Strategic Transfer Pricing and Intensity of Competition

Our model describes optimal transfer prices as a function of the number of multi-divisional firms. Decentralized firms imperfectly observe downstream pricing and quantity decisions. Therefore, transfer prices have two strategic functions requiring a trade-off: limiting affiliated downstream divisions' discounting and production, and making credible threats to induce soft responses from competitors. Depending on which motive dominates (i.e., number of competitors, external upstream markets, and ability to keep "two sets of books"), optimal transfer prices switch from above-marginal-cost to below. The model describes how entry affects equilibrium transfer price, output and profits while causing non-monotonic and discontinuous inter-firm upstream trade flows.