Compensation and Transfer Pricing in a Principal-Agent Model.

This paper studies transfer prices and compensation mechanisms in a principal-agent model with moral hazard and private information by the agent. Production requires unobservable effort by the agent and a purchased input. In general, it is optimal for the principal to create an internal market for the input and charge the agent a tax or subsidy that differs from the market price. Conditions are found under which the optimal compensation function is given by the difference between a nonlinear "revenue" function depending only on output and a nonlinear transfer pricing function that depends only on the amount of the purchased input. Copyright 1991 by Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association.