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Negotiated Transfer Pricing, Specific Investment, and Optimal Capacity Choice

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  • Stefan Wielenberg

    (Otto-von-Guericke-University)

Abstract

This paper investigatesinvestment decisions in a divisionalized firm, in which an upstreamdivision supplies an intermediate product to a downstream division.The upstream division's investment includes two simultaneousdecisions. First, the division determines its capacity level,and second, it invests in a firm specific production technologythat lowers the marginal cost of production. Both the capacityand the specificity decision must be made before the actual demandfor the intermediate product is observable. Since the terms ofinternal trade are negotiated between the divisions, the upstreamdivision faces the well-known holdup problem and thus has incentivesto underinvest. It turns out that a simple contract stipulatinga minimum quantity and a transfer price for excessive quantitiesis sufficient to induce the efficient capacity and specificitydecisions.

Suggested Citation

  • Stefan Wielenberg, 2000. "Negotiated Transfer Pricing, Specific Investment, and Optimal Capacity Choice," Review of Accounting Studies, Springer, vol. 5(3), pages 197-216, September.
    • Handle: RePEc:spr:reaccs:v:5:y:2000:i:3:d:10.1023_a:1009604809480
    DOI: 10.1023/A:1009604809480
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    References listed on IDEAS

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    1. Tai-Yeong Chung, 1991. "Incomplete Contracts, Specific Investments, and Risk Sharing," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 58(5), pages 1031-1042.
    2. Edlin, Aaron S, 1996. "Cadillac Contracts and Up-Front Payments: Efficient Investment under Expectation Damages," The Journal of Law, Economics, and Organization, Oxford University Press, vol. 12(1), pages 98-118, April.
    3. Hermalin, Benjamin E & Katz, Michael L, 1993. "Judicial Modification of Contracts between Sophisticated Parties: A More Complete View of Incomplete Contracts and Their Breach," The Journal of Law, Economics, and Organization, Oxford University Press, vol. 9(2), pages 230-255, October.
    4. Tim Baldenius & Stefan Reichelstein & Savita A. Sahay, 1999. "Negotiated versus Cost-Based Transfer Pricing," Review of Accounting Studies, Springer, vol. 4(2), pages 67-91, June.
    5. Klein, Benjamin & Crawford, Robert G & Alchian, Armen A, 1978. "Vertical Integration, Appropriable Rents, and the Competitive Contracting Process," Journal of Law and Economics, University of Chicago Press, vol. 21(2), pages 297-326, October.
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    Cited by:

    1. Sunil Dutta & Stefan Reichelstein, 2010. "Decentralized capacity management and internal pricing," Review of Accounting Studies, Springer, vol. 15(3), pages 442-478, September.
    2. Jan Thomas Martini, 2015. "The optimal focus of transfer prices: pre-tax profitability versus tax minimization," Review of Accounting Studies, Springer, vol. 20(2), pages 866-898, June.

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