Multidivisional firms have long been struggling to determine the appropriate mechanism for determining the price that a selling division should charge a buying division. Firms deal with different organizational and environmental variables that affect the choice of transfer pricing mechanism. The extent of delegation of authority to divisional managers (i.e., the extent of centralization) is a critical factor. Studies in transfer pricing mechanisms can be classified into two major categories: first, those that try to provide theoretical models that maximize the overall firm's profit, and second, those that focus on real world activities and try to explain the firms' actual practices with regard to transfer pricing. The purpose of this dissertation is to provide theoretical models that can be used to determine the desired level of the restriction for the center to impose on divisions and the optimal transfer price of intermediate products to be traded between divisions of a firm. In most of the models presented in my dissertation, the center cannot observe the market price of the intermediate product, and in some models it cannot observe divisional costs. The center determines the transfer price of the intermediate product and specifies conditions under which divisions trade internally or externally. I show how the center, by using an instrument, a penalty factor that encourages internal trade, can obtain the full information solution in the simplest case, a solution that is optimal for the overall firm as well as for individual divisions. However, when divisional costs are not observable, the full information solution is not obtainable. The optimal value of the penalty factor implies a tradeoff between the benefits of allowing divisions to act to take advantage of price opportunities in outside markets and savings in transactions costs of trades between divisions.
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