Many companies use market-based transfer pricing to value internal sales of intermediate products. This practice leads to efficient outcomes if the external market for the product is perfectly competitive. But what if the product is specialized or proprietary? Tim Baldenius and Stefan Reichelstein studied the efficiency of market-based transfer pricing when the division that makes the product has effective monopoly power, usually due to intellectual property rights. They found that the profit impact of tying the internal transfer price to the external market price hinges on the available production capacity of the upstream division.
The study showed that if the upstream division has market power, the external price generally exceeds the marginal cost of supplying the product to a downstream division. Trading internally at the market price thus allocates too much capacity to external sales and not enough to internal sales. The researchers found that if capacity is constrained, internal discounts will always mitigate this distortion and lead to a more efficient resource allocation for the firm overall. If capacity is not constrained, internal discounts have an ambiguous impact: the downstream division will often be better off, but the upstream division’s profit in the external market may go down, so the net effect on the firm’s profit can be either positive or negative.