This paper examines the theoretical properties of full cost transfer prices in multi-divisional firms. In our model, divisional managers are responsible for the initialacquisition of productive capacity and the utilization of that capacity in subsequentperiods, once operational uncertainty has been resolved. We examine alternativevariants of full cost transfer pricing with the property that the discounted sum oftransfer payments is equal to the initial capacity acquisition cost and the presentvalue of all subsequent variable costs of output supplied to a division. Our analysisidentifies environments where particular variants of full cost transfer pricing induceefficiency in both the initial investments and the subsequent output levels. Ourfindings highlight the need for a proper integration of intracompany pricing rules anddivisional control rights over capacity assets.
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