Transfer Pricing as Bargaining

The Nash bargaining game theory technique is used in this chapter to examine and provide a solution to the transfer pricing problem. We analyze a company with sequential transfers among its several divisions, where central management decides on the transfer price to maximize operational profitability. Throughout the negotiation process, the price shifting between divisions is a tool for bargaining. First, we take into account a point of contention (status quo) between the firm’s divisions, which serves as a deterrent. We offer a methodology and framework for calculating the disagreement point that are based on the Nash equilibrium approach. Then, we introduce the bargaining solution, which is a single-valued function that chooses an outcome from each bargaining problem’s feasible pay-offs. This solution is the result of cooperation between the company divisions involved in the transfer pricing problem. The agreement achieved by the divisions in the game is the most desirable option within the range of plausible outcomes that results in a distribution of the transfer price between divisions that maximizes profit. We provide an optimization approach for computing the negotiating solution. The method’s usefulness is demonstrated through a number of examples, including Markov models in both continuous and discrete time.