The teaching of transfer pricing: Theory and examples

This paper presents a unified framework for teaching transfer pricing at the advanced undergraduate or Masters levels. The approach is based on the economic transfer pricing model of Hirshleifer [Hirshleifer, J. (1956). On the economics of transfer pricing. Journal of Business, 29 (July), 172–184; Hirshleifer, J. (1957). On the economics of the divisionalized firm. Journal of Business, 29 (April), 96–108] but uses a series of numerical examples to “flesh out” the principles arising from the purely diagrammatic approach taken by Hirshleifer. We also develop numerical examples that illustrate the effects that removing the frictionless markets assumptions (that underscore the Hirshleifer approach) can have on optimal transfer pricing rules. The focus here is on the lack of goal congruence introduced by agency considerations and the role of accounting procedures in alleviating these agency issues. The teaching materials embodied in this article were developed “at the coalface” and have been successfully used by the authors in advanced undergraduate managerial accounting classes.