The arm's length principle and tacit collusion

The arm's length principle states that the transfer price between two associated enterprises should be the price that would be paid for similar goods in similar circumstances by unrelated parties dealing at arm's length with each other. This paper examines the effect of the arm's length principle on dynamic competition in two alternative models of vertical market structure. It is shown that the arm's length principle renders tacit collusion more stable and can reduce welfare when collusion targets the maximum collusive profit achievable in each environment.