Very Preliminary Draft

Transfer prices are the values at which divisions within integrated firms trade goods and services. Such pricing is prevalent throughout integrated businesses worldwide.1 In restructured electricity markets, for example, generators may be integrated into supply, or supply and distribution companies may be integrated. In most natural resource production there is extraction and then processing, e.g., extraction and refining the crude oil, and then wholesale and retail of the final product. Enron, for example, extracts, processes, and transports natural gas (and also generates and markets electricity, among other things). Accurately measuring transfer prices is important to provide the appropriate internal (divisional) incentives as well as to the overall profitability of the integrated firm. A difficulty in measuring these prices is that they are generally unobservable. They are not determined in markets, but internally within the integrated firm. Informational asymmetries and divisional profit incentives may lead to strategic manipulation of transfer prices.2 Even if the downstream division of the 1 Although not considered explicitly in this paper, there are also multinational and tax considerations in strategically setting transfer prices, as well as regulating such prices. 2 Arbitrary cost allocation and accounting rules are generally used, which in and of themselves can lead t