Incentive issues in transfer pricing

Abstract

This thesis is concerned with the transfer of resources within an organization. It is assumed that top level management wish to allocate scarce corporate resources as effectively as possible. However, top level management do not have enough information to fully assess the potential return from deployment of resources, in particular divisions of the corporation. Hence, top level management require divisional managers who hold such information to communicate it. Any resultant allocation of corporate resources will clearly affect the profit attained by a division. In addition, it is assumed divisional managers will be compensated partly on the basis of divisional profit, in order to promote higher levels of divisional management effort provision. The inter-relationship between the allocation of corporate resources and divisional management's resultant compensation, leads to an incentive problem. Divisional managers will perceive advantages from communicating information to top level management about the division's potential returns in a strategic (untruthful) fashion in order to improve their compensation. In this thesis it is argued that opportunities for misrepresentation should be controlled. The major result of the thesis is to propose a method for allocating scarce corporate resources and compensating divisional managers, that induces them to tell the truth and provide appropriate levels of managerial effort.