INCENTIVE COMPATIBLE REGULATION OF A FOREIGN-OWNED SUBSIDIARY

Transfer prices are administered charges for intra-firm transfers of factors of production. For a multinational firm, transfer prices for international transfers provide the means to redistribute costs and increase global profits given variations in national tax and profit repatriation policies. Local regulation of a subsidiary may thus be necessary to limit the welfare costs of strategic transfer pricing. Prusa (Journal of International Economics, 1990, 28, 155-172) characterizes the welfare-maximizing regulations for a monopoly subsidiary that induce the firm to report transfer prices truthfully. We show, however, that it can be more efficient to implement regulations that encourage the firm to misrepresent its true transfer costs.