Intrafirm trade, arm's-length transfer pricing rule, and coordination failure

This paper demonstrates that uniform imposition of the arm's-length principle on transfer pricing leads to coordination failure among countries in terms of economic welfare if the countries trade products in the form of intrafirm transactions by multinational firms (MNFs). To highlight this implication, we first show that imposition of the arm's-length principle on an MNF induces it to transfer a product among subordinate divisions at marginal cost, i.e., the competitive price, which is consistent with the purpose of the principle. Nonetheless, if regulators in each country impose the principle on MNFs, all of the following economic welfare measures decrease compared with the situation where the principle is not imposed: (1) consumer welfare in each of the trading countries, (2) profit of each MNF, and thus (3) total world economic welfare. This result indicates that it is possible that enforcement of the principle has no positive effect at all in the world because economic welfare of all economic agents deteriorates when the principle is imposed. A numerical analysis demonstrates that this possibility arises in a broad range of circumstances, even including the situation where a giant economic world power and a small underdeveloped country mutually trade products. In these circumstances, an agreement among trading countries that no country imposes the arm's-length principle may encourage Pareto improvement of the world economy.