Friction in Related-Party Trade When a Rival Is Also a Customer

Related parties in vertical relationships routinely have competing objectives. While conventional wisdom suggests that such frictions can be alleviated by centralized control, this paper demonstrates that decentralization and the tensions that arise in transfer pricing can help coordinate the decisions of affiliated firms. In particular, a vertically integrated central planner may find it difficult to convince a wholesale customer that it will not subsequently encroach on its retail territory, thereby necessitating wholesale price concessions to the wary customer. However, under decentralized control, related parties in the supply chain exhibit strife manifested in limited related-party pricing discounts. In this case, the upstream affiliate's customer realizes retail competition will not be as cutthroat, thereby inducing a greater willingness to pay in the wholesale arena. Such wholesale profit gains can outweigh the costs of transfer pricing distortions that arise in the retail realm. Further, in our setting, wherein input sales both to downstream affiliates and rivals are an issue, arm's length (parity) pricing restrictions can have the upside of solidifying commitments to less favorable related party pricing.