Strategic decentralization, bargaining, and transfer pricing in supply chain efficiency

Abstract
Strategic Decentralization, Bargaining, and
Transfer Pricing in Supply Chain Efficiency
Dae-Hee Yoon
2008
This thesis examines the role of strategic decentralization, bargaining, and transfer
pricing in supply chain efficiency. The first essay analyzes how strategic delegation
using stock options can affect investment hold-up problems in vertical relationships.
In vertical relationships, underinvestment problems can arise because sunk invest-
ment costs are ignored in ex post negotiation. However, the delegation of bargaining
rights to the upstream manager coupled with stock options makes the sunk invest-
ment costs relevant costs from the manager's perspective. The sunk investment costs
are now reversible depending on his exercise decision. Thus, under option-based com-
pensation, the relevant investment costs create the upstream manager's bargaining
power and thereby increase transaction price in negotiation. The resulting increased
transaction price improves the upstream profit and the improved return on invest-
ment induces greater investment by the upstream firm. Despite the higher induced
transaction price, the downstream firm's profit can also improve because the greater
induced investment enhances the viability of the supply chain. Such supply chain
gains also naturally translate into gains in consumer surplus.
The second essay investigates the role of decentralization and vertical licensing
in a durable goods market. A monopolist in a durable goods market faces an over-
investment problem in its R&D decision because it cannot commit to a value of
a new investment in the future which makes its own product obsolete. This pa-
per demonstrates that decentralization and vertical licensing can help address the
overinvestment problem and increase a firm's profit. An internal conflict caused by
decentralization is a natural commitment tool for the monopolist to keep its invest-
ment level down. However, decentralization can also lower the investment too far. In
such cases, permitting vertical licensing from the R&D division to a potential rival
enables the firm to better manage its investment level. The competition induced
by vertical licensing decreases the downstream division's profit but the advantage to

the R&D division from added investment and an expanded market dominates. The
result implies that often observed decentralization and licensing across rivals can be
a means of overcoming the time inconsistency problem in a firm's R&D activities.
The third essay shows the role of decentralization in coordinating market com-
petition and vertical efficiency. There are many circumstances in which manufactur-
ers provide inputs to wholesale customers only to subsequently compete with these
wholesale customers in the retail realm. Such dual distribution arrangements com-
monly suffer from excessive encroachment in that the manufacturer's ex post retail
aggression is harmful ex ante because it undercuts potential wholesale profits. This
paper demonstrates that with dual distribution, a manufacturer can benefit from
decentralized control and the use of transfer prices above marginal cost. Though
these arrangements often create coordination concerns, a moderate presence of such
concerns permits the manufacturer to credibly convey to its wholesale customer that
it will not excessively encroach on its retail territory. This, in turn, permits the man-
ufacturer to reap greater wholesale profits. We also note that this force can point to
a silver lining in arm's length (parity) requirements on transfer pricing in that they
can solidify commitments to a particular retail posture.
Strategic Decentralization, Bargaining,
and Transfer Pricing in Supply Chain
Efficiency
A Dissertation
Presented to the Faculty of the Graduate School
of
Yale University
in Candidacy for the Degree of
Doctor of Philosophy
by
Dae-Hee Yoon
Dissertation Director: Professor Shyam Sunder
December 2008

UMI Number: 3342736
Copyright 2008 by
Yoon,
Dae-Hee
All rights reserved.
INFORMATION TO USERS
The quality of this reproduction is dependent upon the quality of the copy
submitted.
Broken or indistinct print, colored or poor quality illustrations and
photographs, print bleed-through, substandard margins, and improper
alignment can adversely affect reproduction.
In the unlikely event that the author did not send a complete manuscript
and there are missing pages, these will be noted. Also, if unauthorized
copyright material had to be removed, a note will indicate the deletion.
®
UMI
UMI Microform 3342736
Copyright 2009 by ProQuest LLC.
All rights reserved. This microform edition is protected against
unauthorized copying under Title 17, United States Code.
ProQuest LLC
789 E. Eisenhower Parkway
PO Box 1346
Ann Arbor, Ml 48106-1346
Copyright © 2008 by Dae-Hee Yoon
All rights reserved.
Contents
Abstract i
Dedication 1
Acknowledgements 2

1 Introduction 3
1.1 Decentralization 5
1.2 Supply Chains and Its Implication for Accounting 6
1.3 Strategic Delegation 8
1.4 Bargaining in Supply Chains 9
1.4.1 Nash Bargaining 9
1.4.2 Example 12
1.5 Organization of Dissertation 15
2 Using Stock Options to Make Sunk Costs Decision-Relevant: Alle-
viating the Upstream Underinvestment Problem 16
2.1 Model 21
2.2 Benchmark: Integration 23
2.3 Non-Integration 26
2.3.1 The Short Run 27
2.3.2 The Long Run and Pareto Gain 31
u
2.4 Example 37
2.5 Conclusion 40
3 Decentralization and Vertical Licensing: Mitigating the overinvest-
ment problem in a durable goods market 42
3.1 Setup 48
3.1.1 Model 48
3.1.2 Benchmark: The First-Best Solution 50
3.2 Centralization 52
3.3 Decentralization 53
3.4 Licensing and Duopoly 56
3.4.1 Horizontal Licensing under Centralization 57
3.4.2 Vertical Licensing under Decentralization 58
3.4.3 Endogenous Upgrade Level 62
3.5 Example 64

3.6 Conclusion 66
4 Friction in Related Party Trade when a Rival is also a Customer
1
67
4.1 Model 71
4.2 Results 72
4.2.1 Centralization 72
4.2.2 Decentralization 74
4.2.3 Centralization vs. Decentralization 76
4.2.4 Negotiated Pricing 83
4.2.5 Arm's Length Pricing Restrictions 86
4.3 Conclusion 89
^his is a joint work with Professor Anil Arya and Professor Brian Mittendorf.
in
5 Conclusion 91
6 Appendices 94
6.1 Appendix A: Proofs of Propositions in Chapter 2 94
6.2 Appendix B: Proofs of Propositions in Chapter 3 102
6.3 Appendix C: Proofs of Propositions in Chapter 4 107
IV
List of Figures
1.1 Nash Bargaining Solution 11
2.1 The Sequence of Events 27
2.2 The Sequence of Events in the Long Run 31
2.3 The Investment Levels 38
2.4 Profit of the Upstream Firm 38
2.5 Profit of the Downstream Firm 39
2.6 Pareto Gain 39
3.1 The Sequence of Events 50
3.2 The Sequence of Events under Vertical Licensing 59

3.3 The Investment Levels 64
3.4 The Firm's Profit 64
3.5 Endogenous Upgrade and the Firm's Profit 65
4.1 The net benefit of decentralization in terms of wholesale profit (top),
retail profit (bottom), and total profit (middle) as a function of k. . . 79
4.2 The net gain from the decentralization as a function of the bargaining
power 86
v
List of Tables
2.1 Example 38
VI
To my parents
1
Acknowledgements
I am sincerely grateful to Professor Shyam Sunder. He guided my doctoral study
as both a course advisor and a thesis advisor from beginning to end. He always
encouraged me to challenge unknown areas with new ideas. I am also deeply indebted
to Professor Brian Mittendorf. Without his encouragement and help, I would not
have made it through the difficult periods during my doctoral study. I am very
grateful to him for guiding my study and mentoring me.
I also would like to thank Professor Rick Antle for serving on the committee and
giving me his insights for my research. I appreciate Professor Jiwoong Shin for his
kind advice and encouragement. I would like to thank Professor Anil Arya for his
advice and coauthoring the third paper of this thesis.
I also thank Professors Jacob Thomas, Frank Zhang, and Merle Ederhof for their
advice and help during my doctoral study.
Finally, I would like to dedicate this thesis to my father and mother. Without
their sacrifice and support, I could not have pursued my doctoral study. Their love
enabled me to complete this thesis and the doctoral study.
2

Chapter 1
Introduction
In a modern business, a product is an output of efforts of numerous parties such as
employees, managers, suppliers, shareholders and so on. Among the parties, suppliers
are an integral part of the business process, because their efforts and investments
have large impacts on lower costs and higher qualities of final products. To procure
inputs with lower costs and higher qualities from suppliers, manufacturers make
various attempts, such as recognition of best suppliers and sharing production and
marketing information.
However, a manufacturer and a supplier are two independent entities with differ-
ent objectives. Each of these entities focuses on maximization of its own profit rather
than supply chain efficiency. As a result of the different objectives, their bargaining
process for procurement contract cannot avoid conflicts which can cause inefficiency
in supply chains.
To mitigate the inefficiency in supply chains, various contracts such as a long-
term contract based on contingencies, joint venture, and co-investment have been
developed but none of them are complete solutions. For instance, the long term
contract is often not feasible because the contingencies for the long-term may not be
3
identifiable or contractible. In the absence of complete solutions to the supply chain
inefficiency, this thesis shows that accounting can provide substitutes for various
contracts between a supplier and a buyer through a manager's compensation and an
organizational structure.
This thesis consists of three essays. The first essay shows how a manager's com-
pensation affects an investment hold-up problem and supply chain efficiency by in-
creasing a supplier's bargaining power. A supplier's delegation of bargaining to a
manager with stock options transforms sunk investment costs into relevant costs
from a manager's perspective because the sunk investment costs are now reversible
depending on his exercise decision. The relevant costs increase a manager's bar-
gaining power in the negotiation with a buyer and thereby a transaction price and

a supplier's profit increase. The improved transaction price increases the supplier's
investment level and can achieve Pareto gain in the supply chain. In this supply
chain, the manager's option-based compensation is a substitute for a complex con-
tract which protects a supplier from a buyer's opportunism and enhances supply
chain efficiency.
The second essay investigates the role of decentralization and vertical licensing in
a durable goods market. A durable good monopolist faces an overinvestment prob-
lem because it cannot commit to the optimal level of investment over time due to
time inconsistency problem. Its new investment creates a new demand but at the
same time it makes an old product obsolete. If consumers anticipate the arrival of a
new product through the rational expectation of the investment level, they are less
willing to pay for the initial product. Thus, the firm's overall profitability decreases
under the investment for a new innovation. In this overinvestment problem, decen-
tralization based on a negotiated transfer pricing between divisions causes conflicts
which lower the investment level. Also, vertical licensing from the upstream division
4
to a rival allows a firm to transform a market structure from a monopoly to a duopoly
and thereby a firm can better manage the investment levels over time.
The third essay shows that decentralization can be a device of coordinating com-
petition in a market. Under decentralization, a transfer price above marginal costs is
induced by competing objectives of each related party. The double marginalization
reduces the downstream profit but it increases the upstream profit by providing a
concession to a rival firm: a rival is more willing to pay for the input from the up-
stream. Then, a firm's profit increases because the gains from the wholesale profit
dominate the costs of transfer pricing distortion in retail markets.
The remainder of this chapter explains the related literature in decentralization,
supply chains, strategic delegation, and bargaining.
1.1 Decentralization
The effect of decentralization in an organization and a market has been largely inves-
tigated. Holmstrom (1984) shows that decentralization is more compelling form of a

principal's precommitment to a mechanism than centralization with communication.
Schwartz and Thompson (1986) emphasize the role of commitment of decentraliza-
tion in the context of entry deterrence. In their research, decentralization is employed
for an incumbent firm to preempt rational entry in its market because a newly cre-
ated division can duplicate a new entrant's strategy while freely competing against
each other. Melumad and Reichelstein (1987) show that without communication,
delegation is preferred to centralization for the principal's interest. On the other
hand, when communication between the agent and the principal exists, the perfor-
mance of decentralization is equivalent to that of centralization under only some
special conditions. Melumad and Mookherjee (1989) show that decentralization can
5
be used for a government to commit to an audit strategy. In this setting, delegation
of an audit policy to a manger enables the government to commit to an audit policy
ex post. Melumad, Mookherjee, and Reichelstein (1995) compare the performance
of delegation with that of centralization in the presence of an intermediate agent.
They show that the additional incentive problem in the three-tier hierarchy can be
mitigated by sufficient monitoring of an intermediate agent's contribution to the joint
output and a specific sequence of contracting.
Also,
a supply chain is another form of decentralization and many papers have
examined the effect of decentralization in distribution channels. Desai et al. (2004)
find that having a retailer in the distribution channel helps a manufacturer improve
profit under some conditions in a durable good market. In detail, they show that
under two-part prices the wholesale price should be higher than the manufacturer's
marginal cost to cope with the durable good problem. Balasubramanian and Bhard-
waj (2004) examine the benefit of decentralization in the presence of multiple decision
variables: price and quality. Decentralization allows each division to focus on price
and quality respectively without spillover effect and the firm can choose a proper
level of quality which maximizes its profit. Arya and Mittendorf (2006a) show that
in a durable good market channel discord can mitigate the overproduction problem.

1.2 Supply Chains and Its Implication for Account-
ing
While the accounting research on divisional relationships in a firm (e.g., transfer
pricing and capital budgeting) has been extensively done, the role of accounting
information in supply chains has been overlooked until recently.
One may think that the results in divisional relationships are just analogous to the
6
issues in supply chains. But it is not necessarily the case. The important difference
between supply chains and divisional relationships is goal congruence. In divisional
relationships, a divisional manager's payoff is aligned with a firm's goal and the
decision making can be coordinated with relative ease via compensation and transfer
pricing by headquarters. On the other hand, supply chains consist of two independent
firms and each firm has its own objective. The different objectives cause conflicts
between firms and the conflicts often lead to inefficiency such as underinvestment
problems in supply chains (Williamson 1979, 1985). But the conflicts cannot be as
readily controlled as in divisional relationships. The two independent entities make
it difficult to coordinate mechanisms such as managers' compensation and transfer
pricing for supply chain efficiency. For the coordination, they need to go through a
complex negotiation process, which causes another conflict. Therefore, the solutions
in divisional relationship cannot be simply applied to the issues in supply chains.
For that reason, we need to examine the role of accounting separately in the context
of supply chains.
Only a few papers have investigated the role of accounting in supply chains. Ra-
jan and Baiman (2002) investigate the effect of information sharing in buyer-supplier
relationships. They show that a buyer's information sharing of innovation can en-
hance production efficiency, but it can also induce a supplier's misappropriation of
the shared information. Such a trade-off determines the level of information exchange
in supply chains. Kulp (2002) analyzes the determinants and effects of the use of two
alternative inventory management systems in supply chains: a traditional system and
a Vendor Managed Inventory (VMI) system. The result shows that the reliability of

a retailer's acounting information and a manufacturer's ability to capture the shared
information affect the performance of the VMI. Arya and Mittendorf (2006c) inves-
tigate the role of accounting earnings fixation in a vertical relationship. They show
7
that the higher demand of downstream under earnings fixation increases the rents
of upstream which lift the investment incentive, thereby mitigating an investment
hold-up problem. On the other hand, this thesis investigates the role of accounting
information in mitigating conflicts in supply chains via a manager's compensation
and an internal organizational structure, which has not been examined before.
1.3 Strategic Delegation
Since Schelling (1960) first stressed the notion of strategy of conflict, many papers
(e.g., Vickers (1985), Fershtman and Judd (1987), and Sklivas (1987)) have exam-
ined the benefit of strategic delegation in competition between rivals. Vickers (1985)
examined the role of strategic delegation in various situations and suggested the po-
tential implication in horizontal competition and vertical relationships. Fershtman
and Judd (1987) and Sklivas (1987) show that the strategic choice of compensation
changes a manager's behavior and, as a result, the firm's profit can be affected in hor-
izontal competition. In quantity competition, a manager becomes more aggressive
as a result of the strategic choice of incentives. On the other hand, in price compe-
tition the manager becomes less aggressive as a result of the strategic compensation
and a firm's profit improves. Alles and Data (1998) show that in decentralized firms
transfer prices should exceed marginal costs when considering strategic interaction
in duopolistic price competition. In their paper, the cost-plus transfer price induces
a marketing manager to set a price higher, thereby mitigating market competition.
Similarly, Gox (2000) analyzes that a publicly observable commitment to an ab-
sorption costing system can be a strategic device to achieve softened competition in
duopoly.
8
1.4 Bargaining in Supply Chains
Bargaining is prevalent in everyday life and it is prominent in business. Employment

contracts, mergers and acquisitions, and especially procurement contracts are all the
result of bargaining. To predict the equilibrium of this common practice, economists
have searched extensively for bargaining models and the optimal strategy for the
negotiation process. In the past several decades, numerous bargaining models have
been developed and examined, but the Nash bargaining solution (Nash 1950, 1953)
is still the most commonly employed model in economic research. The model is
very general without strong assumptions, and unlike other models with multiple
equilibria, it generates a unique solution by using simple intuitions. In the next
section, I explain the detailed formulation of the Nash bargaining solution.
1.4.1 Nash Bargaining
The Nash bargaining solution is based on the subtle concept of cooperation, which
means that "the two individuals are supposed to be able to discuss the situation and
agree on a rational joint plan of action, an agreement that should be assumed to be
enforceable." (Nash, 1953) The important negotiation device in the Nash bargaining
solution is the threat based on the disagreement point, which is the payoff in the
event of negotiation failure. Thus the disagreement points and the set of feasible
payoffs available to both players jointly decide the negotiation outcome for the two
parties.
Nash (1953) shows the unique bargaining solution using two approaches: the
negotiation model and the axiomatic method. The axiomatic approach is commonly
used, and the explanation of the Nash bargaining solution in this section follows this
approach. According to Myerson (1991), the bargaining problem is defined by (F, v),
9
where F is a subset of R
2
, which is closed and convex and v =
(t>i,
v<f)
is a vector in
R

2
.
1
Additionally,
F n {(x
1
,x
2
) | xi > vi and x
2
> v
2
} (1)
is nonempty and bounded. F stands for the set of feasible payoff allocation, and v
stands for the disagreement point. In this formulation, the bargaining problem is
defined as a problem of finding a solution function
(f>
(F, v), where
t(F,v) = (cj
)l
(Fv),<j
)2
(F,v)). (2)
The axioms for the Nash bargaining solution are as follows.
Axiom 1 (Strong Efficiency).
<f>
(F, v) is an allocation in F, and, for any x in F, if x >
4>
(F, v), then x =
(/)

(F, v).
Axiom 2 (Individual Rationality).
</>
(F, v) > v.
Axiom 3 (Scale Covariance). For any numbers Ai, A2,7
l5
and 7
2
such that Ai > 0
and\
2
> 0, ifG = {(Ai^i + ^
lt
X
2
x
2
+ 7
2
,) I (xi,x
2
) e F} andw = (Ai^i +7
X
,
X
2
v
2
+ 7
2

),
then 0 (G, w) = (Ai0
x
(F, v)+'y
1
, A
2
0
2
(F, v) + 7
2
).
Axiom 4 (Independence of Irrelevant Alternatives). For any closed convex set G,
ifGQFandcj) (F, v) € G, then
(p
(G, v) =
(f>
(F, v).
Axiom 5 (Symmetry). If v\ = v
2
and {{x
2
,x
x
) | (xi,x
2
) G F}, then
<\>
x
(F,v) =

<t>
2
(F,v).
Axiom 1 implies that the bargaining solution should be feasible and Pareto effi-
cient. Axiom 2 suggests that each player should get a payoff which is greater than
^n this section, I follow a notation in Myerson (1991).
10
the disagreement point. Axiom 3 indicates that the real outcome is not changed by
order preserving linear transformations of the utilities. Axiom 4 means that deleting
feasible alternatives which are not chosen, should not affect the bargaining solution.
Axiom 5 implies that if bargaining positions of players 1 and 2 are symmetric in the
bargaining, the bargaining solution is also symmetric. The Nash bargaining solution
satisfies these axioms and generates one unique solution by the maximization of the
product of the two parties' incremental profit as follows.
•
(F, v) G argmax {x\
—
v\) (x
2
—
v
2
)
x£F, x>v
(3)
Figure 1.1 describes how the Nash bargaining solution is decided by the axioms.
Haver 2
(0,0)
\
F

\ <.x
1
-v.Xx
1
-v
i
)
=
c
\
\
Player I
Figure 1.1: Nash Bargaining Solution.
Based on the disagreement points (vi, v
2
), two parties decide the negotiation outcome
(xi,x
2
) = (^, ^) by the notions of symmetry and efficiency. At the point, the
Nash product {x\
—
fi) (x
2
—
^2) is also maximized.
11
One common question for the Nash bargaining solution is why it uses the prod-
uct to get the negotiation outcome instead of simply splitting the total surplus by
half.
The idea of splitting the total surplus by half is based on the egalitarian so-

lution which distributes equal gains to two bargainers. In this interpersonal utility
approach, the axiom of scale covariance is generally violated because the interper-
sonal comparison does not have decision-theoretic significance (Myerson 1991). The
Nash bargaining solution is a synthesis of the egalitarian solution and the utilitarian
solution which maximizes the sum of two persons' utility. Then, under only some
conditions, the egalitarian solution is the same as the Nash bargaining solution by
corresponding to the utilitarian solution.
If the players are asymmetric in their bargaining strengths, the two persons bar-
gaining problem can be generalized to a nonsymmetric Nash bargaining solution by
dropping the axiom of symmetry. Then, the positive number a and
/3
(0 < a,
(3
< 1)
imply each party's bargaining power and the Nash product is defined as follows.
(xi - v
x
)
a
(x
2
- v
2
f
, where a +
(3 —
1.
1.4.2 Example
Using an example of the bargaining between a supplier and a buyer in a vertical
relationship, I show how the Nash bargaining solution predicts a unique equilibrium.

The buyer is a monopolist in the final market with a linear demand function (p =
a
—
bq) and it purchases intermediate goods from a supplier. The supplier produces
the intermediate goods at constant marginal cost c. Then, the upstream firm's profit
12
IS
7Ti = (t - c)q (5)
while the downstream firm's profit is
7r
2
= (p - t)q. (6)
Through the bargaining process, the two parties decide the transaction price t
and the supplier has bargaining power p and the buyer has bargaining power 1
—
p.
Backward induction is used to get the equilibrium. First, the buyer decides the
quantity (q) as follows:
Max q(a
— bq —
t). (7)
i
Then the quantity and the price are
a-ta+t
9 =
-2T
;P=
-2
(8)
Second, based on the quantity and price, the two parties negotiate the transfer price

by maximizing the Nash product.
Max [(p - t)q}
l
~
p
'[(t - c)q]
p
(9)
Then, the equilibrium outcomes are
,'a-c\
(a-c)(2
—
p) a + c (a - c\ ._.
The equilibrium outcomes maximize the Nash product, that is, total surplus, and
allocate the surplus to each party according to the bargaining power. As we see in
13
the result, the transaction price becomes larger as the supplier's bargaining power
(p) increases. Accordingly the quantity decreases and the external price increases,
thereby causing the double marginalization problem. As the supplier's bargaining
power becomes larger, the double marginalization problem becomes more severe be-
cause the buyer responds to the increase of the transaction price by decreasing the
external quantity which causes the price increase.
According to the equilibrium outcomes, each party's profit is as follows:
*. = ('-^
=
(a
~
c)2
8
!

2
~
p)p
; (ID
(a - c)
2
(2 - p)
2
The sum of two firms is
711+2
= 166
(12)
, which is the supply chain efficiency. The supply chain efficiency is smaller than
the first-best outcome under integration ( ^ )• The result implies that the supply
chain suffers from double marginalization as long as p > 0, that is, when there is a
conflict in the bargaining.
Example 1 Demand function is p = 2
—
q, c = 1, and p = \. Then, the equilibrium
outcomes are as follows:
13
TTl
5
4
!
3
32
q =
;TT2
3

8
r=
; v
9
64'
14
1.5 Organization of Dissertation
The following chapters examine the role of strategic delegation, transfer pricing and
bargaining in enhancing supply chain efficiency. Chapter 2 examines how strategic
delegation coupled with stock options increases a firm's bargaining power using sunk
costs.
Chapter 3 investigates the role of decentralization and vertical licensing in
overcoming the overinvestment in a durable goods market. Chapter 4 shows that
the friction due to decentralization can be a way of coordinating market competition
and vertical efficiency. Chapter 5 concludes this thesis.
15