Delegation and Transfer Pricing in a Principal-Agent model

This paper studies transfer prices and compensation mechanisms in a principal-agent model with moral hazard and private information by the agent. Production requires unobservable effort by the agent and a purchased input. In general it is optimal for the principal to create an internal market for the input and charge the agent a tax or subsidy which differs from the market price. Conditions are found under which the optimal compensation function is given by the difference between a nonlinear "revenue" function depending only on output and a nonlinear transfer pricing function which depends only on the amount of the purchased input.