Companies in Different States: The common logic of free trade agreements and transfer pricing

Abstract

This paper explores the strategic decisions of multinational enterprises (MNEs) selling their products to related parties in international markets. In order to minimize cost and maximize profit, companies manipulate their intrafirm activities: they set the transfer price (TP), change the location of their operations (by production displacement, providing services etc.), or create artificial transactions. These patterns guide the formulation of some theory and the development of a microeconomic model. The optimal choices firms make depend heavily on three considerations: where the competitive advantages are at a higher level, where lower tax and tariff rates are paid, and where to produce at a lower level of cost. Firms’ reactions to a given import tariff or corporate income tax (CIT) are illustrated by game theory. We identify companies and countries as common actors in economies and examine interactions between them with a scenario analysis of the 8-way interaction. We concentrate on an MNE perspective and evaluate the cooperating behavior of inter-companies which take actions to reach higher profit levels in our game. The game is continued and free trade agreements (FTAs) appear. Profit still retains its centrally important role to multinational enterprises well beyond other political interests. The results suggest that a situation where the lower tax rates combined with eliminated tariff rates generate greater profitability to MNEs.