Transfer Pricing in a Decentralized Firm

Ronald Howard's editorial comments in the June, 1967 volume of this journal stressed the power of the pricing mechanism in the control and optimization of social systems. This article illustrates how such a concept can be applied via a decomposition algorithm for quadratic programming. A set of artificial markets for scarce resources and transfer goods is introduced into a model of a divisionalized firm and a quadratic decomposition algorithm is used to find the optimal (profit maximizing) set of prices for these goods. The algorithm requires a minimal amount of information transmission from the divisions to corporate headquarters and can be applied to divisionalized firms operating in imperfect markets. It also has significant behavioral implications not found in other decomposition algorithms for the firm which employs a profit-center method of control. The value of the algorithm is evident in those situations where decentralization is either desirable or a necessity and where interdependencies exist.