Prices which are set in transactions between different branches or divisions of a business firm. Use of transfer pricing represents an attempt to replace administrative coordination by a market mechanism in allocating resources within a large corporation. For example, suppose division A of a firm mines a raw material and then passes it on to division B for processing. Under a centralized system, information on the costs of mining in division A and the costs of processing and revenue from output in division B would be collected by ‘the centre’, and the appropriate amount of the raw material to be transferred from A to B would be determined centrally. Under a transfer pricing system each division would be made a profit centre, and a price for division A’s output would be set. Each division would then be expected to maximize its profit at this transfer price. The advantage of this system is held to be the savings in information and coordination costs and the improvements in management efficiency and morale that result from greater autonomy.
Reference: The Penguin Dictionary of Economics, 3rd edt.