Divisional performance measurement and transfer pricing for intangible assets

This paper examines the effectiveness of three transfer pricing methodologies for an intangible asset that is developed through bilateral, sequential investment. In general, a royalty-based transfer price that can be renegotiated provides better investment incentives than either a non-negotiable royalty-based transfer price or a purely negotiated transfer price, and in some cases induces first-best investment. This result contrasts with previous research that finds that the inability to limit renegotiation of initial contracts reduces investment efficiency. Further, I examine how tax transfer pricing rules inform optimal internal transfer prices when the firm decouples internal and external transfer prices.