Transfer-pricing mechanisms: An experimental investigation

Abstract

This study evaluates, in a laboratory setting, the performance of the Ronen and McKinney (1970) and the Ronen (1992) transfer-pricing schemes. Both mechanisms possess, in theory, the property of inducing efficient production and truth-telling, while decision-making autonomy is maintained. The Ronen/McKinney scheme, however, allows for multiple Nash equilibria and if the divisions' managers coordinate their messages they are expected to exploit the mechanism at the expense of the overall profitability of the firm. The Ronen (1992) scheme was designed to prevent this; towards this end, a penalty factor was incorporated into the original Ronen/McKinney scheme to make truth-telling and optimal production a unique equilibrium. The basic results are that under the Ronen/McKinney scheme and with coordination of messages being allowed, subjects collude and earn significantly higher profits than amounts implied by the overall optimal solution. Without the penalty factor, subjects seemed not to converge towards the efficient level of transacting at the end of the experiment. It is not clear whether with additional trials such conversion would have occurred. The inclusion of the penalty factor, however, eliminated the collusive behaviour. In fact, most of the pairs implementing the Ronen mechanism reached the efficiency predicted by the theory whether or not coordination of messages was allowed.

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