Review of Quantitative Finance and Accounting, 15 (2000): 217±233
# 2000 Kluwer Academic Publishers. Manufactured in The Netherlands.
Collusion Proof Transfer Payment Schemes with
Department of Accounting, College of Management, National Taiwan University
KASHI R. BALACHANDRAN
Department of Accounting, Stern School of Business, New York University
Abstract. Most of the current studies on transfer pricing under asymmetric information focus on a single
principal and a single agent. Under a separating management and ownership assumption, transfer pricing is at
minimum a three-person problem involving one principal and two agents.
This paper considers a transfer pricing problem with two agents who possess private information and seek to
maximize their net cash ¯ows, instead of divisional accounting pro®ts. The objectives of this paper are: (1) to
derive a direct-revelation mechanism that induces truth telling and ef®cient allocation; (2) to study the agents'
collusion behaviors under the direct-revelation mechanism.
The ®ndings indicate that when agents have the option to quit after contracting, it is optimal for the center to
produce less than the ®rst-best output level unless the costs for both divisions are at their lowest levels. The optimal
amount of underproduction varies according to the demand condition. In addition, two sets of transfer functions,
named as identical and nonidentical functions, are derived to induce truth-telling and yield optimal equilibrium
output. The two sets of transfer functions are subject to collusion. However, the functions induce different
collusion behaviors among agents, that is, the collusion sets for both functions are not common sets. This property
enables us to eliminate any collusion between agents, particularly prior to their observation of private information.
Key words: transfer pricing, multiple agents, information asymmetry, information rent, collusion
JEL Classi®cation: C72, D82
This paper formulates the transfer pricing problem for a ®rm with the center considered
the principal and the two divisions (manufacturing and distribution) as agents with private
information who seek to maximize their net cash ¯ows. We explicitly consider the scenario
in which the agents are allowed to quit after contracting.
The major purposes of this paper are to derive explicit direct-revelation mechanism to
induce optimal solutions, instead of just characterizing the optimal solutions, and to study
collusive behaviors among agents under the proposed mechanism. Particularly we design
two types of transfer functions, identical and nonidentical functions, which induce
different collusion behaviors. However, both types of functions generate the same
equilibrium outcomes. By choosing either identical or nonidentical transfer functions, ex
post, based on agents' reported information, the principal can eliminate collusion between
agents. Although we do not consider collusion between agents after they observe their
private information, it is still an interesting case and can be observed in many
Collusive behaviors among agents are usually precluded in the accounting literature of
asymmetric information. Several work dealing with collusion in the accounting literature