ) 2 3 2 2 2 ] [1 2 ] + 3 36[2 q1c ( ) + mc ( )q2c ( ) + q2c ( )2 2 2 2 2 ] ! I c ( )2 2 2 2: (22) The controllable market-based transfer price has the advantage that it provides a link to the competitor's pricing behavior. Division 1 strategically increases its market price, pc1 , above the level of the benchmark case, pc1 (I) > p1 (I). Although the induced quantity is lower, q1c (I) < q1 (I), the per unit pro tability of each unit increases, pc1 (I) the term q1c (I c )[a + C(I c ) 2tc (I c ; c C(I) > p1 (I) C(I), which is represented by )]=2. Since increasing competition alleviates the coordination problem and, thus, lowers the markup above marginal costs, @mc =@ < 0, this e ect becomes stronger with increasing intensity of competition. The increased per unit pro tability can lead to the case that the basic value of the controllable market-based transfer price can exceed the one of the benchmark case for su ciently intense competition. Technically, B c ( ) and B c ( ) B ( ) for 2[ c B ( ) for ; ] (notice, whether the cuto value is interior, c 2 [0; c ] , depends on the parameters). However, since the controllable market-based transfer price transmits only imperfectly cost information to the nal market, the exibility value of the controllable marketbased transfer price is below the one of the benchmark situation, but exceeds the one of the uncontrollable market-based transfer price, F u ( ) F c( ) F ( ) for all . Modifying again our notation, the following Lemma summarizes key characteristics for the controllable market-based transfer price method. Lemma 2 Under the controllable market-based transfer price method, (i) the expected transfer price exceeds the expected costs, E[tc ( )] > E[C(I c ( ))] for all : (ii) The induced investments and expected quantities on both markets are below the ones of the benchmark case, I c ( ) I ( ), E[q1c ( )] E [q1 ( )] and E[q2c ( )] (iii) The maximum expected corporate pro t is given by: E [ F u( ) F c( ) F ( ) for all and B c ( ) 16 B ( ) for c( E [q2 ( )] for all . )] = B c ( ) + F c ( ) 2 [0; c ] and B c ( ) 2 where B ( ) for 2[ c ; ]. Previous work has shown that the optimal controllable market-based transfer price entails no markup over expected costs in the absence of competition and speci c investments (Baldenius and Reichelstein 2006), while it entails a discount in the absence of intra-company coordination problems (Arya and Mittendorf 2008). Somewhat surprising, our analysis shows that the interrelation of intra-company coordination and strategic interaction on the intermediate market necessitates a markup that is decreasing with the intensity of competition. 3.1.3 Uncontrollable versus controllable market-based transfer pricing This section compares the e ciency of the two market-based transfer pricing schemes. As outlined, the uncontrollable market-based transfer price never exceeds the expected marginal costs, while the controllable market-based transfer price is never below the expected marginal costs. Not surprisingly, the uncontrollable market-based transfer price induces higher investments and higher expected traded quantities on both markets compared to the controllable market-based transfer price. However, the controllable market-based transfer price has the advantage that it is more e ective in softening competition on the external intermediate market which gets increasingly important with increasing intensity of competition. Hence, the basic value of the uncontrollable market-based transfer price exceeds the basic value of the controllable market-based transfer price for low intensity of competition (and vice versa). As outlined, the exibility value of the con- trollable market-based transfer price always exceeds the one of the uncontrollable market-based transfer price. Accordingly, we might suspect that the uncontrollable market-based transfer price outperforms the controllable market-based transfer price in environments with low cost uncertainty. The following proposition summarizes our discussion. Proposition 1 Comparing the two market-based transfer pricing methods, we get: (i) the expected optimal controllable market-based transfer price is above the expected uncontrollable market-based transfer price, E[tc ( )] E[tu ( )] for all . (ii) The induced investments of the uncontrollable market-based transfer price and the associated expected quantities on both markets exceed the ones of the controllable market-based transfer price, I u ( ) > I c ( ), E [q1u ( )] E[q1c ( )] and E [q2u ( )] 17 E[q2c ( )] for all . (iii) Uncontrollable market-based transfer pricing dominates controllable market-based transfer pricing for low cost uncertainty (and vice versa), E[ u( )] E[ c( )] if and only if b2uc ( ) := 2 Bu( ) F c( ) Bc( ) : F u( ) In Section 3.3, we further discuss implications of this result and relations to the literature. 3.2 Cost-based transfer pricing To provide insights on the e ectiveness of market- versus cost-based transfer pricing, we study in the following the two most prominent cost-based transfer pricing methods: under cost-plus transfer pricing the transfer price is based on actual costs plus a markup, while the standard cost-based transfer price is determined by central o ce ex-ante. 3.2.1 Cost-plus transfer pricing Under cost-plus transfer pricing, the transfer price is set equal to actual marginal costs plus a markup, m; that central o ce determines ex-ante, t+ = C(I) + m. Abstracting from competition on the intermediate market, cost-plus transfer pricing is frequently discussed in several textbooks (e.g. Solomons 1965, p. 167, Sahay 2003 provides an overview). Cost-plus transfer pricing transmits actual cost information to the nal market. At rst glance, cost-plus transfer pricing seems to delink the pricing decisions on the external intermediate and nal market. However, the imposed markup induces investment incentives and thus links the two markets. At date 4, Division 2 determines the monopoly price based on the transfer price, t+ , yielding a monopoly quantity of q2+ (I; m) = [a t+ ]=2 = [a C(I) m]=2. The quantity equals the one of the benchmark case if no markup is employed, m = 0. At date 3, Division 1 determines its price. Since the cost-plus transfer price and the induced quantity cannot be in uenced by the pricing decisions, the equilibrium prices and induced quantities at date 3 are the same as the ones in the benchmark + case, i.e. p+ i (I) = pi (I) and qi (I) = qi (I) for i = 1; C. Summing up, cost-plus transfer pricing does not connect the pricing decisions on the intermediate and nal market. At date 1, Division 1's optimal investment strategy is given by: w0 (I + ) = xE " q1+ (I + ) m + 2 18 2 # + p+ C(I + ) 1 (I ) : 2 2 4 1 (23) C(I)] q2+ = m q2+ , it bene ts only Since Division 1 receives a pro t from internal trade of [t indirectly from its investments in that lower costs increase internal trade, @q2+ =@I = x=2. Hence, the rst term, xE q1+ (I + ) + m=2 , depicts Division 1's investment decision without strategic con+ x 2 E p+ 1 (I ) siderations. The strategic e ect, 2 C(I + ) =( 4 1 2 ), equals the one of the benchmark case. Finally, at date 0, central o ce determines the optimal markup, 2 2 4 m+ = x2 2 1 2 2 4 2 1 2 2 2 2 x2 E q2+ ( ) : (24) The markup balances the investment decision, I + , and internal trade decision, q2+ , which both depend on the markup. In the absence of speci c investments, x = 0, central o ce determines m+ = 0 and achieves e cient production for both divisions. The markup is decreasing in the intensity of competition, @m+ =@ < 0, since the central o ces wants to decrease the investments in order to soften competition on the intermediate market.17 The rm's maximum expected corporate pro t, E [ E[ +( )] = =: E 1 2 +( )], is given by: q1+ ( )2 + m+ ( )q2+ ( ) + q2+ ( )2 B+( ) + F ( ) I + ( )2 2 (25) 2: While the basic value, B + ( ), is below the one of the benchmark case, B ( ), the exibility value equals the one of the benchmark situation since cost-plus transfer pricing transmits perfectly cost information to Division 2. Lemma 3 Under the cost-plus transfer price method, (i) the transfer price exceeds the costs, t+ ( ) > C(I c ( )) for all : (ii) The induced investments and the expected quantities on both markets are below the ones of the benchmark case, I + ( ) I ( ), E[q1+ ( )] E [q1 ( )] and E[q2+ ( )] (iii) The maximum expected corporate pro t is given by: E [ B+( ) +( E [q2 ( )] for all : )] = B + ( ) + F ( ) 2 where B ( ) for all : 17 Abstracting from an external intermediate market, a key insight on cost-plus transfer pricing is that the optimal markup increases with increasing trade at the nal market, q2+ , and the importance of the investment, x, i.e. m+ (0) = x2 E q2+ (I + ; m+ ) =[2 x2 ] for = 0 (Sahay 2003). Our analysis adds to this key insight by showing that the markup decreases with the intensity of competition on the intermediate market. 19 3.2.2 Standard cost-based versus cost-plus transfer pricing A classical research question is whether rms should use actual or standard cost-based transfer pricing (e.g. Eccles 1983, 1985). While cost-plus transfer pricing incorporates actual cost information, the standard cost-based transfer price, tsc , is determined by central o ce ex-ante. Since the standard cost-based transfer price does not transmit any cost information to the internal market and does not link the two markets together, standard cost-based transfer pricing might be seen as ine ective. At date 4, Division 2 determines the monopoly price based on the transfer price, tsc , yielding a deterministic quantity of q2 (tsc ) = [a tsc ] =2. Trade is e cient if by coincidence actual marginal costs equal the transfer price, tsc = C(I). At date 3, Division 1 has no incentive to strategically adapt its output decision in order to generate a favorable transfer price. The equilibrium prices and associated quantities are the same as the one in the benchmark case, i.e. psc i (I) = pi (I) and qisc (I) = qi (I) for i = 1; C. Standard cost transfer pricing does not link the pricing decisions of the two markets. Division 1's investment strategy at date 1 is given by: w0 (I sc ) = " # sc ) sc ) psc (I C(I 1 : 2 2 4 1 2 xE q1sc (I sc ) + q2sc (tsc ) (26) The rst term, xE [q1sc (I sc ) + q2sc (tsc )], depicts Division 1's investment decision without strategic considerations, considering the direct marginal bene t of reducing costs. The strategic e ect on the competitor, sc x 2 E [psc 1 (I ) 2 C(I sc )] =( 4 1 2 ), equals the one of the benchmark case. The transfer price has an in uence on the investment level in that it in uences the quantity, q2sc (tsc ). A higher transfer price, tsc , reduces the quantity, q2sc (tsc ), and thus the investment level. Finally, at date 0, determining the standard cost-based transfer price equal to expected marginal costs is optimal, tsc = E[C(I )]. In contrast to cost-plus transfer pricing, the intensity of competition does not impact the structure of the standard costs-based transfer price. However, the expected costs depend on the induced investment level that is decreasing in the intensity of competition. 20 The rm's maximum expected corporate pro t, E [ E[ sc ( )] = E 1 =: B ( ) + 2 )], is given by: I sc ( )2 2 q1sc ( )2 + q2sc ( )2 (27) 2 2 ] [2 [4 sc ( 2 2 ] [1 2 2 ] =: B ( ) + F sc ( ) 2; where the basic value equals the one of the benchmark case. Since the standard cost-based transfer price does not transmit any cost information to Division 2, the exibility value equals the one of the benchmark case at the intermediate market. Abstracting from an external intermediate market, previous literature (Pfei er, Schiller and Wagner 2011) has shown that standard cost-based transfer pricing dominates cost-plus transfer pricing if cost uncertainty is su ciently low (and vice versa). The following Proposition reveals that this key insight also carries over to our set-up irrespective of the intensity of competition.18 Proposition 2 Under the standard cost-based transfer price method, (i) the transfer price equals the expected costs, tsc ( ) = E[C(I ( ))] for all : (ii) The induced investments and the expected quantities on both markets equal those of the benchmark case, I sc ( ) = I ( ), E[q1sc ( )] = E [q1 ( )] and E[q2sc ( )] = E [q2 ( )] for all : (iii) The maximum expected corporate pro t is given by: E [ F sc ( ) sc ( )] = B ( ) + F sc ( ) 2 where F ( ) for all : (iv) Standard cost-based transfer pricing dominates cost-plus transfer pricing for low cost uncertainty (and vice versa), E[ 3.3 sc ( )] E[ +( )] if and only if 2 b2+s ( ) = B ( ) F +( ) B+( ) : F sc ( ) Performance comparison of market- versus cost-based transfer pricing This section provides a performance comparison of the market- and cost-based transfer pricing methods. Our results re ne suggestions in textbooks to use marginal actual cost-based transfer 18 Comparing the two cost-based transfer price methods, we get a similar result as in Proposition 1: (i) the expected optimal cost-plus transfer price is above the standard cost-based transfer price, E[t+ ( )] tsc ( ) = E[C(I + ( ))] for all . (ii) The induced investments of the standard cost-based transfer price and the associated expected quantities on both markets exceed the ones of cost-plus transfer pricing, I sc ( ) > I + ( ), E [q1sc ( )] E[q1+ ( )] and E [q2sc ( )] E[q2+ ( )] for all . 21 pricing in the absence of competition on the intermediate market and the market price in the case of a perfect intermediate market (e.g. Drury 1996, Atkinson et al. 2001, Horngren et al. 2009). Brie y stated, we nd that (i) the uncontrollable market-based transfer price is optimal for low up to intermediate intensity of competition and intermediate cost uncertainty, (ii) the controllable market-based transfer price is optimal for high intensity of competition if cost uncertainty is not extremely high, (iii) cost-plus transfer pricing is optimal if cost uncertainty is su ciently high, and (iv) standard cost-based transfer pricing is optimal if the intensity of competition is not too high and cost uncertainty is rather low. In the absence of cost uncertainty, 2 = 0, the standard cost- based and the controllable market-based transfer price are the optimal schemes. In the absence of competition, = 0, the standard cost-based and the uncontrollable market-based transfer price are identical and the two cost-based transfer prices weakly dominate the two market-based transfer prices. Before we discuss this issue more in detail, we provide the following formal result, using the following de nition b2ij ( ) = [B i ( ) B j ( )]=[F j ( ) F i ( )] for i; j = u; c; +; s and i 6= j. Proposition 3 The other three transfer pricing methods are dominated by: (i) uncontrollable market-based transfer pricing if min b2uc ( ) ; b2u+ ( ) (ii) controllable market-based transfer pricing if b2u+ ( ) (iii) cost-plus transfer pricing dominates if 2 (iv) standard cost-based transfer pricing if 2 Figure 2 illustrates our nding (Data: a = 1, 2 2 b2us ( ) : max b2uc ( ) ; b2cs ( ) : max b2u+ ( ) ; b2c+ ( ) ; b2+s ( ) : min b2us ( ) ; b2cs ( ) ; b2+s ( ) : c = 0:1, x = 0:01, = 0:99). - Insert Figure 2 Since the maximum variance, 1:92 10 4, is below the cuto value, b2c+ ( ), the controllable market- based transfer price always dominates the cost-plus transfer pricing for high values of . Although the standard cost-based and the uncontrollable market-based transfer price are identical for = 0, their performance di ers signi cantly with increasing intensity of competition. No competition on the intermediate market, = 0. Abstracting from an external inter- mediate market, previous literature has studied the e ectiveness of various cost-based transfer 22 pricing methods (Baldenius, Reichelstein and Sahay 1999, Sahay 2003, Pfei er, Schiller and Wagner 2011). Since for = 0 standard cost-based and the uncontrollable market-based transfer price are equivalent, the two cost-based transfer pricing methods dominate (weakly) the market-based ones. Consistent with previous literature (Pfei er, Schiller and Wagner 2011), cost-plus transfer pricing dominates standard cost-based transfer pricing for high cost uncertainty (and vice versa). Previous literature has studied the e ectiveness of controllable market-based transfer prices in the absence of competition when actual cost-based transfer prices are not available (Baldenius and Reichelstein 2006).19 If actual cost-based transfer prices are not available, we get immediately from Proposition 3 that controllable market pricing dominates the other two transfer pricing methods if 2 maxfb2uc (0) ; b2cs (0)g: Otherwise, controllable market-based transfer prices are dominated by the other transfer pricing methods. Further, as highlighted by Proposition 3, controllable market- based transfer prices perform pretty well for high intensity of competition if the cost uncertainty is not too high. Corollary 1 In the absence of competition, = 0, cost-plus transfer pricing is optimal if b2+s (0), while standard cost-based transfer pricing is optimal if 2 2 b2+s (0). In particular, stan- dard cost-based transfer pricing and uncontrollable market-based transfer pricing are equivalent and controllable market-based transfer pricing is weakly dominated by the other transfer pricing methods. No cost uncertainty, 2 = 0. Previous literature has shown that in the absence of an intra- company coordination problem, 2 = 0 and x = 0, controllable market-based transfer pricing always dominates cost-based transfer pricing (Arya and Mittendorf 2008). Since for 2 = 0 each transfer price scheme has a zero exibility value, the expected corporate pro t equals the associated basic value. As outlined previously, the basic value of standard cost-based transfer pricing exceeds the one of controllable market-based transfer pricing if the intensity of competition is not too high (and vice versa), B sc ( ) = B ( ) B c ( ) for 2 [0; c ] and B sc ( ) B c ( ) for 2[ c ; ]. Standard cost-based transfer pricing always outperforms cost-plus and uncontrollable market-based transfer pricing, B sc ( ) B + ( ) and B sc ( ) B u ( ) for all : Summing up, our result complements this previous nding by showing that in the absence of cost uncertainty cost-plus transfer pricing is 19 Baldenius and Reichelstein (2006) nd that controllable market-based transfer pricing cannot achieve rst-best for unconstrained capacity, while they show that controllable market-based transfer pricing can induce rst-best for constrained capacity. 23 indeed always dominated, while standard cost-based transfer pricing is optimal for low intensity of competition. Corollary 2 In the absence of cost uncertainty, optimal for low intensity of competition c 2 = 0, standard cost-based transfer pricing is , while controllable market-based transfer pricing is optimal for high intensity of competition, c . In particular, standard cost-based transfer pricing dominates cost-plus transfer pricing and uncontrollable market-based transfer pricing. No speci c investments, x = 0. In the absence of speci c investments, cost-plus transfer pricing allows achieving the same outcome as the benchmark case. Accordingly, cost-plus transfer pricing dominates standard cost-based and uncontrollable market-based transfer pricing. As before, the basic value of the controllable market-based transfer price can exceed the one of the benchmark case for su ciently intense competition. Accordingly, we obtain the following result. Corollary 3 In the absence of speci c investments, x = 0, cost-plus transfer pricing is optimal if 2 b2c+ ( ), while controllable market-based transfer pricing is optimal for 2 b2c+ ( ). In par- ticular, cost-plus transfer pricing dominates standard cost-based transfer pricing and uncontrollable market-based transfer pricing. Summing up, the corollaries highlight that all three factors, i.e. market competition, cost uncertainty and speci c investments, are necessary to provide a non-trivial performance comparison. 4 Extension: Cournot quantity competition In this section, we brie y report how our results change when the rm faces di erentiated Cournot competition on the intermediate market, relaxing aF = aI (see appendix for details). In contrast to Bertrand competition, the rm can improve its competitive position on the intermediate market by increasing its investments. However, the strategic incentive for overinvestment runs in the opposite direction to the intra-company coordination problem that induces underinvestment. Importantly, under Cournot competition, the market prices, p1 and pC , are the residuum of the quantity decisions, q1 and qC , and not decision variables itself, i.e. pi = aI qi qj . Consequently, the market-based transfer prices become in uenceable by Division 1 irrespective of which marketbased transfer price is used. Despite these di erences, most of our previous key insights carry over to the Cournot case. For sake of simplicity we use the same notation as in our previous sections. 24 In the case of an integrated rm, the quantity decisions on the two markets are separated. We obtain the monopoly quantity on the nal market, q2 (I) = [aF C(I)] =2, and the well-known equilibrium outputs in a di erentiated Cournot duopoly on the intermediate market, q1 (I) = [aI [2 ] 2 2C(I)] = 4 and qc (I) = [aI [2 2 ] + C(I)] = 4 . The rm's investment de- cision is given by: 2 w0 (I) = xE q1 (I) + q2 (I) + 4 2 (28) q1 (I) : The term, xE [q1 (I) + q2 (I)], depicts the rm's optimal investments without strategic considerations. The term, x 2 E [q1 (I)] =[4 2 ], re ects the strategic e ect to increase the investments. The rm's maximum expected corporate pro t can be stated as a basic plus a exibility value E[ 4.1 ( )] = B ( )+ 4 2 2 ] [4 + 1 4 2 = B ( )+F ( ) 2: (29) Characteristics of the transfer pricing methods Studying the di erent transfer prices, we show that changing the mode of competition hardly in uences our insights about cost-based transfer pricing, but alters our insights about market-based transfer pricing. We thus start with cost-based transfer pricing. Standard cost-based transfer pricing. As before, standard cost-based transfer pricing separates the two markets, q2sc (tsc ) = [aF tsc ]=2, and induces the same quantities on the intermediate market and the same investments as in the benchmark case, q1sc (I) = q1 (I) and I sc = I . The optimal standard-cost-based transfer price is set equal to the expected marginal costs, tsc = E[C(I sc )]. The rm's maximum expected corporate pro t, E [ E[ sc ( )] = sc ( )], is given by: 4 B ( )+ 4 2 2 2 = B ( ) + F sc ( ) 2: (30) As before, the basic value equals the one of the benchmark case. Cost-plus transfer pricing. Under cost-plus transfer pricing, Division 1 has no incentive to adapt its output decision on the intermediate market, q1+ (I) = q1 (I) (and q2+ (I; m) = [aF Division 1's investment decision is given by: 25 C(I) m]=2). w0 (I + ) xE q1+ (I + ) + = m + 2 4 2 2 q1+ (I + ) : (31) As before, Division 1 receives a pro t from internal trade of mq2+ and thus bene ts only indirectly from its investments in that lower costs increase internal trade, q2+ . The strategic e ect on the competitor, 2 E[q1+ (I + )]=[4 2 ], equals the one of the benchmark case. Finally, the optimal markup, m, balances investments and trade on the nal market, 2 2 ] [4 m+ = x2 2 2 4 8x2 E q2+ (I + ; m+ ) : (32) In contrast to Bertrand competition, the markup is, ceteris paribus, increasing in the intensity of competition, , since more competition makes higher investments more favorable. While the basic value, B + ( ), is below the one of the benchmark case, B + ( ) < B ( ), the exibility value equals the one of the benchmark case. The maximum expected corporate pro t, E[ +( )], is given by: E[ +( )] = B+( ) + F ( ) 2: (33) Uncontrollable and controllable market-based transfer pricing. In contrast to Bertrand competition, the market price, pi = aI qi qj for i; j = 1; C and i 6= j, is the residuum of the quantity decisions, q1 and qC . Hence, both market-based transfer prices depend on Division 1's quantity decision: @ 1 @q1 @ 1 @q1 = = [aI 2q u1 [aI 2q c1 2tu aF + C(I) 2 u qC C(I)] c qC aF + C(I) C(I)] 2 2tc =0 (34) = 0: In contrast to the Bertrand case, the uncontrollable market-based transfer price also links the two markets. Under both methods, the traded quantity on the intermediate market is, ceteris paribus, below the one of the benchmark case. Similarly, Division 1 determines the investments as w0 (I l ) = E @C(I l ) l @ 1 q1 ( ) + q2l ( ) + @I @pC @plC @ 1 @pl2 + @I @p2 @pC @plC @I for l = u; c; (35) yielding the following investment decision for uncontrollable and controllable market-based transfer 26 pricing, respectively: 2 w0 (I u ) w0 (I c ) = xE q1u ( ) + q2u ( ) + aF + C ( ) [2 + ] u q1 ( ) + [2 + ] 8 16 " 3 = xE q1c ( ) + q2c ( ) + 4 3 2 2 q1c ( ) + 3 2 aF + C ( ) 8[3 2tu ( ) (36) # 2tc ( ) : 2 ] Finally, at date 0, central o ce determines the optimal discount for both market-based transfer prices. In contrast to Bertrand competition, both transfer prices entail a positive markup, E [tu (I u ; u E [C(I u )] )] and E [tc (I c ; c E [C(I c )]. )] (37) While the controllable market-based transfer price still entails a markup, yet the uncontrollable market-based transfer price entails a markup and not a discount as in the Bertrand case. The reason is that although a discount helps mitigating the intra-company coordination problem, Cournot competition on the intermediate market provides a stronger countervailing e ect. A markup makes Division 1 more aggressive, strengthening Division 1's position on the intermediate market. The associated maximum expected corporate pro ts for uncontrollable and controllable marketbased transfer pricing are given by: E[ E[ u( c( )] )] = = Bu( ) + Bc( ) + (2 + ) 16 + 3 [4 2 2 3 6 2 2 32 3 2 (2 + ) 2 2 ] 2 2 ] 9[2 + 64[3 2 2 ] 2 + ! [2 + ]2 256 2 ! 2 =: B u ( ) + F u ( ) =: B c ( ) + F c ( ) 2 2: (38) Since the controllable market-based transfer price responds stronger to changes in Division 1's quantity decision, the coordination problem and the strategic e ect are more pronounced under this method. The basic value of the uncontrollable market-based transfer price exceeds the one of the controllable market-based transfer price if the intensity of competition is not too high (and vice versa), B u ( ) B c ( ) for 2 [0; uc ] and B u ( ) B c ( ) for 2[ is satis ed depends on the parameters). As before, we get: F u ( ) the case of homogeneous Cournot competition, equivalent, i.e. E [ u (1)] =E[ uc ; ] (notice, whether F c( ) uc F ( ) for all . In = 1, a single price exists and both methods are c (1)] : 27 4.2 Performance comparison of market- versus cost-based transfer pricing As in the Bertrand competition case, broadly stated, cost-plus transfer pricing is optimal in highly uncertain cost environments, while standard cost-based pricing is optimal if cost uncertainty is rather low. For intermediate cost uncertainty and low intensity of competition uncontrollable market-based transfer pricing is optimal, while controllable market-based transfer pricing is optimal for high intensity of competition and not too high cost uncertainty. In the absence of cost uncertainty, 2 = 0, the standard cost-based and the controllable market-based transfer price are the optimal transfer pricing schemes. In the absence of competition, = 0, the uncontrollable market-based and standard cost-based transfer price are identical and the two cost-based transfer prices weakly dominate the two market-based transfer prices. Figure 3 illustrates our nding (Data: aI = 5, aF = 1, c = 0:8, x = 0:5 with a maximum variance of 1:6). In contrast to Figure 2 for the Bertrand competition case, the size of the intermediate market exceeds the size of the nal market since controllable market-based transfer pricing is never optimal for aF = aI (a detailed discussion is given below). { Figure 3 { De ning the cut-o values as before, i.e. b2ij ( ) = [B i ( ) B j ( )]=[F j ( ) F i ( )] for i; j = u; c; +; s and i 6= j, we obtain the following formal result. Proposition 4 In case of Cournot competition, the other three transfer pricing methods are dominated by: (i) uncontrollable market-based transfer pricing if min b2uc ( ) ; b2u+ ( ) (ii) controllable market-based transfer pricing if b2u+ ( ) (iii) cost-plus transfer pricing dominates if 2 (iv) standard cost-based transfer pricing if 2 2 2 b2us ( ) : max b2uc ( ) ; b2cs ( ) : max b2u+ ( ) ; b2c+ ( ) ; b2+s ( ) : min b2us ( ) ; b2cs ( ) ; b2+s ( ) : Size of the two markets and ancillary trade. Studies on transfer pricing have documented that the magnitude of internal trade can vary extremely across rms (e.g. Emmanuel and Mehafdi 1995, Chapter 3). Broadly stated, for non-ancillary internal trade, aF >> aI , solving the intra-company 28 coordination problem gets more important than strategic considerations on the intermediate market. In contrast to price competition, even for the case of equal market size, aF = aI , controllable market-based transfer pricing is never optimal. Corollary 4 If the market size of the intermediate market exceeds the one of the aF nal market, aI , controllable market-based transfer pricing is never optimal. Finally, it is instructive to ask how key factors (competition, cost uncertainty, and speci c investments) a ect the optimality of the transfer pricing methods. The following Corollary summarizes the results that are similar to the Bertrand competition case. Corollary 5 In the case of Cournot competition, we get: (i) in the absence of competition, = 0, cost-plus transfer pricing is optimal if while standard cost-based transfer pricing is optimal if 2 2 b2+s (0), b2+s (0). In particular, standard cost-based transfer pricing and uncontrollable market-based transfer pricing are equivalent and controllable market transfer pricing is weakly dominated by the other transfer pricing methods. (ii) in the absence of cost uncertainty, for low intensity of competition 2 = 0, standard cost-based transfer pricing is optimal c , while controllable market-based transfer pricing is optimal for high intensity of competition, c . In particular, cost-plus and uncontrollable market-based transfer pricing are never optimal. (iii) in the absence of speci c investments, x = 0, standard cost-based and uncontrollable marketbased transfer pricing are never optimal. 5 Conclusion While surveys discuss a variety of market- and cost-based transfer price methods applied in practice (e.g. Emmanuel and Mehafdi 1995, Feinschreiber 2004), properties and e ectiveness of the individual transfer pricing schemes seem to be less well understood. Using an incomplete contracting framework, we investigate frequently used market- versus cost-based transfer pricing schemes to coordinate intra-company trade when the rm faces competition on the intermediate market. Transfer 29 pricing provides investment incentives up-front, governs competitive behavior on the intermediate market and guides intra-company trade. Re ning a frequently made proposal in textbooks to use marginal actual costs as the transfer price in the absence of competition on the intermediate market, we nd that in this case cost-plus transfer pricing is optimal if cost uncertainty is su ciently high, while standard cost-based transfer pricing is optimal if cost uncertainty is su ciently low. The optimal standard cost-based transfer price is set equal to the expected marginal costs, while in contrast to the textbook proposal the optimal cost-plus transfer price entails a markup over marginal costs. Our analysis can also be helpful in extending a frequently made proposal to use the unadjusted market price in the case of a perfect intermediate market. In fact, we nd for an imperfect intermediate market that using the competitor's price (uncontrollable market-based transfer price) is optimal for low intensity of competition and intermediate cost uncertainty. Using the rm's market price (controllable market-based transfer price) is optimal for high intensity of competition if cost uncertainty is not too high. Both market-based transfer price methods necessitate adjustments. While the optimal controllable market-based transfer price entails a markup over expected marginal costs, the optimal uncontrollable market-based transfer price entails a discount. Summing up, our analysis provides new insights into the design of additive discounts and markups for cost-based and market-based transfer prices and compares the e ectiveness of these commonly used transfer pricing schemes. 30 Mathematical appendix A.1 Bertrand competition Regularity conditions. For simplicity, we restrict our analysis to C(I) = 99=100. Positive costs, 0. Since in the benchmark case the investments are the largest which are decreasing in , assuring c xI (0) 0 is su cient to guarantee positive costs, yielding x2 a: c Positive quantity, q1 0. Since the controllable market-based transfer price induces the lowest q1 that is decreasing in , assuring q1c c (A1) c = 0 is su cient to guarantee positive quantities, yielding a 1679803863894170744002 + 8610685384794589354551x2 10199 8363985317511261998 97757614145369620851x2 329969659359788319479850x4 a 10199 8363985317511261998 To assure c 97757614145369620851x2 (A2) : c, x must ful ll x x 0:1715: (A3) Finally, since the benchmark case induces the highest investments, the associated second order condition is binding, yielding xsoc ( x ) = s 2 2 2 4 32 However, since this condition is ful lled for x 40 2 2 1 + 13 4 for all : 6 x, we can omit it Characterization of the benchmark solution. The backward induction process is detailed in the text. Using the equilibrium values from (6), (7) and (8), yields E[ ( )] = E[[p1 ( ) = E = 1 C( )] q1 ( ) + [p2 ( ) (I )2 2 (I )2 2 2 E [q1 (I )] + E [q2 (I )] + 2 2 1 2 C( )] q2 ( )] (I )2 2 q1 (I )2 + q2 (I )2 31 [2 [4 2 2 ] 2 2 ] [1 2 ] + 1 4 2; with E [q1 (I )] 2 [a = E [q2 (I )] = x 2 1 ] c 32 2 2 2 4 40 2 1 4 2 + 13 2a 2 4 6 2 4 6 4a 2 x2 2 32 2 2 2 2 [a a 2 1 c] 4 2 4 I 2 2 2 2 2 4 [a = c] 2 32 40 40 2 + 13 4 2 1 32 + 13 6 40 2 2 x2 x2 2 4 + 13 (A4) x2 6 x2 : Proof of Lemma 1. We rst characterize the solution for the uncontrollable market-based transfer price. The backward induction process is detailed in the text. Plugging (11) and (12) into (13), yields Iu ( ) = x 2 2 3 2( 1 with k u = 8 + (4 E [q1u ( )] = [9 + (5 2a [2 E [q2u ( 2 ] [2 + )]2 + x21 )] = 2( 1 a+ 2 8 6 4 2 4 2 c ku (A5) x2 k u ) 2 + 2 ) 5 2 2 4 ) 2 2 2 (4 [ + 2]) x2 k u ) 4 2 + ]+ 4 x2 k u ) a 2 2 (A6) + c 2 2 1 2 ) 2a [2 2 2( 1 c 2 2 4 2 + 2a [3 + ] 2 [3 + ]))]). Forward induction yields ] [1 2 2 [1 + ] + 8 1 x2 2 2 4( 1 4 ) x2 k u ) 2a [4 + (3 [3 + ])] (4 4( 1 2 2 4 ) 2 [2 + ]) x2 k u ) : Calculating the optimal discount yields 0 = d d = = @ 1 @pu2 @ 2 @puC @I u + @p2 @ @pC @I @ E [puC ( ) C( )] 2 + x2 2( 1 Using the equation above and E [tu ( )] = E[puC ( ) Using (A5), (A6) and (15) yields E [ (i) E[tu ( )] 2 1 u( )] = E u 1 (2 + )] E [q2u (I u ; [4 2 4 ] = E [C(I u ) 2 q1u ( )2 2 ) 2 u x2 k u ) )] : mu ] yields (14) and (15). mu ( )q2u ( ) + q2u ( )2 (I u ( )2 =2): E[C(I u ( ))] follows (14) and (15). (ii) We show I u ( ) I ( ), E[q1u ( )] E [q1 ( )] and E[q2u ( )] E [q1 ( )] for all . To induce I u ( ) = I ( ), (9) and (13), the following equation must be ful lled, 32 # a + C(I ) 2tu (I ; mu ) : 2 2 4 " xE [q2 (I )] = xE q2u (I ) Using E [q2 (I )] = (a E [C(I )]) =2, E [q2u (I )] = (a E [tu ]) =2, and E [tu (I ; mu )] = E[C(I )] mu , reduces the above equation to a E [C(I )] 2 a = yielding as solution, m b u = (a E [C(I )])=(4 E[mu ] < m b u for all , we get: I u ( ) (iii) B u ( ) E [C(I )] 2mu ; 2 2 4 a 2 2 ) = E [q2 (I )] =(2 4 I ( ) and thus E[q1u ( )] Similarly, E [q2u ( )] = E [q2 ( )] requires (a solution m e u = E [C(I u ) mu E [C(I )] 2 E [C(I u )] ). Since E [q1 ( )] : mu )=2 = (a E [C(I )])=2 yielding as C(I )] : Since E [mu ] < m e u for all , we get: E[q2u ( )] B ( ) and F u ( ) 2 2 E [q1 ( )]. F ( ) follows as outlined in the text. Proof of Lemma 2. We rst characterize the solution for the controllable market-based transfer price. Plugging the equilibrium values of (17) and (19) into (20), yields Ic ( ) = x 2a [1 2 ] [2 + 3] 3 2 3 ] 18[2 3 2 2 2 1 2 c 3 2 2 2 2 2 ]2 6 x2 2[3 2 3 2 5 1 4 + 2 4 : (A7) Forward induction yields E [q1c ( )] = E [q2c ( )] = 3 36 2 6 2 2 x2 2a 2 2 2 2 36 2 6 2 3 2+ 3 36 2 2 1 + 2 2 6 5 2 2 2 4 3 2 2 3 x2 ] (a [3 + ] 2 [1 + ]) + c 3 2 2 4 2 2 1 [1 36 2 2 x2 2a 2 2 3 2 1 a(3 + [1 2 2 1 3 2 2 2 2 + 4 3 4 3 2 ] ) 4 3 3 2 2 2 c 2 2 2 2 2 3 2 2 4 3 2 3 3 3 2 2 x2 + 4 2 x2 2 2 x2 : Calculating the optimal discount yields 0= d d @ @pcC @ 1 @pc2 @ 2 @pc1 @ 2 @pc1 @I c + + + @pC @ @p2 @ @p1 @ @p1 @I @ 2 c( ) c )] c( ) E [q2c ( )] E [p C(I E [p C(I c )] 2 1 1 1 = 2 + 2 2 2 3 2 3 2 4 2 4 c [3 4 + ]E [q2 ( )] x2 2 3 2 9[2 ] 1 x2 [3 2 2 ]2 6 5 2 + 4 = 33 (A8) and thus the transfer price (21). Using (A7), (A8) and (21) yields E[ c( )] = E[[pc1 ( ) = E =: Bc( ) + C( )] q1c ( ) + [pc2 ( ) 2 1 I c ( )2 2 C( )] q2c ( )] I c ( )2 2 a + C( ) 2tc ( ) c q1 ( ) + mc ( )q2c ( ) + q2c ( )2 2 ! 2 2 2 2 3 2 2 3 3 2: 2 2 2 + 2 2 18[2 ] [1 ] 36[2 ] q1c ( )2 + (i) E[tc ( )] > E[C(I c ( ))] follows directly from (21). (ii) We show I c ( ) I ( ), E[q1c ( )] E [q1 ( )] and E[q2c ( )] E [q2 ( )] for all . To induce I c = I , using (9) and (20), the following property must be ful lled, # " p (I ) C(I ) 1 2 xE q1 (I ) + q2 (I ) 2 2 4 1 = xE " q1c (I ; mc ) + q2c (I 2 ; mc ) 4 # pc1 (I ; mc ) C(I ) : 2 2 4 2 1 2 Solving the above equation for m b c and using (A4), (A7), (A8) and (21), reveals m bc = with k c = 384 I c( ) [a 576 2 C(I )] 384 864 4 2 576 4 104 + 352 6 2 + 13 4 + 816 1008 8 2 6 404 + 652 8 + 103 4 182 6 10 11 + 19 a kc 8 . However, since E [mc ] < m b c for all ; > 0, we get: I ( ). From that nding follows directly E [q1c ( )] < E [q1 ( )] and E [q2c ( )] < E [q2 ( )]. (iii) B c ( ) B ( ) and F u ( ) F c( ) F ( ) follows as outlined in the text. Proof of Proposition 1. (ii) We show I c ( ) I u ( ), E[q1c ( )] E [q1u ( )] and E[q2c ( )] E [q2u ( )] b using (13) and (20), the following equation must be ful lled, for all . To induce I c = I u = I, " # u (I) b C(I) b b 2tu (I; b mu ) p a + C( I) 1 2 u u xE q1 Ib + q2 Ib 2 2 2 4 2 4 1 h i3 2 4 b C(I) b pc1 (I) 2 c c b b 4 5: = xE q1 (I) + q2 (I) + 2 2 6 4 2 Solving the above equation for m e c , using (A5), (A6), (15), (A7), (A8) and (21), yields 34 m ec with g = 4 2 h = i b 768 C(I) a 2 2 6 ) 576 2 2 2 4 548 6 + 118 8 ) 576 1008 2 + 652 4 576 2 + 352 4 104 6 + 13 384 4 + 1308 2 4 a 2 1584 2 1008 8 2 5 + 652 182 6 + 19 8 3gmu ; 182 6 + 19 8 4 11 10 8 . Since E [mc ] < m e c we get: I c ( ) I u ( ). From that nding follows directly E [q1c ( )] < E [q1u ( )] and E [q2c ( )] < E [q2u ( )]. (i) The relation E[tc ( )] E[tu ( )] follows from I c ( ) I u ( ), mc ( ) > 0 and mu ( ) 0. (iii) The cut-o value b2uc ( ) follows from (16) and (22). Proof of Lemma 3. We rst characterize the solution for the cost-plus transfer price. The backward induction process is detailed in the text. Since p+ 1 (I) = p1 (I), inserting (7) into (23), yields I + (m) 2 2 2 4a 2 ]2 + m [1 + ] [2 + ] [2 = x 2 2 1 2 2 4 2 2 4 2 4 c 2 x2 2 2 : (A9) Forward induction yields E q1+ (m) E q2+ (m) = 2 4 2 2a 2 2 2 1 = a m 2 c 2 2 4 2 x2 2 2 4 1 2 2 2 2 2 4 2 2 2 x2 x2 x2 2 2 +m 2 2 2 4 2 cx 8 2 2 2 4a 2 2 m 2 c 4 2 + 4 2 4 1 2 2 2 8 2 [1 + ] [2 + ] 2 2 (A10) x2 : Calculating the optimal markup m, yields (24) as solution of 0= d dm = @ 1 @p+ @ 2 @I + 2 + @p2 @m @I @m = m 2 2 1 x2 4 2 2 2 4 2 2 2 q1+ ( )2 + m+ ( )q2+ ( ) + q2+ ( )2 2 1 2 2 4 2 x2 E q2+ (I + ; m) : Using (A9), (A10) and (24) yields E[ +( )] = E 1 =: B+( ) + 2 2 ] [2 [4 2 2 ] [1 35 2 ] + 1 4 2: I + ( )2 2 (i) E[t+ ( )] > E[C(I + ( ))] follows directly from (24). (ii) Since m+ =2 q2 ( ), cost-plus transfer I ( ), implying E[q1+ ( )] E [q1 ( )] for all . (iii) pricing yields I + ( ) B+( ) E [q1 ( )] and E[q2+ ( )] B ( ) follows as outlined in the text. Proof of Proposition 2. We rst characterize the solution for the standard cost-based transfer price. The backward induction process is detailed in the text. Since psc 1 (I) = p1 (I), plugging the equilibrium value of (7) and q2sc (t) = [a tsc ] =2 into (23), yields I sc (t) = x [1 2 2 ] [1 + ] 4 2 1 [a 2 2 4 q1sc (t) = 4 2 2 2 4 c 2 2 2 (A11) : x2 t)=2) 2 2a 2 2 1 2 2 4 Forward induction yields (notice q2sc (t) = (a 2 t] + 4a [2 + ] 2 2 2 + 2 4 2 2 x2 [a 4 2 t] 2 2 2 c 2 2 : x2 (A12) Calculating the optimal transfer price tsc , yields d dt @ 1 @pc2 @p2 @t = = t E [C (I sc )] 2 = 0 ! tsc = E [C (I sc )] : (A13) From tsc = E [C (I sc )] follows I sc ( ) = I ( ), E[q1sc ( )] = E [q1 ( )] and E[q2sc ( )] = E [q1 ( )] for all . Taking the equilibrium values from (A4) into account, yields E[ sc ( )] = E 1 2 q1sc (I sc )2 + q2sc (I sc )2 2 2 (I sc )2 [2 ] =: B ( ) + 2 2 2 [4 ] [1 2 ] 2: (i) E[tsc ( )] = E[C(I sc ( ))] = E[C(I ( ))] follows I sc ( ) = I ( ). (ii) As shown before. (iii) F sc ( ) F ( ) follows as outlined in the text. (iv) The cut-o value b2s+ ( ) follows directly from (25) and (27). Proof of Proposition 3. Comparing (16), (22), (25) and (27) provides the cut-o values. Proof of Corollaries 1, 2 and 3. As outlined in the text. A.2 Cournot competition Regularity conditions. For didactical reasons, we assume aI =aF > 2. and C(I) = 1. Positive costs, 0. Since under the benchmark case the investments are the largest which are decreasing in 36 , assuring c xI (0) 0 is su cient to guarantee positive costs, yielding c = x2 c Positive quantity, q1 (A14) 0. Since the controllable market-based transfer price induces the lowest q1 that is decreasing in , assuring q1c c Finally, to assure c 8aI + 9aF : 18 0 is su cient to guarantee positive quantities, yielding 18x4 aF + aI 36 14x2 72 28x2 c = 9x4 : (A15) c, we get for x x x = 6 s a qI 23aI + 18aF + 9 5a2I + 4a2F : 4aI aF Finally, since the benchmark case induces the highest investments, the associated second order q 2 2 condition is binding, yielding x xsoc ( ) = 2 4 =[ 4 8 2 + 32] for all : However, since this condition is ful lled for x x, we can omit it. Characterization of the benchmark solution. The backward induction process is detailed in the text. Using the equilibrium values q2 (I) = [aI C(I)] =2, q1 (I) = [aI [2 ] 2C(I)]= 4 2 and (28), yields E[ ( )] = E [q1 ( )] = with E [q2 ( )] I = = (I )2 + 2 E [q1 ( )]2 + E [q2 ( )]2 4 4 x 2 aI [2 2 4 [aF )] 2 2 2 2 2 2 4 aF 4 4 2 4 32 8 + 2 c ] + 4x (aI [2 32 8 + 2 + 8aI [2 )] 2 4 2 2 [4 2 32 8 4 1 4 2 c x2 )] c 2 + 2 2 ] x2 + 2x2 aF 2 2 2 4 2aF ) x2 32 + 4 8 2 (A16) + x2 4 : Characterization of the standard cost-based transfer price. The backward induction process is detailed in the text. Using E [q1sc ( )] = E [q1 ( )], q2sc ( ) = E [q2 ( )] and I sc = I and (A16) yields E[ sc ( )] = E 1 2 q1sc ( )2 ] + E[q2sc ( ) 37 2 (I sc )2 2 =: 4 B ( )+ 4 2 2 2: Characterization of the cost-plus transfer price. The backward induction process is detailed in the text. Using q1+ ( ) = q1 ( ) ; a (7) and (23) yields 8aI [2 I + (m) = x ] 16 c 2 2 2( 4 + 2 2 4 : 8x2 ) (A17) Forward induction yields E q1+ (m) = aI [2 4 q2+ (m) E 2 4 = aF c 2 ] 2 c + x2 2 2 8x2 8aI [2 + x2 ] 16 c 2 2 4( 4 + (A18) 2 2 4 : 8x2 ) We obtain the optimal markup, solving d dm = @ 1 @q2+ @ 2 @I + + @q 2 @m @I @m = m 2 q2+ (I + ; m+ ) 2 2 ] E x2 [4 2 2 2 4 8x2 : Using (A17), (A18) and (32) yields E[ +( )] = E q1+ ( )2 + m+ ( )q2+ ( ) + q2+ ( )2 I + ( )2 =: B + ( ) + 2 4 [4 2 2 ] + 1 4 2: Characterization of the uncontrollable market-based transfer price. The backward induction process is detailed in the text. Using q2u (tu ) = [a I u ( ) = xk u 2aI with k u = 8 + 3 [2 + ] E [q1u ( )] = + E [q2u ( )] = + c [2 aF 2 tu ]=2 and (34) in (36), yields + ] 2 + 4aI [1 + ] 2 64 [2 + ] 16 + 3 [2 + ] 8 2 c [2 x2 + ] + 32 [1 + ] (A19) . Forward induction yields 16 (2aI [aF + 2 ] c [2 + ]) 64 [2 + ] 16 + 3 [2 + ] 2 x2 [2 + ] x2 2 [4 + ] aF aI 4 + 2 + 4 [2 + ] 8 8 64 [2 + ] 16 + 3 [2 + ] 2 x2 aF 16 [2 ] (aI [2 + ]) 2 2 2(64 [2 + ] x2 ([16 8 c [2 + ] (A20) x2 ) [2 + ] 16 + 3 [2 + ] (4 [3 + 5])])aF aI [4 + ] (2 2(64 [2 + ] 16 + 3 [2 + ] 2 x2 ) 2 [2 + ] x ( (16 [2 + ] [2 3 ])) : 2(64 [2 + ] 16 + 3 [2 + ] 2 x2 ) [1 ] )) Calculating the optimal discount , yields d d = u @ @qC @ 1 + @qC @ @q2 @q2u @q u @q u + 2 C @ @qC @ + @ 2 @q1u + @q1 @ 38 u @ 2 @q1u @ 2 @qC + @q1 @I @qC @I @I u @ =0 and thus u = E [puC ( ) with Du ( ) = 2( + 2)[16 (2 E [ q1u + 2q2u ] x2 Du ( ))E [q2 ( )] ; 4+ 2 C( )] [3( + 2) 2 x2 [ + 2][3( + 2) + 8]]=[64 2 + 16]] (A21) 0 for < 0:975 (and vice versa). Using the equilibrium values from (A19), (A20) and (A21), yields E[ u( )] aF + C( ) 2tu ( ) u q1 ( ) + mu ( )q2u ( ) + q2u ( )2 2 ! 2 (2 + ) 16 + 3 2 (2 + ) [2 + ]2 2: + 2 2 256 [4 ] = E q1u ( )2 + =: Bu( ) + I u ( )2 2 Characterization of the controllable market-based transfer price. The backward induction process is detailed in the text. Using q2c (tc ) = [a Ic ( ) = x 3 12 8 2 4 + tc ]=2 and (34) into (36), yields aF + 6aI [2 2 2 16 3 2 ] 6 3 2 2 3 6 c 2 2 6 4 2 : x2 (A22) Forward induction yields E [q1c ( )] = 3x2 2 6 2 aF aI [2 2 ] 6 2 2 6 3 E [q2c ( )] = + 3x2 2aI [2 2 ] 6 2 4 6 aF 2 4 3 2 + 12 2 2 6 3 3 6 2 10 3 aF 2 [2 ] (aI 6 3 2 2 2 2 2 3 6 24 6 x2 [2 + ]) 2 2 3 6 2 +8 3 2 ] aF 3 c 4 + 3 (2aI [2 x2 c 2 2 x2 : (A23) Calculating the optimal discount , yields d d = c @ @qC @ 1 + @qC @ @q2 @q2c @q c @q c + 2 C @ @qC @ and thus with Dc ( ) = 3 2 [16 c = E [pc1 ( ) C( )] 2 ]=[16[3 + @ 2 @q1c + @q1 @ 2 2 ] 3x2 [6 16E [q2c ( )] 2 4[6 ] 2 39 c @ 2 @q1c @ 2 @qC + @q1 @I @qC @I 2 2 ] ] @I c @ =0 0 8E [q1c ( )] + x2 Dc ( )E [q2c ( )] ; 2 4[6 ] (A24) 2 ) Using (A22), (A23) and (A24) yields E[ c( )] aF + C( ) 2 2 2 3 6 = E q1c ( )2 + =: Bc( ) + 32 3 2 2 2tc ( ) q1c ( ) + mc ( )q2c ( ) + q2c ( )2 ! 2 2 9[2 ] 2: + 2 2 64[3 ] I c ( )2 2 Proof of Proposition 4. The reasoning is similar to Propositions 1, 2 and 3. 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Performance comparison for the case of Bertrand competition Variance 2 0.10 Uncontrollable market-based transfer pricing Cost-plus transfer pricing ˆ u2 0.08 0.06 ̂ 2s ˆ us2 0 04 0.04 ˆ cs2 Standard cost-based transfer pricing 0.02 0.2 0.4 0.6 0.8 Co ontrollable market-ba ased transsfer pricing g 0 12 0.12 ˆ c2 1.0 Intensity of Competition Figure 3. Performance comparison for the case of Cournot competition

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