Transfer pricing is the accounting value that is assigned to goods and services flowing from one division of a firm to another division (Eun and Resnick, 2014).
Assume that there are two integrated enterprises located in two countries and engage in Cournot competition in domestic country. We firstly set up a simple model and discuss the regime of headquarters decide the transfer prices under no capacity constraint and one of the two firms faces capacity constraint. Then discuss two regimes that the government adopts marginal cost and market price as Arm’s Length prices under no capacity constraint and one of the two firms faces capacity constraint respectively. Finally, we compare the results of the above three regimes.
It is shown that under the situation of no AL principle and no capacity constraint, the upstream division will subsidy the downstream division for both of the two MNEs.
The increasing marginal cost of upstream division will deteriorate the social welfare in the domestic country under the situation of no AL principle and no capacity constraint. Besides, if the marginal cost of intermediate input decreases or the capacity constraint of intermediate input is relieved the social welfare of domestic country will improve under the situation of one of the two upstream divisions faces capacity constraint.
When the domestic government decides to regulate Arm’s Length prices: (1) Under the situation of marginal cost as AL transfer price, (a) if the marginal cost of intermediate input decreases, the social welfare of domestic country will deteriorate (improve); (b) if one of the two upstream divisions faces capacity constraint, when the capacity constraint of intermediate input is relieved, the social welfare of domestic country will improve. (2) Under the situation of market prices as AL transfer prices, (a) if the marginal cost of intermediate input decreases (increases) the social welfare of domestic country will improve (deteriorate); (b) if the capacity constraint of foreign intermediate input is relieved, the social welfare of domestic country will deteriorate;
(c) if the capacity constraint of domestic intermediate input is relieved, the social welfare of domestic country will improve.
As for the situation of no capacity constraint, the policy of regulating marginal cost as AL prices will only benefit the two firms at the expense of domestic
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consumers and domestic social welfare. If it is the foreign upstream division that faces capacity constraint, any kind of AL regulation will hurt domestic firm, consumers, and social welfare.
We also discover that the effect of optimal import tariff is equivalent to the AL measure of marginal cost.
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