In order to be able to apply a correct transfer pricing method to satisfy the arm’s length principle, it is important to understand the reason for the existence of MNEs when compared to corporate entities going into the market alone. Once the reason is understood, a further analysis is needed to establish how this affects the arm’s length principle.
Vannoni (n.d.) states that the relevant theoretical approaches which discuss the nature and existence of MNEs are the transaction costs theory, the monopolistic advantage theory and the resources theory, which are discussed in detail below.
Transaction Cost Theory
Vannoni (n.d.) defines the ‘transaction cost’ as the cost involved in making an economic exchange between two parties and is the result of imperfect information in markets which behave irrationally and therefore lead to bounded rationality and opportunism. This implies that the cost of gathering the information, bargaining prices and the enforcement costs of a transaction fall within the transaction cost. MNEs exist because they manage to organise these costs more efficiently and therefore have transaction cost savings.
The ‘monopolistic advantage’ which is established through a monopoly is defined by Philip Mohr, Louis Fourie and Associates (2008:246) as “a market structure in which there is only one seller of a good or service that has no close substitutes. A further requirement is that entry to the market should be completely blocked”. It may be argued that there is no such thing as a real monopoly but MNEs may come very close. Examples of MNEs in ‘near-monopolies’ are: Microsoft, SABMiller or Coca-Cola. From such a ‘near-monopoly’ an MNE has certain advantages over smaller companies. One of the obvious reasons is that an MNE within a near-monopoly can charge higher prices for goods or services to its clients or customers when compared to a competitive market. If there is no substitute for a commodity or service, prices are higher because the customer cannot obtain the same good or service more cheaply anywhere else. MNEs gain most advantages by effectively managing inefficiencies that arise in markets, by communicating and assisting each other with information or resources, which is not the case
between two competing independent parties.
The final theory, the resource theory, is defined by Wade and Hulland (2004) as follows:
“firms possess resources, a subset of which enable them to achieve competitive advantage, and a subset of those that lead to superior long-term performance. Resources that are valuable and rare can lead to the creation of competitive advantage. That advantage can be sustained over longer time periods to the extent that the firm is able to protect against resource imitation, transfer, or substitution. In general, empirical studies using the theory have strongly supported the resource-based view.”
From the theories discussed above one can conclude that the reason for establishing an MNE is to save costs, acquire better information in a market, reduce risks and to be more competitive when compared to an independent corporate entity.
When discussing the arm’s length principle in our next post the above will become more evident and important.