10.6 Transfer pricing
10.6.1 Context
As firms become larger there is a tendency for them to adapt a structure involving various divisions that in many cases are semi-autonomous. These divisions may be organized in various ways: they may perform parallel activities within the same areas, as is the case with GM; they may perform parallel activities in different areas or countries, as is the case with many multi-nationals; or they may perform vertically integrated activities in either the same or different areas. It is the last situation where transfer pricing is largely relevant. A transfer price represents an internal price within a firm, which is charged by one division to another for some intermediate product. There are
two main functions of charging such an internal price:
1 To foster greater efficiency within the firm as a whole, so that the whole firm will maximize profit.
2 To evaluate the performance of the various divisions of the firm, as profit centres in their own right.
As will be seen, these two functions can conflict with each other. Before considering an example it should be explained that transfer pricing can occur under three different conditions as far as the product is concerned: when there is no external market, when there is a perfectly competitive external market, and when there is an imperfectly competitive external market. These situations are now discussed in turn in conjunction with an example.