Intrafirm resource allocation and transfer pricing under asymmetric information: A principal-agent analysis of decentralized decision-making in a multidivision firm

An equilibrium analysis examines decentralized decision-making in a multi-division setting. Decentralized decision-making in this case is possible if each division acts as a separate firm which maximizes the outcome of the division and a center is not required to coordinate the activities the two divisions. A review of the pertinent literature on decentralization and transfer pricing shows either that the solutions in previous studies allowed less profitable alternative equilibria which were preferred by the divisions, or the studies were not of decentralized decision-making as the solutions require a center which makes the ultimate output decisions.; The firm's decision-making problem is modeled in a two agent principal-agent environment under two production processes; the divisions produce in parallel (horizontal integration) and in sequence (vertical integration). Numerical examples are provided to aid in understanding. The parallel process extends previous multi-agent studies from decentralized decision-making to centralized decision-making. If communication is costless, centralized decision-making is weakly preferred to decentralized decision-making. Correlation of the divisions' private information is shown as a necessary and sufficient condition for strict gains from centralization.; The sequential production process extends the parallel production process to where the divisions' production problems are dependent. A portion of the upstream division's output is used as an input to the downstream division's production. Three equilibrium contracts are examined in terms of the ability to allow decentralized decision-making: both divisions report truthfully as a best-response to truthful revelation by the other division (Bayes-Nash equilibrium); both divisions report truthfully regardless of the actions of the other agent (dominant strategy equilibrium); and finally one division reports truthfully as a dominant strategy and the second division reports truthfully as a best response to the first division's truthful reporting (hierarchical equilibrium). The second best Bayes-Nash contract requires a center and is therefore not decentralized. The next best alternative, the hierarchical equilibrium, does allow decentralized decision-making and is shown to correspond with a transfer pricing type communication system. A further result shows that the intermediate product is always allocated at an efficient level where marginal cost is equated with marginal revenues.