Internal markets or hierachies: Transfer prices or budgets?

Since decades existing literature has pointed to the effectiveness of transfer prices compared to budgets in enabling decentralized decisions. We attest to the relative performance of these mechanisms by analyzing them in a standard incomplete contracting model. This allows to characterize how both mechanisms provide ex ante investment and ex post intra-firm trade incentives. We show that budgets dominate over prices if there is a strong positive complementarity between the outside markets measured in terms of the linear regression beta factor. This complementarity is an important factor whether a firm should establish an internal market or a hierarchy to coordinate decentralized decisions.