Review of Quantitative Finance and Accounting, 14 (2000): 161±192
# 2000 Kluwer Academic Publishers, Boston. Manufactured in The Netherlands.
The Role of Transfer Price for Coordination and Control
within a Firm
Chungnam National University, Korea
KASHI R. BALACHANDRAN
Stern School of Business, 40 West Fourth Street, New York, NY 10003
Abstract. This paper explores the role of transfer prices as coordinating mechanisms within a ®rm. Three cases
(full information; pure adverse selection; adverse selection and moral hazard) are analyzed and compared to show
how quantity and effort are affected as assumptions on observability are progrssively relaxed. The analysis of the
second case, having two observable variables, identi®es the necessary and suf®cient condition under which ``the
local approach'' can be applied. The third case is reinterpreted as transfer prices in a direct delegation setting. The
main results are: First, the optimal transfer price is standard average cost plus. Second, it is not necessarily
decreasing in quantity unlike the downward sloping demand function.
Key words: transfer price, moral hazard, information asymmetry, coordination
The purpose of this paper is to explore the role of transfer price as a coordinating
mechanism within the agency theory framework considering both hidden information and
hidden action. This is modeled in a single period and single agent framework, called a
``subcontracting model'' by Balachandran and Ronen (1989) (hereafter, BR). Single agent
models do not address the free rider and collusion problems which must be important in a
multi-divisional ®rm, but they do capture the incentive problems by interdivisional
transfers. In this paper, we consider three cases: full information (Case 1), pure adverse
selection (Case 2), and both adverse selection and moral hazard (Case 3). The sequential
examination of these settings allows us to examine how quantity and effort decisions are
affected as assumptions on observability are progressively relaxed.
In a pure adverse selection framework, the optimal transfer payment has been studied in a
variety of context, (see, for example, Myerson and Satterthwaithe, 1983, Mussa and Rosen,
1978, Baron and Myerson, 1982, and Baron and Besanko, 1984). Baron and Myerson (1982)
analyzed the design of an incentive compatible pricing rule for the monopolist. In their
model, the monopolist's cost, linear in quantity, is unknown to the regulator who maximizes
a weighted sum of the expected gains to consumers plus the expected pro®t for the ®rm.
They showed that the optimal regulated price is higher than the ®rm's marginal cost for
incentive purposes. Our analysis extends theirs in that we incorporate moral hazard aspects
under general cost function where the principal's objective is to maximize his own welfare.