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Encyclopedia of Law & Economics - 7500 ARBITRATION



Bruce L. Benson
DeVoe Moore Professor and Distinguished Research Professor
Department of Economics, Florida State University
© Copyright 1998 Bruce L. Benson



1. Introduction

2. Why Should Arbitration Be Studied?

3. Why Is Commercial Arbitration Chosen Rather than Litigation?

4. Does Commercial Arbitration Rely on Reciprocities and PrivateSanctions, or on Legal Sanctions?

5. What are the Consequences of Legal Sanctions for Arbitration?

6. Are Precedents Produced Through Arbitration?

7. Are There Important Differences in Labor Arbitration Institutions?

8. Does Final Offer Arbitration Encourage Negotiation (or DiscourageArbitration)?

9. Do Arbitrators Split the Difference?

10. Does Conventional Interest Arbitration "Chill" Negotiations?

11. How Are Arbitrators Selected?

12. Conclusions: "Exchangeability" and the Benefits of Arbitration


Bibliography on Arbitration (7500)

Other References


Within the economics literature on arbitration, some studies, generallyconsidering commercial disputes, emphasize arbitration-litigation relationships.For instance, commercial arbitrators often rely on customary commercial lawrather than national law, suggesting that arbitration can be a jurisdictionalalternative to litigation rather than simply a procedural one. In support of this,the literature demonstrates that arbitration is a potential source of precedent, andis viable without judicial backing. Others studies, mostly dealing with labordisputes, focus on negotiation incentives given alternative forms of compulsoryinterest arbitration. Arbitration selection processes' implications for arbitratorbehavior and the relative "quality" of arbitration are also considered.

JEL classification: K41, J52

Keywords: Arbitration, Customary Law, Private Sanctions, Precedent, InterestArbitration, Exchangeability

1. Introduction

The law and economics literature on contracts and contract enforcement hasfocused almost exclusively on judicial adjudication (Rubin, 1995, p. 113), despitethe fact that the vast majority of contracts are never adjudicated. Outside therealm of law and economics there is a large literature on alternative disputeresolution (ADR) including arbitration, for instance, indicating that even whendisputes can not be resolved through negotiation or mediation, they are directedaway from national courts and into arbitration, at least for some large categoriesof contracts. Lew's (1978, p. 589) detailed examination of the evidence oninternational commercial contracts concludes that around eighty percent ofthese contracts had arbitration clauses at the time of his study, for example, andthat over time, "more and more [international traders] ... turn to arbitration."More recent studies confirm this trend: Casella (1992, p. 1), Berger (1994, p. 12)and others report that about 90 percent of all international trade contractscontain arbitration clauses. Similarly, within the United States, arbitration underthe auspices of various commercial organizations, or by independent arbitrators,perhaps from the American Arbitration Association (AAA), resolve at leastthree times as many commercial disputes as the common law courts do(Auerbach, 1983, p. 113).

Arbitration of disputes between employers (both government and private)and unionized employees has also been routine (and even compulsory forgovernment employees, as well as for some private sector employees, whennegotiation proves inadequate) for several decades in the United States.Furthermore, while non-union employees' disputes were almost never arbitratedbefore 1970, growing numbers are now resolved by arbitrators (Ware, 1996, p. 1).Arbitration is also used for disputes between businesses and customers. Forinstance, the New York Stock Exchange formally provided for arbitration in its1817 constitution, and it "has been working successfully ever since," primarilyto rectify disputes between Exchange members and their customers (Lazarus, etal., 1965, p. 27). The Council of Better Business Bureaus (BBB) operatesarbitration programs for consumers in many parts of the United States, severalautomobile manufacturers have contracts with the BBB to arbitrate car owners'complaints, AAA arbitrators annually resolve thousands of insurance claims,the National Association of Home Builders offers AAA arbitration of buyers'complaints against association members, medical malpractice arbitration, begunin 1929, is on the rise, and so on (Denenberg and Denenberg, 1981).Non-contract civil disputes are also shifting to arbitration in the United States,in part to avoid litigation costs such as delays due to congested governmentcourts (Bloom and Cavanagh, 1987, p. 35). Indeed, a new private-for-profit courtindustry, developing since 1979, offers a wide variety of ADR procedures toresolve all kinds of disputes [there were more than 50 such firms in the UnitedStates 1992, most with offices in several states (Ray, 1992, p. 191)]. These firmsare attracting growing numbers of customers [as well as profits and investors(Phalon, 1992, p. 126)], including many who do not contractually stipulate ADRprior to the dispute arising.

While arbitration has not attracted much attention in the core of the law andeconomics literature, there are some exceptions [e.g., Landes and Posner (1979),Bernstein (1992), Shavell (1995)]. Furthermore, expanding "law and economics"to include some contributions from "new institutional economics" and laboreconomics, reveals considerable analysis of various aspects of arbitration, thusproviding the foundations upon which a law-and-economic approach tounderstanding arbitration's functions can be built. There is a much largerliterature on arbitration outside of economics, of course, including severaljournals exclusively concerned with arbitration or ADR, but this review focuseson research by economists or by legal scholars who have adopted alaw-and-economics approach (and at times, contributions from the largerliterature referred to in this research), thus leaving out some issues that may beattracting attention in the larger literature and/or of potential but yet unexploredinterest from a law-and-economics perspective.

The economics literature on arbitration divides, roughly, between laborarbitration and commercial arbitration. However, within this literature, a different(but correlated) division is also apparent. In particular, some studies, mostlyconcerned with commercial arbitration, emphasize relationships betweenarbitration and litigation, while other economics research, primarily in the laborliterature, focuses on arbitration's influence on negotiation incentives(explorations of the arbitration process are found in both literatures). Thefollowing presentation is organized in reflection of this division. It appears thatthe reason for the differences in focus arises, at least in part, because commercialarbitration is generally an ex ante voluntary decision by both parties tocontractually specify arbitration over litigation in the event of a dispute, whilethe most widely studied examples of labor arbitration by economists (interestarbitration dealing with public sector employees) are compulsory under statutelaw. This is probably due to the fact that data on some compulsory arbitrationsystems can be obtained relatively easily, while data on general grievancearbitration is not nearly as accessible. As a consequence, however, within theeconomics literature, voluntary commercial arbitration is often depicted as acooperative endeavor to minimize the costs of dispute resolution, while laborarbitration tends to characterized as a much more adversarial process. In reality,like commercial arbitration, most private-sector labor arbitration arises throughcollective bargaining contracts rather than through compulsory statutes, theprimary exception being parts of the transportation industry governed by theRailway Labor Act, so as indicated below, the impression taken from the laboreconomics literature on arbitration may be quite misleading.

First, some of the reasons for why law and economics scholars should beinterested in arbitration are discussed in Part 2. An important one, at least forcommercial law, is that arbitrators often resolve disputes under customarycommercial law and/or trade association rules rather than under the statuteand/or precedent law of a particular nation. That the choice of arbitration is ajurisdictional issue rather than simply a procedural one might not be acceptedif, as is frequently claimed, arbitration is not viable without judicial enforcementof arbitration agreements and rulings, and/or arbitration is simply acompromising process and not a source of legal interpretation and precedent.Therefore, the arguments and evidence regarding these two "arbitration versuslitigation" issues are explored in Parts 3 through 6. The arbitration/negotiationrelationship as it is depicted in the labor economics literature, primarily inconsideration of the effect of alternative forms of compulsory arbitration onincentives to negotiate, is examined in Parts 7 through 10. Arbitration selectionprocesses and their implications for arbitrator behavior and the relative "quality"of arbitration are examined in Part 11, and concluding comments appear in Part12.

2. Why Should Arbitration Be Studied?

There are many reasons for more careful consideration of arbitration in the lawand economics literature. For instance, the similarities between arbitration andcivil litigation are considerable, so perhaps we can learn something about morecomplex dispute resolution processes by studying arbitration (Ashenfelter, 1987,p. 342; Bloom and Cavanagh, 1987, p. 353). The differences between arbitrationand litigation may also be instructive. For example, unlike judges and juries,arbitrators tend to specialize in particular types of disputes. A knowledgeablespecialist can render a decision more quickly and with less information transferfrom, and therefore less costs incurred by, the disputants, and is less likely tomake an error, but Ashenfelter (1987, pp. 342-343) raises another point: sincedisputants typically have veto power in arbitrator selection, arbitratorscompeting for business have incentives to develop expertise and renderunbiased decisions echoing those of past arbitrators. Thus, as explained below,considerable empirical evidence suggests that arbitrator decisions arestatistically "exchangeable". In contrast, U.S. juries are selected for their lack ofknowledge in an effort to assure "unbiased justice" (fairness), but theexchangeability of expert arbitrators' decisions suggests an alternative way toachieve bias-free justice while reducing the likelihood of error or bias:competition between "experienced jurors."

Perhaps a more important reason for considering arbitration is to gain a fullerunderstanding of contracting and contract law. In this regard, the focus onjudicial adjudication in the law and economics literature on contracting wouldbe appropriate if court precedents and statutes as interpreted by a nation-state'scourts (as well as court interpreted trade agreements between nations) was theexclusive source of law shaping contracts. This is not the case, however, at leastin the area of commercial contracting (Rubin, 1995; Benson, 1989, 1998a, 1998b;Bernstein, 1992, 1996). For instance, Lew's (1978, p. 582-583) examination ofinternational commercial arbitration records demonstrates that arbitrators often"denationalize" disputes, looking instead to a "non-national and generallyaccepted rule or practice appropriate to the question at issue .... developedthrough the concerted efforts of those concerned with and participating ininternational commerce" (Lew, 1978, p. 582-583). That is, as Berman and Dasser(1990, p. 33) explain, international arbitrators "refer to international commercialcustom, including contract practices in international trade, as a basis for theiraward", and no nation's law is applied unless the contract specifies it or theparties expect it [also see Trakman (1983) and Benson (1992b)].

Standards of business practice and usage within trade associations andother commercial groups [or a trade association's explicit internal "legislation"(Bernstein, 1996)] are also the sources of many of the basic rules under whichcontracts are drawn up and disputes are arbitrated within many countries.Bernstein's (1992, p. 126) examination of the systematic rejection of state-createdlaw by the diamond industry in favor of its own internal rules (includingarbitration institutions and privately produced sanctions) provides a veryrevealing example: the New York diamond merchants' "Board of Arbitrators doesnot apply the New York law of contracts and damages, rather it resolvesdisputes on the basis of trade custom and usage." Furthermore, despiteBernstein's (1992, p. 116) contention that "the diamond industry is unique in itsability to create and, more important, to enforce its own system of private law",the same abilities actually exist in many other commercial groups. The fact is thatcommercial arbitration makes "the courts secondary recourse in many areas andcompletely superfluous in others" (Wooldridge, 1970, p. 101). Thus, while manycontend that law is what judges say it is, this is only true in contracts to theextent that a judge is expected to have the last word on the contract; whenadjudication is not sought, perhaps due to the availability of arbitration and thebenefits it produces (and/or private sanctions to discourage adjudication, anissue discussed at length below), other behavioral rules can and often willcontrol the contracting parties' conduct (Rubin, 1995, pp. 118, 124; Bernstein,1992, 1996; Benson, 1998b, 1998c, 1998d).

Furthermore, if government courts are occasionally called upon, thusinfluencing the expectations of parties to particular kinds of contracts, "influenceis different from control.... [and] One cannot assume, moreover, that theinfluences flow only in one direction" (Rubin, 1995, p. 124). Some of the newrules for business behavior that develop through evolving practices, contractualnegotiations, and arbitration are likely to be recognized and adopted by judges(Chen, 1992; Benson, 1989; 1990, pp. 227-229; 1998b), for instance. But evenwhen the courts do not recognize custom as a relevant source of law (perhapsbecause they conflict with precedents or statutes), a judicial decision does nothave to be treated as a permanent determinant of behavioral rules. A contractcan specify different types of behavior along with a general arbitration clause,thereby nullifying the future application of the judicial ruling (De Alessi andStaaf, 1991). Thus, an understanding of the evolution of contract law, at least inmany areas of commercial activity, requires recognition of arbitration, not onlyas an ADR, but at least in conjunction with contracts, as a mechanism fornullifying statutes and precedents - that is, as an alternative to legislation andjudge-made precedent (Wooldridge, 1970, p. 101; Benson, 1989, 1990a, 1990b,1992a, 1992b, 1995a, 1998b, 1998c, 1998d; Bernstein, 1992, 1996; Rubin, 1995).This is in sharp contrast to the view that arbitration is essentially a proceduralissue [e.g., Brunet (1987)], of course, but it is reinforced below when thepotential for precedent setting through arbitration is discussed. Before thispotential for law creation through arbitration can be fully appreciated, however,an understanding of what motivates the use of arbitration in commercial contractdisputes is required.

3. Why Is Commercial Arbitration Chosen Rather than Litigation?

Any dispute is "adversarial" of course, but in the commercial area, the voluntaryuse of arbitration is motivated by positive economic incentives. Privatearbitration appears to be an attractive substitute for litigation, in part becausearbitrators can be selected on the basis of their expertise in matters pertinent tospecific disputes, as noted above. Government judges need have no suchexpertise, so arbitration reduces the uncertainty associated with judicial errorand/or bias. This specialization also means that arbitration can be accomplishedfaster, less formally, and often with less expense than litigation because theparties do not have to provide as much information to the arbitrator as theywould to a judge/jury. Another benefit arises when government court time isallocated by waiting, since delay can be devastating to a business. Otherpotentially important benefits include: (a) arbitration is generally less"adversarial" than litigation so it is more likely to allow continuation ofmutually-beneficial repeated-dealing relationships; (b) if desired, privacy can bemaintained; and (c) businessmen may wish to avoid the application ofstate-made law by agreeing to something in a contract that would be overturnedin a government court, since an arbitrator looks to the contract first and thecontract can specify the relevant law for deciding a case (e.g., business practiceand custom rather than the statutes or judicial precedents of a particular nation).For elaboration on some or all of these points, see Mentschikoff (1961), Lazarus,et al. (1965), Williamson (1979), Trakman (1983), Ashenfelter (1987), Berman andDasser (1990), Benson (1989, 1990b, 1992b, 1995a, 1998a, 1998b, 1998c), Bernstein(1992, 1996), Currie (1994), Shavell (1995), and Rubin (1995). The potential ofmutual gains (lower costs of dispute resolution and/or a larger "pie" to share inthe long run) means that there clearly is a "cooperative" element to arbitrationas compared to litigation.

Despite widespread recognition of at least some of the benefits listed above,a frequent contention is that the defendant can always refuse to engage inarbitration or to accept an arbitration ruling, so the plaintiff must be willing andable to seek judicial (government) enforcement in order to have a credible threatto induce acceptance [see, for example, Willoughby (1929, p. 56); Lazarus, et al.(1965, pp. 31, 125); Landes and Posner (1979, p. 247); Domke (1984, p. 27); andShavell (1995, p. 3)]. If this is correct then the contention that arbitration ofteninvolves a choice between legal systems may be at least partially undermined.After all, if the primary threat backing arbitration is litigation, then for it to becredible arbitration procedures and awards will have to be acceptable to judges.

In sharp contrast, Charny (1990, pp. 409-412) maintains that when a"community of transactors recognizes an authoritative nonlegal decisionmaker"such as an arbitrator, "nonlegal sanctions" will induce the members of thecommunity to accept arbitration and comply with the arbitrator's judgement;thus, arbitration and nonlegal sanctions are "a perfect substitute for legalenforcement." These nonlegal sanctions are essentially the "private" (asapposed to government-imposed) sanctions discussed in the large economicsliterature suggesting that bond-posting or hostage-taking [e.g., Klein and Leffler(1981); Williamson (1983); Kronman (1985)], including the potential loss ofreputation [e.g., Kreps (1990), Ellickson (1991), Milgrom, et al. (1990), Klein(1997)], provides powerful sources of credibility, and Charny (1990) explains thatthis analysis also applies for commitments to arbitrate [also see Wooldridge(1970); Trakman (1983); Auerbach (1983); Bernstein (1992); Benson (1989, 1992b,1995a, 1998a, 1998b, 1998c)]. Perhaps more important than these negative threats,however, are various positive incentives associated with relation-specificreciprocities that arises in repeated dealings (Fuller, 1964, p. 24; Axelrod, 1984;Ellickson, 1991; Trakman, 1983, p. 10; Benson, 1989, 1998c). Indeed, one potentiallong-term benefit from accepting an unfavorable arbitration award is thereciprocal commitment by a trading partner to accept low cost arbitration andabide by an unfavorable judgement in any future dispute. Of course, privatesanctions reinforce such incentives, so the combination can provide strongincentives to arbitrate even without an added "legal" (i.e., government-imposed)threat (indeed, reciprocities are valuable assets which can be threatened, andtherefore, part of the private sanctions arsenal).

4. Does Commercial Arbitration Rely on Reciprocities and Private Sanctions,or on Legal Sanctions?

Those who see legal sanctions as necessary to back arbitration cite UnitedStates arbitration history as "evidence" in support of this view. In light of thecompeting hypotheses that reciprocities and private sanctions create strongincentives to arbitrate, Benson (1995a) re-examines this alleged "historicalevidence": that arbitration supposedly was not in widespread use in the UnitedStates prior to passage by New York (1920), New Jersey (1923), the federalgovern Pennsylvania (1927) and California ment (1925), Oregon (1925),Massachusetts (1925), (1927) of statutes commanding the common law courtsto enforce arbitration agreements and rulings [examples of this contentioninclude Willoughby (1929, p. 56) and Lucas (1987, p. 55)]. Prior to this, it is oftenalleged (incorrectly, as explained below) that agreements to arbitrate weregenerally not considered binding under common law until the these statuteswere passed, and that hostile judges felt free to overturn arbitration decisionsif one of the parties chose to litigate [examples include Lazarus, et al. (1965, p.18); Horwitz (1977); Murray, et al. (1989, p. 435); Allison (1990, p. 11)].

A relative lack of litigation in the United States regarding arbitration issuesappears to be the evidence that many have looked to in contending thatcommercial arbitration was not widely used before 1920. It is true that litigationover issues arising in arbitration increased dramatically following passage of the1920s statutes [see Sturges (1930)], but court records do not provide a clearpicture of the historic level of arbitration because the vast majority of arbitrationdecisions are never appealed, and the statutes themselves may have increasedthe propensity to appeal rather than the propensity to arbitrate, as explainedbelow. Moreover, an examination of newspapers, merchant letters, and therecords of organizations providing arbitration services, such as the New YorkChamber of Commerce, clearly demonstrate that commercial arbitration actuallywas in widespread use in each of the British Colonies almost three centuriesbefore modern arbitration statutes were passed (Auerbach, 1983; Jones 1956;Smith, 1961, pp. 180-188; Odiorne, 1953, 1954). After the revolution, arbitrationremained in wide use in all of the states (Auerbach, 1983; Jones, 1956, p. 219;Smith, 1961, p. 180-188; Odiorne, 1953, 1954). Why? Because "Not only didcourts, according to one New York merchant, dispense 'expensive endless law';they were slow to develop legal doctrine that facilitated commercialdevelopment" (Auerbach, 1983, p. 33).

Common law judges in America were hostile toward arbitration during theeighteenth and early part of the nineteenth century, as they exhibited anincreasing willingness to overturn arbitrators' decisions for issues relating toeither law or fact is evident [see Benson (1995a) for cases and references]. Theuse of commercial arbitration developed during the colonial andpost-revolutionary periods in spite this hostility, however, suggesting that courtbacking is not a prerequisite for such arbitration. Later in the nineteenth century,a trend toward less hostility can be detected in several state courts (Macneil,1992; Benson 1995a), but arbitration continued to evolve both in states wherethe courts were relatively receptive and states where judicial acceptance wasevolving more slowly (Benson, 1995a). For instance, as New York merchantsorganized into various associations and exchanges, provisions were alwaysmade for the arbitration of disputes among members (Jones, 1956, p. 214), despiteNew York's maintenance of the common law doctrine of revocability ofarbitration clauses in statutes longer than many other states.

The volume of evidence regarding the widespread and growing use ofarbitration is particularly heavy for the last four decades of the nineteenthcentury (Jones, 1956, pp. 214-215; Wooldridge, 1970. p. 101; Auerbach, 1983;Macneil 1992; Benson, 1995a). Indeed, these developments suggest thatarbitration was being substituted for litigation, since this period witnessed risinglitigation costs due to court congestion and trial delay, as well as increasinguncertainty costs regarding the credibility of state courts' implicit commitmentsto support business contracts as "the growth of the regulatory state unsettledadvocates of commercial autonomy who turned to arbitration as a shield againstgovernment intrusion" (Auerbach, 1983, p. 101; also see Benson, 1995a). Risinglitigation costs increased incentives to establish contractual arrangements andorganizations (e.g., trade associations, commercial exchanges) to govern theprocess of dispute resolution and insure against litigation (e.g., arbitrationclauses, arbitration institutions, institutionalized private sanctions). Thus, by theend of World War I, arbitration had clearly made the courts irrelevant forcontract disputes by a large segment of the business community in the UnitedStates (Wooldridge, 1970, p. 101).

Perhaps private sanctions and reciprocities are sufficient to encouragedisputants to live up to most ex ante agreements to arbitrate, but to date, mostarbitration apparently arises under preexisting agreements (or mandates in thecase of compulsory interest arbitration discussed below). Does this mean thatarbitration cannot be agreed to after a dispute has already developed, unless astrong (i.e., state-backed) sanction can be brought to bear. An alternativeexplanation for the apparent lack of ex post arbitration may simply be Shavell's(1995, p. 9) point that the benefits of arbitration are greater when agreed to exante than when established ex post. However, he also notes that an ex postagreement to arbitrate can still reduce dispute resolution costs (Shavell, 1995, p.9). Other potential benefits from ex post arbitration agreements include thepossibility that the dispute will be resolved more amicably (arbitration is a lessadversarial procedure), that risks of judicial error are reduced, and/or that theparty's prefer the application of alternative law (e.g., custom, the rules designedin a trade association). Thus, arbitration should also be attractive ex post, andperhaps legal sanctions to explicitly encourage such arbitration would bebeneficial. However, there appears to be an evolving trend toward more ex postarbitration even without direct efforts to encourage it through legal sanctioning.For instance, nonmembers of the diamond merchants' organization who have adispute with members often request ex post that the diamond industry'sarbitration board hear their cases, and this is done if both parties sign an ex postagreement to arbitrate (Bernstein, 1992, p. 126). Furthermore, the recent and rapiddevelopment of private for-profit courts that resolve business disputes, personalinjury disputes, divorces, construction warranty disputes, disputes over loandefaults, and so on, as they arise (Pruitt, 1982; Benson, 1990b; Ray, 1992;Phalon, 1992), and the growing scope of arbitration of non-contract civildisputes, both suggest that arbitration can be quite attractive even fordisputants who do not precommit, and that private institutions are evolving toprovide such services.

Additional evidence that reciprocities and/or private sanctions are sufficientto support a great deal of commercial arbitration at least, comes frominternational commerce. International contracts often expressly exclude litigationand almost always refer disputes to arbitration, and international trade disputesthat cannot be resolved through negotiation are almost always arbitrated [e.g.,Lew (1978); Trakman (1983); Berman and Dasser (1990); Casella (1992); Berger(1994); Benson (1990b, 1992b, 1998c)]. Certainly, statutes in several nations, aswell as various international treaties and agreements mandate court enforcementof international arbitration agreements, but the fact, as David (1985, p. 357)stresses, is that:

A sense of fair dealing on one hand, the respect for public opinion on the other,also the fear of being criticized by one's own community or thatnon-performance may be interpreted as evidence that one's business is in acritical financial situation are reasons why arbitral awards are most generallypromptly and willingly executed by business people. Such conduct may also beencouraged if the losing party is led to believe that the community will notremain passive in case of non-performance, but that sanctions may be imposedif the award is not executed.

Arbitration is also attractive because international traders generally assumethat national courts will not enforce obligations derived solely from customarycommercial law (Chen, 1992, p. 100). Indeed, during the medieval period this wasparticularly true, and as a result, the medieval "Law Merchant" was an almostpure system of privately-arbitrated customary commercial law backed by privatesanctions [e.g., Trakman (1983); Berman (1983); Benson (1989, 1990b, 1998b,1998c, forthcoming); Milgrom, et al. (1990)].

5. What are the Consequences of Legal Sanctions for Arbitration?

Rejection of the hypothesis that government sanctions are necessary for allsuccessful commercial arbitration does not definitely follow from the refutationof the evidence typically supporting it. Indeed, a middle ground is obviouslyalso possible that may well be consistent with all of the evidence. Rubin (1994,p. 4), for example, suggests that "private parties can use many availablemechanisms to make agreements self-enforcing ... [but] the law can facilitate theuse of these mechanisms ... [by enforcing] arbitration clauses in contracts ifparties insert such clauses." Perhaps positive incentives from reciprocitiesand/or private sanctions are not strong enough to support arbitration for some(many?) commercial transactions, and therefore, statutes mandating courtbacking are, on net, beneficial, as is often claimed [e.g., Rubin (1994); Shavell(1995a); Ware (1996)]? Frequently, however, those who call for arbitrationagreements and awards to be enforced by the judicial system look only to thebenefits of state backing without considering potential costs. The fact is thatwhen reciprocities and private sanctions provide sufficient sources of credibilityfor transactors, state-imposed sanctions may actually raise transactions costs(Ashe, 1983; Auerbach, 1983; Trakman, 1983; Benson, 1989, 1990b, 1995a, 1998b;Charny, 1990, pp. 426-429; Bernstein, 1992, pp. 154-157) [note that this appearsto be consistent with a similar argument from the labor arbitration literaturediscussed below, that the availability of compulsory arbitration can raise thetransactions costs of negotiations]. For instance, an enormous number of courtcases were filed as businessmen tried to determine what characteristics ofarbitration would be considered "legal" by the courts (Sturges, 1930), and thishas continued: the early 1980s were still witnessing a "growing number of courtchallenges to arbitration awards" (Ashe, 1983, p. 42).

Ashe (1983, p. 42) suggests that the increase in appeals reflects theincreasing use of lawyers in arbitration because losing attorneys have a strongertendency to circumvent the arbitrator's decision than does the losing party whotends to have greater "allegiance to the system of arbitration itself" whenlawyers' "advice" is not involved (i.e., there is a principle/agent problem betweenattorneys and their clients). It is clear that lawyers were rarely involved withcommercial arbitration in the United States before the 1920s [indeed, Auerbach(1983) and Benson (1995a) contend that the arbitration statutes were passed dueto the lobbying efforts of Bar Associations, because lawyers saw arbitration asa growing threat to their business and sought to "legalize" it in order to gain arole in the arbitration process], but as Charny (1990, pp. 388, 403-405) explains,when state-imposed sanctions are available, the demands placed on formalcontract writing are increased. If reciprocities and private sanctions alone apply,particularly within narrowly focused commercial organizations, less formality incontracting is required because the parties are intimately familiar with businesspractice and custom in their particular area of transactions; they understandwhat a general statement in a contract means, and they can choose an arbitratorwith similar intimate understanding. However, a judge is much less likely to havesuch an understanding, so a contract that may face judicial scrutiny will have tobe much more specific and formal in order to avoid a high probability of judicialerror (Charny, 1990, pp. 385, 404). Thus, after the modern statutes were passed,some businesses, forced to pay attention to the prospect of judicial review, hadto make their arbitration processes compatible with statute and precedent lawincluding court procedure. In order to do so, they had to consult lawyers indrafting contracts and involve lawyers in arbitration [for instance, lawyerrepresentation before AAA arbitration tribunals rose from 36 percent in 1927 to70 percent in 1938, 84 percent in 1942, and 91 percent in 1947 (Auerbach, 1983,p. 111; Benson, 1995a); also see Bernstein (1992, p. 156) for related discussionabout the growing use of lawyers in diamond industry arbitration].

The increased likelihood of appeal reflects more than the increasing relianceon lawyers, however. Cohen (1921, p. 150) observed, after New York ArbitrationAct's passage in 1920, that this statute

establishes legal machinery for protecting, safeguarding and supervisingcommercial arbitration. Instead of narrowing the jurisdiction of the SupremeCourt it broadens it.... Instead of being ousted of jurisdiction over arbitration, thecourts are given jurisdiction over them, and ... the party aggrieved has his readyrecourse to the courts.

When the state asserts that it is the source of authority and sanctions forarbitration agreements it implies that rulings from arbitrated commercial disputesare less decisive than they otherwise would be, weakening incentives to abideby arbitrated settlements explicitly subject to potential appeal. Furthermore, thereis the possibility that upon appeal a judge will find private sanctions themselvesto be illegal (e.g., as a restraint of trade). For instance, in Paramount LaskyCorporation vs. United States (282 U.S. 30 (1930)) an explicit agreement toboycott designed to back an arbitration system was struck down. A group ofmotion picture producers had agreed to place an arbitration clause in allcontracts with motion picture exhibitors, and to boycott any exhibitor whorefused arbitration or refused to accept an arbitration ruling. Thus, governmentsanctions can undermine the ability or incentives to use private sanctions(Ashe, 1983, p. 42; Bernstein, 1992, p. 156; Benson, 1989, 1995a, 1998d), and evenstifle the development of trust relationships and organizations from whichreciprocities and private sanctioning mechanisms often spring (Benson, 1989,1995a, 1998d; Charny, 1990, p. 428). So the possibility that government sanctionsto back arbitration may benefit some parties for whom reciprocities are uncertainand private sanctions provide weak threats does not imply that such sanctionsare, on net, beneficial, because they may raise costs to others for whomreciprocities and private sanctions are or could be strong enough.

6. Are Precedents Produced Through Arbitration?

Even if the net effect of court backing of arbitration is negative, however, theremay be another reason for judicial review. For instance, Brunet (1987, p. 19)contends that "the output of conventional litigation should be viewed as apublic good - society gains more from litigation than would be produced iflitigation were left to the private market." This presumably is the case becausethe results of arbitration and other forms of ADR are "internal" to the partiesinvolved (Brunet, 1987, pp. 14-15) so they will either not produce precedent, orwill under produce precedent. Similarly, Landes and Posner (1979, p. 238, 239,245) argue that "because of the difficulty of establishing property rights in aprecedent, private ... judges might deliberately avoid explaining their resultsbecause the demand for their services would be reduced by rules that, byclarifying the meaning of the law, reduce the incidence of disputes"; that "aproblem is that a system of voluntary adjudication is strongly biased against thecreation of precise rules of any sort"; and further, that commercial arbitration is"not a source of rules or precedents." Thus, the increasing use of arbitrationapparently is eroding "the guidance function of the law" (Brunet, 1987, p. 23).

Secrecy is often a characteristic of arbitration. For instance, Bernstein (1992,p. 124) explains that within the diamond industry "As long as judgments arecomplied with, the fact of the arbitration as well as its outcome are officially keptsecret. "But this" official" secrecy does not mean that precedents are nevercreated, or that too few rules exist. The parties to the dispute will certainlyconsider the arbitration result in future dealings under similar circumstances, forinstance, and probably have to explain them to trading partners. But moreimportantly, a diamond bourse (trading club) is "an information exchange asmuch as is a commodities exchange. As one author put it, 'the bourse grapevineis the best in the world. It has been going for years and moves with theefficiency of a satellite communications network.... Bourses are the fountainheadof this information and from them it is passed out along the tentacles that stretcharound the world" as each local bourse is part of an umbrella organization that,among other things, arbitrates disputes between members of different bourses,enforces arbitration judgments from other bourses, and facilitates theestablishment of uniform trading rules throughout the industry (Bernstein, 1992,p. 121). Under such a circumstance, "official" secrecy is probably not much ofa constraint on the spread of important information about an arbitration rulingthat might provide new precedent. It is clear that in the diamond industryarbitration results do "become known through gossip" (Bernstein, 1992, p. 126)at any rate.

Bernstein (1992, pp. 126-127) contends that when diamond industryarbitrators hear complex cases "it is difficult to determine what substantive rulesof decisions are applied", and such observations may appear in support of theview that arbitration does not produce effective precedent. However, as Fuller(1981, p. 90) explains, "Even if there is no statement by the tribunal of thereasons for its decision, some reason will be perceived or guessed at, and theparties will tend to govern their conduct accordingly." Thus, precedent of a sortmay well be produced even in such an environment. Furthermore, andimportantly, it must be recognized that within a customary legal system there area number of ways for new rules to evolve (e.g., through unilateral adoption ofbehavior that is observed and emulated, through bilateral negotiation andcontracting with resulting contract clauses spreading and becomingstandardized), besides through precedent (Benson, 1998b), so when a particulararbitration process does not appear to be designed to produce precedent itsimply may mean that precedent is a relatively unimportant source of new rulesfor the relevant group, or that circumstances do not change often enough torequire new rules. And importantly, if situations change, making precedent moreimportant, the group is also free to change its arbitration procedures. Thus, asBernstein (1992, p. 150) explains, diamond dealers have begun to recognize that"The lack of written decisions and a tradition of stare decisis makes it difficultto determine in advance the type of sanctioned behavior. In order to increasepredictability, many bourses in the world federation have relaxed the norm ofcomplete secrecy. Arbitrators publish written announcements of the principlesused to decide novel cases while keeping the parties and other identifying factssecret." Private dispute resolution mechanisms are very flexible and diverse.They can even accommodate the demands for precedent setting while stillmeeting demands for privacy. However, privacy is not always as important assome critics of arbitration seem to believe.

Landes and Posner (1979), Brunet (1987) and others who see in arbitration afailure to create external benefits appear to take the characteristics of somearbitration and extrapolate them to all arbitration, assuming that arbitration is amuch more homogeneous commodity than it really is. But if external benefits aresignificant there are strong incentives to internalize them, so when precedentsbecome important institutional adjustments are likely to be made. Indeed thisprovides traders with one of the incentives to form groups such as tradeassociations and diamond bourses which clearly can internalize the benefits ofprecedents. Within such an organization, it is easy to imagine a contractualarrangement that creates incentives to minimize disputes by setting clearprecedents (e.g., consider arbitrators who compete to receive a lump-sum feeunder a contract to handle all of the disputes between members of a particularorganization over a particular period of time, or arbitrators chosen from themembership of an association who have high opportunity costs if theyencourage excessive disputes in the form of time spend away from their businesspursuits, and who also personally benefit from clear precedents). Thus, thosearbitrators who, as characterized by Landes and Posner (1979, p. 240), "... tendto promulgate vague standards which give each party to a dispute a fightingchance" actually do less business. Fuller (1981, pp. 110-111) contends thatincentives are exactly the opposite, for instance: "Being unbacked by statepower ... the arbitrator must concern himself directly with the acceptability of hisaward. He may be at greater pains than a judge to get his facts straight, to stateaccurately the arguments of the parties, and generally to display in his award afull understanding of the case."

An obvious hypothesis is that when the environment is a dynamic changingone in which the need for existing rules may be frequently inadequate guides fora new dispute, arbitration rulings are likely to be recorded and/or made knownto the relevant group [which certainly is not likely to be the entire "public," ofcourse, but in general, that is not necessary or even desirable - the idea that asingle universal system of law is somehow superior to polycentric law withparallel, as well as overlapping and competitive jurisdictions is not consistentwith either theory or reality (Benson, 1990a, 1990b, 1992a; Berman, 1983)]. Thisin turn creates incentives for arbitrators to make careful rulings based on pastbusiness practices, customs and precedents established within the relevantgroup. For support of this hypothesis, consider international commercialarbitration. When no clear rule applies from the "private international lawsystems from which the parties come" arbitrators must determine the appropriatenew rule (Lew, 1978, p. 584). To do so, "in their desire to "denationalize" theaward and make it acceptable and fair, arbitrators often try to show the inherentcorrectness of their decision in the award itself.... arbitrators may refer to severalrules to show how they all lead to the same result" (Lew, 1978, pp. 584-585).Thus, international arbitration has characteristics often attributed to the commonlaw, as arbiters look to past rulings, practices, traditions, and usage in extendingthe law to new issues - that is, in producing new precedent based on older law.In fact, the general view of international arbitrators is that, "owing no allegianceto any sovereign State, international commercial arbitration has a specialresponsibility to develop and apply the law of international trade" (Lew, 1978,p. 589).

It appears that the misallocation of resources under arbitration is not be asgreat as Landes and Posner (1979) and Brunet (1987) predict. Indeed, the lawmaking consequences of private arbitration led Wooldridge (1970, p. 104) tosuggest that its substantial growth in this century has involved a "silentdisplacement of not only the judiciary but even the legislature." Furthermore,Bernstein (1992, p. 117) points out that "nonlegal norms trump legal rules in agiven [voluntary] market only where market participants find that keeping to theindustry norms advances their own self-interest. The private regime must bePareto superior to the established legal regime in order to survive." [In additionto their contentions that private judging underproduces precedent, however,Landes and Posner (1979) and Brunet (1987, p. 21) argue that the common lawproduces efficient rules as contended by Rubin (1977) and Priest (1977), but thevalidity of this argument has also been subject to considerable attack; thisliterature is not discussed here, but see for instance, Rizzo (1980a, 1980b),Aranson (1986), and Benson (1990a, 1990b, 1992a, 1996)].

7. Are There Important Differences in Labor Arbitration Institutions?

Non-compulsory labor arbitration in the private sector is also growing, ascollective bargaining agreements include arbitration clauses much like manycontracts between businessmen do. The development of repeated dealingsbetween unions and firms with institutionalized collective bargaining along withstrike and lockout options appears be a sufficient stimuli for arbitration of manygrievances and perhaps even contract disputes when negotiations break down.The incentives of the decision-makers must also be recognized. Arbitration maybe relatively attractive to union leaders, for instance, because of their legalstatus. They are in a position of representing everyone in the union, includingthose who apposed their election and perhaps even campaigned against them.Indeed, they have a legal duty to represent all members, and therefore, in orderto avoid a breach of fair representation lawsuit, union officials may pursuegrievance arbitration in cases that they would prefer not pursue or wouldnegotiate in the absence of the antagonistic position held by the member withthe grievance. Arbitration of such cases is clearly more attractive than thealternatives (a strike or a lawsuit) that may be much more costly for the union asa whole, including the union leader's supporters. Thus, grievance arbitration mayoffer union leaders an effective way to avoid controversy and maintain theappearance (and indeed, the reality) of fairness (this suggests that theavailability of grievance arbitration may reduce strikes, litigation, and negotiation- the later is a subject that is widely considered in the labor arbitration literature,and discussed below).

There also appears to be incentives to structure grievance arbitration so thatbenefits of precedents can be internalized. After all, both labor unions andcorporate management are likely to recognize that repeated disputes over thesame type of issues are costly, and therefore that arbitration which establishesclear precedent is desirable. In this light, consider the incident reported byBloom and Cavanagh (1986, p. 412): "a system known as expedited arbitrationwas adopted by labor and management in the basic steel industry in 1971. Underthis system, unresolved employee grievances that do not requireprecedent-setting rulings are arbitrated by a rotating panel of young,inexperienced arbitrators (mostly lawyers) who decide the case for a relativelysmall fee within two weeks of the decision to arbitrate." When a resolution isexpected to be particularly valuable because it will set a precedent, moreexperienced, more expensive arbitrators are chosen (factors determining thechoice of arbitrators are discussed below). This system was established becauseof rising costs and increasing delays due to a relative shortage of experiencedarbitrators. While it has not yet attracted "an in-depth study," it is spreading(Bloom and Cavanagh, 1986, p. 412). United Steel Workers contracts outside thebasic steel industry now include it, and it has also been included in some UnitedMineworker contracts, and is employed in the U.S. Postal Service. Thus, it isinstructive for at least three reasons. First, it points to the fact that within an"industry" (the group of employers and the union, not simply the two parties ina particular dispute) the benefits of precedent can be recognized andinternalized, even in some types of labor arbitration. Second, it reinforces the factthat arbitration is flexible enough to produce a mix of dispute resolutionprocedures and outcomes. Third, it suggests that even labor arbitration mayhave a cooperative element, in contrast to the perception one draws from theeconomics literature on the subject [Non-union employees' disputes are alsobeing resolved by arbitrators in growing numbers (Ware, 1996, p. 1)]. Thisperception reflects the fact that the focus of the economics literature on laborarbitration has been on compulsory interest arbitration.

Compulsory interest arbitration is almost exclusively a "public sector"phenomena (baseball arbitration and some transportation sector arbitration areamong the few exceptions). Yet many of the publications in thisinterest-arbitration literature begin with a brief discussion of the widespread useof arbitration in commercial areas, perhaps also recognizing that arbitrationbetween individuals and their employers is frequently used to resolveprivate-sector labor grievances, implicitly suggesting that inferences from theirempirical and/or theoretical examination of compulsory public-sector arbitrationapply under other institutional arrangements as well. This clearly is not alwaysthe case, however. For instance, the compulsory-arbitration focus of theliterature might create the impression that labor arbitration in general must relyon state backing or mandates. Much of the literature does not appear torecognize that the institutional environment might create different incentives,although there are a few exceptions. Bloom and Cavanagh (1987, p. 355) andCurrie (1989, pp. 365-366) note that private sanctions and expectations ofreciprocities may be quite weak for some government employers whoseincentives are tied to particular constituencies that may not view an arbitrated(or negotiated) outcome as desirable, for example. Currie (1989, p. 366) alsosuggests that significant principle/agent problems may arise whenimperfectly-monitored self-interested union leaders are bargaining withimperfectly-monitored self-interested government officials [private-sectormanagers are not perfectly monitored either, but the incentives to monitor publicofficials are much weaker (Benson, 1995b)]. When publicly employed laborersare protected by civil service "tenure" the potential for reciprocities and privatesanctions influencing their behavior may also be sharply limited. Thus, theinstitutional background may be very important, and expanding the scope of thestatutes (e.g., to mandate arbitration in place of private sector strikes andlockouts) might alter incentives to develop and use labor arbitration institutionsvoluntarily, as evidenced by some of the things that have happened incommercial arbitration since arbitration statutes were passed in the 1920s.

Compulsory arbitration can take different forms, but it often means that strikeand lockout options are precluded for public employees by the state, so if oneparty requests arbitration the other can be forced to accept it. Thus, Stevens(1966), in an early and influential contribution to this literature, describescompulsory arbitration as a bargaining tool in a purely distributional dispute(e.g., a zero-sum dispute over the distribution of a fixed "pie" to be dividedbetween employers and a union) that has much in common with a strike or alockout. In particular, if arbitration is costly then when it is threatened, it caninduce the other party to negotiate. Furthermore, he explains that arbitrationmechanisms can be designed to encourage negotiated settlements (discouragearbitration), and as demonstrated by the empirical research discussed below, thisclearly appears to be the case. He then suggests that arbitration should bedesigned to impose costs on bargainers in order to encourage voluntarysettlements. In fact, following Stevens, it is often contended that the mostsuccessful form of compulsory arbitration "is one that is not used" (Long andFeuille, 1974, p. 202). A recommendation that arbitration be made more costly inorder to encourage negotiation obviously requires a strong normative belief thatnegotiated settlements are more desirable than arbitrated settlements (Bloom andCavanagh, 1987, p. 354; Currie, 1989, p. 364). This norm seems to permeate theeconomics literature on labor arbitration [with important exceptions, like Bloomand Cavanagh (1986, 1987), Ashenfelter (1987), and Currie (1989)]. Indeed, asCurrie (1989, p. 364) explains, "most industrial relations experts believe thatsettlements reached by the parties themselves are superior to those imposed byan arbitrator", but without much theoretical basis for the belief. There is sometheoretical basis for the conclusion, of course. In particular, as Stevens (1966)alleges, standard interest arbitration as a compromising process tends to "chill"bargaining as it creates incentives for negotiators to misrepresent their trueunderlying profit and/or utility-maximizing positions, expecting arbitrators tosplit the difference between their extreme demands. However, there arealternative theoretical explanations for the relationship between arbitration andnegotiation that can produce the same empirical fact and quite differentnormative implications.

Law and economics scholars might anticipate that arguments forencouraging negotiations are based on Coase's (1960) famous theorem, that ifthe transactions costs of bargaining are not prohibitive an efficient allocation ofresources is achieved through voluntary negotiation. However, the decision toarbitrate obviously implies positive transactions costs for bargaining (perhapsin the form of uncertainty for the union representative regarding the "political"or legal consequences of a negotiated settlement that might be perceived asbiased or unfair to some of the membership), and in that context the typicalinference drawn from Coase is to lower the cost of negotiating (e.g., by clarifyingproperty rights, or in labor arbitration, perhaps by allowing the aggrieved partyrather than the elected union leaders to choose a negotiator), not raise the costof the alternative. Thus, for instance, in the diamond industry, Bernstein (1992,p. 124) explains that parties who submit a dispute to arbitration must firstparticipate in a conciliation proceeding before a conciliation panel that attemptsto help the parties negotiate a settlement. Only if such third-party aidednegotiation fails can the dispute go to arbitration. This is clearly a mechanismintended to encourage negotiation without raising the cost of arbitration, insharp contrast to Stevens' (1966) proposal, and an estimated 85 percent of thediamond-industry disputes submitted to arbitration are settled during thisconciliation procedure.

Moreover, as Williamson (1979) explains, characteristics of the transactionthat determine transactions costs (e.g., degree of asset specificity, frequency ofthe transaction, uncertainty) determine the efficient organizational choice, given"market", "bilateral" (direct negotiation and contracting), and "trilateral" (use ofa third-party), or "ownership-integration" governance options. Under thesecircumstances, if arbitration is used it may be because the transactions costs ofnegotiation are relatively high, so fair arbitration is a more efficient means ofachieving a settlement. Thus, encouraging negotiation by raising the costs ofarbitration can reduce efficiency. As Posner (1986, p. 366) notes in hisdiscussion of summary jury trials and other ADR options, the objective shouldnot be to maximize negotiated settlements but to minimize the total costs of thesystem of achieving settlements, whether voluntarily or through third-partyprocedures.

Perhaps the points made here do not apply to Stevens' (1966) argumentsabout compulsory labor arbitration, however. The disputants themselvespresumably have not voluntarily designed this governance arrangement if it ismandated by statute [in all likelihood, public sector unions and employerslobbied to influence the statutes, of course, but the statutes may not allow thetransaction-specific adjustments in governance organizations that would leadto efficient outcomes (Benson, 1995b)]. Compulsory arbitration still may be acooperative outcome if it is the low cost dispute resolution mechanism relativeto a particular high-transactions-cost negotiation, however. Indeed, Bloom andCavanagh (1986, p. 409) point out that "labor practitioners place greateremphasis [than economic theorists] on arbitration as a mechanism for helpingdisputants identify and reach efficient outcomes. In their view, arbitrators areprofessional gatherers and processors of information who play a highlyconstructive role in a bargaining process which is better treated as a cooperativeattempt at problem solving than as direct economic conflict." Furthermore,Bloom and Cavanagh (1986, p. 421) conclude, from their study of the selectionof arbitrators (discussed below), that "the similarity of union and employerpreferences for different arbitrators suggests that collective bargaining functionsmore cooperatively than most existing models indicate." Doubt is cast on thetheoretical underpinnings of this hypothesis by considering the assumption thatarbitrators split the difference between offers. Farber (1981) raises importanttheoretical questions regarding the assumption, noting that even empiricalevidence of difference splitting would not be sufficient to prove that this is theobjective of the arbitrator since parties are likely to position their offers aroundthe expected arbitration award. That is, "the expected arbitration outcome shapesthe parties' bargaining positions rather than the reverse" (Farber, 1981, p. 70).Gibbons (1988) goes even further, modeling arbitration in the context of athree-party game in which arbitrators also learn about the state of theemployment relationship from the parties' offers.

8. Does Final Offer Arbitration Encourage Negotiation (or DiscourageArbitration)?

Stevens (1966) and several others propose what has come to known as final offerarbitration (FOA) to overcome the hypothesized tendency for compromisingarbitration to "chill" negotiation. FOA requires the arbitrator to choose one orthe other of the two sides' final offers rather than choosing some compromisebetween them. The idea is that the negotiators will have incentives to movetoward relatively reasonable positions before arbitration, but in doing so theyare presumably more likely to reach a negotiated settlement on their own. FOAhas been implemented in labor arbitration through statute law in a number ofplaces, and as a consequence, it has attracted a good deal of theoreticalanalysis.

Crawford (1979) provides one of the earliest formal theoretical examinationsof FOA. He notes that if the arbitrator's exogenously determined notion of whata settlement should be is known to the two parties then FOA and conventionalarbitration will lead to the same outcome in a zero-sum distributional game.Under conventional arbitration neither party would settle for a distributiondifferent from the arbitration outcome so all awards have to correspond to thatoutcome whether they are achieved through negotiation or arbitration. If thearbitrator selects the final offer closest to his preferred outcome, the same is true,as one party can always improve on any final offer by offering the arbitrator'spreferred settlement. Of course, given positive arbitration costs (i.e., if use ofarbitration makes the process a negative-sum game), arbitration should actuallynot be used at all. This might appear to desirable, given the arguments byStevens (1966), Long and Feuille (1974) and others, but in this case the partiesare simply agreeing on what the arbitrator would award anyway, so arbitrationis actually the determining factor, not negotiation (Ashenfelter and Bloom, 1984,p. 112).

Crawford (1979) also draws on Schelling's (1963) model of commitment,suggesting that parties find it advantageous to commit to a position that iscostly to disavow. Given uncertainty about the strength of the parties'commitments, the potential for commitment by both parties can lead to adisagreement and therefore to arbitration. Factors that increase the payoff tocommitment increase the likelihood of disagreement. Still, the model predicts thatFOA should not increase the likelihood of negotiation. Indeed, Crawford (1979,p. 152) suggests that "FOA may create a Prisoner's Dilemma situation andthereby prevent agents who would otherwise cooperate from agreeing on anefficient settlement." Of course, in a repeated game setting the prisoner'sdilemma outcome of non-cooperation is less likely (Axelrod, 1984), so if theinteraction generating the dispute is not viewed by the negotiators as a one-shotgame this result may not hold. Nonetheless, Crawford's framework does notappear support the contention that FOA should increase the propensity tobargain.

Actually, Crawford (1979) does raise one point that implies that FOA can berelatively "costly". If negotiations break down, neither final offer may actuallybe efficient (or equitable, depending on the objectives of the arbitrator and/orthe nature of the dispute - the outcome of a zero sum dispute may reflect thearbitrator's view of equity, for instance). If there are multiple issues involved inthe dispute, for example, both final offers may involve inefficient mixes ofsolutions. Constraining the arbitrator to choose one or the other would,therefore, guarantees an inefficient solution. Crawford (1979) concludes that"multiple FOA" is superior to single FOA arbitration, but under conventionalarbitration the arbitrator has a full range of outcomes to consider, so an efficientsolution is also possible. If conventional arbitrators are expected to search foran efficient solution (or an equitable distribution in a zero-sum bargain) ratherthan to split the difference, and if bargaining costs are high, FOA could easily"encourage" more bargaining and more costs than conventional arbitrationdoes, but in this case, the result actually involves higher transactions costs.Thus, whether FOA is desirable or not depends on what bargainers expectarbitrators to do, which in turn should depend on what they actually do Bloom(1981, p. 243).

Farber and Katz (1979), and Farber (1980, 1981) offer a different view ofcompulsory arbitration than Crawford (1979). They assume that the parties areuncertain about arbitrator's preferences and explain that the likelihood of abargain depends on the parties' expectations about the arbitration award andtheir risk preferences. For instance, similar expectations about arbitrationoutcomes and significant arbitration costs can produce a contract zone, andFarber and Katz (1979) suggest that a larger the contract zone increases theprobability of a bargaining settlement. Divergent expectations (e.g., overlyoptimistic expectations by at least one party), on the other hand, can preventsuccessful bargaining. However, Farber and Katz (1979) conclude thatuncertainty about arbitration's outcome coupled with risk aversion on the partof at least one party, can also produce a contract zone, while greater certaintyabout the arbitration award, and hence less risk, may mean that no contract zoneexists and arbitration results. Thus, in keeping with Stevens' contention thatarbitration should be structured to encourage negotiation, Farber and Katz(1979) express concern that uncertainty will decline as parties gain experiencewith arbitration, and that arbitration will become more prevalent over time (thisis one variant of the "narcotic effect" hypothesis discussed below). In addition,the relative impact of FOA and conventional arbitration depend on the parties'attitudes toward risk and their expectations about arbitrator preferences, amongother variables.

In line with Stevens (1966), Kochan (1980) contends that FOA is moreeffective at imposing costs on parties if they fail to reach a negotiatedsettlement. After all, the expected award from FOA is a probability weightedaverage of two points while the expected conventional award in a probabilityweighted average of a distribution of potential awards, and by removing theability of an arbitrator to compromise, the relatively low risk middle part of thisdistribution is removed. FOA appears to be riskier, and as Farber and Katz (1979)emphasize, uncertainty regarding the behavior of the arbitrator is a source ofarbitration costs. But this reasoning is flawed (Farber, 1980; Crawford, 1982;Farber and Bazerman, 1987, 1989). For instance, Farber and Bazerman (1989) pointout that the risk of FOA can be manipulated by manipulating offers, and FOAeliminates the high risk tails of the distribution as well as the low risk middle.Indeed, they use existing estimates of arbitration behavior, assuming constantabsolute risk aversion utility functions and identical normal prior distributionson arbitrator's concept of an appropriate award, and conclude that contractzones are unambiguously larger under conventional arbitration than under FOA.Given that identical-expectation contract zones are relatively large, it should takea greater degree of divergent expectations to offset the potential for bargainingunder conventional arbitration. Thus, if larger contract zones imply that avoluntary settlement is more likely, negotiation should be more prevalent underconventional arbitration.

In contrast to the standard view, however, Bloom (1981) explains that widercontract zones do not necessarily imply a greater likelihood of successfulnegotiations [a point also made by Crawford (1981)]. After all, there may besubstantial direct costs of negotiations, as well as uncertainty about settlementpoints within the contract zone. Indeed, it may be easier to agree if there is onepoint in the contract zone that both parties prefer to arbitration than if there area large number of alternatives. Thus, raising the costs and/or uncertaintyassociated with arbitration may not lead to more negotiated settlements. In thislight, Farber and Bazerman's (1989) finding of larger contract zones underconventional arbitration does not necessarily imply more negotiations, a factthat they recognize. However, they point to another of their results, contendingthat the best explanation for relatively more negotiated settlements under FOA,as hypothesized by Stevens (1966), comes from their finding that theexpected-utility-maximizing-Nash-equilibrium last offers given to an arbitrator(where a negotiator is indifferent between the last offer and the expectedarbitration award) are closer under FOA than conventional arbitration. Thus,they conclude that strategically, when equilibrium offers are farther apart theparties are more reluctant to make concessions. If this is the case, then FOAdoes not appear to raise the cost of arbitration, although it does influencebargaining behavior.

An alternative hypothesis, apparently not found in the literature buttentatively proposed above, is that when bargaining costs are high arbitrationbecomes relatively attractive because arbitrators are expected to search for theefficient (or equitable) solution to a dispute rather than simply splitting thedifference, and that FOA constrains such a search so FOA is less attractive(more costly) than conventional arbitration. Note that this hypothesis isconsistent with recent empirical findings by Burgess and Marburger (1993) that"FOA awards tend to be of 'low quality' in the sense that they lie outside therange of negotiated settlements" in their study comparing baseball playersalaries determined through negotiation versus those determined through FOAarbitration. Indeed, A number of empirical testable hypotheses follow from thistheoretical literature, and a growing body of empirical research addresses manyof them.

9. Do Arbitrators Split the Difference?

The "split-the-difference" assumption appears to be key to the conclusion thatconventional arbitration chills negotiations (Feigenbaum, 1975; Feuille, 1975;Anderson and Kochan, 1977; Starke and Notz, 1981). In this regard, Bloom (1986)finds that on average, arbitration decisions in his sample appear to bemechanical compromises between the parties' final offers, but he also emphasizesthat there is in fact a substantial amount of unexplained variance in arbitrationawards, so that the overall conclusion need not apply to any particular case. Hisexamination of written arbitration decisions also finds a correlation between finaloffers and the facts in each case (a finding supported by several studiesdiscussed below). That is, negotiators tend to adjust final offers to be consistentwith the facts that arbitrators are expected to look at, as Farber (1981) suggests,and therefore arbitrators can use the parties' final offers as a source ofinformation about facts. Furthermore, Bazerman and Farber's (1985) study ofwage awards by 64 actual arbitrators in 25 simulated conventional arbitrationcases clearly suggests that arbitrators look at both final offers and the facts ofthe case, weighing the facts more heavily than the offers. The facts also areincreasingly important as the offers diverge, contradicting "the naivesplit-the-difference view of arbitrator behavior" Bazerman and Farber's (1985, p.76).

Farber and Bazerman (1986) report the results of a similar study comparingarbitrator behavior under FOA and conventional arbitration. They assume thatthe same criteria, determining awards based on facts rather than offers,characterizes arbitrator behavior under different arbitration schemes. Theirfindings support the assumption: again, conventional arbitration awards areweighted averages of the facts and offers with weights depending on thereasonableness of the offers, and final offer awards are also determined by thefacts and the offers. Thus, it appears that arbitrators are generally consistent intheir behavior under different arbitration regimes (Farber and Bazerman, 1986, p.842). Ashenfelter and Bloom (1984) reach similar conclusions about the virtuallyidentical decision processes for arbitrators under conventional arbitration andFOA, using a data sample drawn from New Jersey where public employeedisputes can be decided under conventional arbitration if the parties agree to it,but FOA if they do not. Arbitrators, it seems, do much more than split thedifference.

10. Does Conventional Interest Arbitration "Chill" Negotiations?

Despite the significant evidence that arbitrators do not simply split thedifference, there does appear to be empirical evidence of a chilling effect toconventional arbitration. One source of evidence [although there is in fact nostrong theoretical linkage, Currie (1989, p. 364)], is the hypothesized "narcoticeffect" (Kochan and Baderschneider, 1978, p. 431) of third party disputeresolution. It is contended that when compulsory arbitration is available partiesbecome reliant upon it rather than negotiating. Early studies conclude that suchan effect exists because, for example, wage settlements appear to be lessresponsive to market conditions when third-party procedures are employed [e.g.,Kochan and Baderschneider (1978), Butler and Ehrenberg (1981), and Auld, etal. (1981)]. Bloom and Cavanagh (1987, p. 355) point out that the simpledescriptive statistics which appear to support the hypothesis are far fromconclusive [also see Anderson (1981)], however, as a complete test of thehypothesis would require establishing serial correlation in the use of arbitrationafter controlling for heterogeneity across bargaining units.

Currie (1989) provides what may be the most sophisticated empirical analysisof the "narcotic effect" hypothesis to date. She finds, controlling for a numberof other factors, that bargaining units who used arbitration in the previous roundof negotiations are at least ten percent more likely than other bargaining unitsto use it in the current round, thus supporting the narcotic-effect hypothesis.Yet, the total number of arbitrations in previous years (her sample included 35years of compulsory arbitration by teachers in British Columbia) has a negativeeffect on the probability of arbitration, and variables intended to captureattitudes toward risk, changes in the degree of uncertainty associated witharbitration awards, and differing beliefs about awards do not have significanteffects on the probability of using arbitration. Thus, Currie (1989, p. 378)concludes that the typical explanations for a narcotic effect do not appear tohold, so "A theoretical explanation of this 'stylized fact [positive statedependence],' perhaps in the context of a dynamic model of arbitration, is badlyneeded." Indeed, the result is consistent with the idea suggested above that anexperience with arbitration simply reveals that the net benefits of arbitration arehigher than previously believed, so when the transactions costs of negotiationprove to be high, those with experience tend to opt for arbitration relatively morequickly. A very similar point is made by Bloom (1981, p. 243), when he observesthat if the split-the-difference hypothesis does not hold and arbitration appearsto chill negotiation it may be because "the parties view this mechanism[compulsory arbitration] as the least costly alternative for establishing acontract." Of course, if this is the case, the "chilling" of negotiations may wellbe appropriate from an efficiency perspective, and designing arbitrationmechanisms to raise the cost of arbitration is inefficient [another possibleexplanation for increasing relative use of arbitration might be that union leadersperceive an increasing probability of breach of fair representation lawsuits inlight of the perceived increases in the propensity to litigate in the United States,leading union officials to pursue more grievance arbitration in cases that theywould prefer to negotiate in the absence of this perceived threat].

There is yet another set of studies that probably provides the strongestevidence of a potential chilling effect of conventional arbitration: the growingliterature comparing negotiation under FOA and conventional arbitration. Itappears that FOA increases the probability of a negotiated settlement (Feuille,1975; Neale and Bazerman, 1983; Farber and Bazerman, 1989). Thus, Stevens(1966), Farber and Katz (1979), and others who suggest that the nature of thearbitration process influences the likelihood of a bargained outcome appear tobe correct. But does this support the contention that arbitration should bestructured to encourage negotiation or that FOA is desirable? The answer stilldepends on the relative costs and benefits of negotiated and arbitratedsettlements, as Bloom (1981) suggests. In this regard, the evidence of arbitratorbehavior, including evidence from the FOA literature, is instructive. Somecharacteristics of arbitration behavior have already been discussed, such as thefact that they apparently do not split the difference. However, in order to fullyappreciate the reasons for this and other characteristics of arbitrator behavior,we must first look at the arbitrator selection process.

11. How Are Arbitrators Selected?

Many critics of arbitration and other forms of ADR contend that these privatealternatives to litigation will be biased. The proposed reasons for such bias vary,however. Some contend that arbitrators are easily corruptible, so the bias is infavor of the disputant with the most financial resources: "If the rendering ofverdicts is to be independent of the relative wealth of the litigants, then theprovision of judicial services naturally requires separation of thedecision-makers gain from that of each litigant. This fact either requires heavyregulation or it requires public provision of the judge directly" (Mabry, et al.,1977, p. 83). A different bias is seen by Landes and Posner (1979, p. 254) whocontend that "... it might seem that competition would lead to an optimal set ofsubstantive rules and procedural safeguards. But this is incorrect. Thecompetition would be for plaintiffs, since it is the plaintiff who determines thechoice among courts having concurrent jurisdiction of his claim. The competingcourts would offer not a set of rules designed to optimize dispute resolution buta set designed to favor plaintiffs regardless of efficiency." Brunet (1987, pp.31-40) simply concludes that arbitration's procedures bias results away from"quality", "accurate" results because they do not incorporate as muchinformation as litigation does [Currie (1994) makes a similar point except that shefocuses on the relative use of information in arbitration and negotiation, and sheis much more tentative in her normative conclusions]. Essentially, he sees ADRprocedures as too "informal, ambiguous, and not administered in a managerialfashion" and lacking effective discovery processes (Brunet, 1987, pp. 31-33).

All such arguments involve a failure to recognize the potential for creatingan arbitrator selection process to avoid such biases. Indeed, as Bloom andCavanagh (1986, p. 409) explain, "one of the most important characteristics ofarbitration systems is that they may be designed in different ways." Notsurprisingly, arbitration selection mechanisms actually vary widely. For example,within some organizations a single arbitrator or panel is appointed for a setperiod to arbitrate all disputes between members. Of course, prescreening occursbecause these arbitrators are chosen from a competitive pool by the associationthrough its membership approved selection process. For instance, in thediamond industry, arbitrators are elected from the organization's membership fortwo year terms (Bernstein, 1992, pp. 124-125). A different alternative is thatcontracting parties or organizations preapprove a list of arbitrators, and if adispute arises, an arbitrator is chosen from the list by some preset mechanism(e.g., random selection, rotating selection, selection by a third party such as agoverning board of the association). Yet another common selection systemgives the parties to a dispute the resumes of odd numbered list of arbitratorsfrom a larger preselected group (e.g., preselected by a trade association, orprovided by the AAA), with each party having the power to successively vetonames until one remains. Thus, a second level of prescreening is added at thedisputant level, contributing "to the legitimacy of the arbitrator and his awardin the eyes of the parties" (Bloom and Cavanagh, 1986, p. 409). The parties arealso given the arbitrator's resumes, so they know about experience, training, thenature of awards given in the past, and so on. A similar practice, the subject ofBloom and Cavanagh's (1986) empirical study discussed below, is also common:the parties are given a list and resumes of seven potential arbitrators with thepower to veto three and rank the other four, and the arbitrator who is not vetoedby either party and has the highest combined rank is chosen. Another commonpractice is for both sides of the dispute to provide a list of, say six arbitrators,and each can then veto any or all of the names on the other party's list; if allnames are vetoed each provides another list and the process is repeated (clearly,this procedure requires that both parties want to arbitrate, so they do notcontinue to provide unacceptable names). All such systems guarantee theappointment of an arbitrator without requiring explicit agreement by the twoparties while still allowing for prescreening of the potential arbitrators.

In light of the fact that selection mechanisms allow veto, each party might beexpected to support at least some candidates that are expected to be unbiased.In fact, it widely contended that arbitrators are chosen for their expertise,reflected by their experience and training, as well as for their consistency indeciding cases solely on their merits, and for their impartiality [e.g., Elkouri andElkouri (1985)], but before Bloom and Cavanagh's (1986) study, little statisticalevidence existed to verify this. They examine the selection of arbitrators for 75public employee disputes in New Jersey. A number of findings are of interest.First, in many cases the union and the employer have similar rankings,suggesting that their preferences for arbitrator characteristics are at leastmoderately similar. Second arbitrators with perceived biases tend to beeliminated. Thus, arbitrators that exhibit a tendency over time to favor labor aregiven poorer rankings (generally vetoed) by management and vice versa.Similarly, economists get low rankings by labor, relative to lawyers and laborrelations practitioners, perhaps because "economists are likely to be heavilyinfluenced by efficiency conditions" (Bloom and Cavanagh, 1986, p. 418) suchas the advantages of competition, mobile labor, and other factors that laborunions tend to undermine. Third, both employees and employers showsignificant preferences for experience, controlling for impartiality and training.Clearly, while it is not possible to prove that experience reflects arbitratorspecific-characteristics such as expertise, it probably does because experienceboth adds to expertise and is a reflection of past popularity. Fourth, while anumber of variables representing impartiality, experience, and training appear tobe significant, their magnitudes are small, suggesting "that the parties arerelatively indifferent to many of the arbitrators in the New Jersey system" (Bloomand Cavanagh, 1986, p. 419). It would appear that the preselected group of 70arbitrators that each panel of seven in this sample is drawn from are actuallyperceived to be quite similar. As Ashenfelter (1987) explains, this is preciselywhat should be expected.

12. Conclusions: "Exchangeability" and the Benefits of Arbitration

Given that disputants have the same information about arbitrators and the powerto veto any arbitrator that are expected to be biased, (Ashenfelter, 1987) explainsthat arbitrator decisions should be statistically "exchangeable." Furthermore, anumber independent empirical studies tend to verify this exchangeabilityhypothesis [e.g., Ashenfelter and Bloom (1984), Bazerman and Farber (1985),Farber and Bazerman (1986), Ashenfelter (1987), Bloom (1986), Faurot andMcAllister (1992), Burgess and Marburger (1993)]. Consider for example, Faurotand McAllister's (1992) study of salary arbitration in major league baseball. Theyhypothesize that an arbitrator will attempt to base decisions on the same criteriawith the same weights as other arbitrators in order to avoid being vetoed, andfind that the expected value of the arbitrator's notion of a fair settlement issignificantly influenced by a number of fact-based variables specified in thecontract (the Basic Agreement): player performance in the last year, careerperformance and consistency, recent club performance, and previouscompensation (Faurot and McAllister's, 1992, p. 710; also see Burgess andMarburger, 1993).

Furthermore, while some evidence might appear to suggest that arbitrationis biased, a careful examination generally reveals the opposite. For instance,Ashenfelter (1987, pp. 343-345) discusses a sample of New Jersey's FOA systemfor police disputes in which the employers win only about a third of thedecisions. However, both conventional arbitration and FOA are used in thissystem, so they can be compared. Recall the evidence discussed above thatarbitrators choose conventional awards using a consistent criteria based on thefacts, and that FOA arbitrators use the same criteria, choosing the final offerclosest to their preferred award. In this light, Ashenfelter (1987) comparesconventional and FOA awards and finds that on average, union offers were morereasonable than the employee offers (perhaps because union bargainers weremore risk averse, or perhaps because employers were making unreasonableoffers for political reasons), so the disproportionate number of union winsreflects bargaining positions, not arbitrator bias, and is actually consistent withthe exchangeability hypothesis. He also examines a set of data from the IowaFOA system for public employees where, in contrast to New Jersey, theemployer offers were more frequently chosen, but in this case it appears that theemployers' offers were, on average, the "more reasonable."

It is exchangeability, Ashenfelter (1987, p. 341) suggests, that underlies thecontinued acceptability of labor arbitration systems. Indeed, given the politicalinfluence of unions and bureaucratic organizations (Benson, 1995b), it is hardto imagine that compulsory arbitration statutes could survive if they were notperceived by both parties to be beneficial relative to alternatives (strikes,lockouts, litigation, negotiation when transactions costs are high). The view inthe commercial arbitration literature that arbitration is a positive-sum processappears apply to compulsory labor arbitration as well.

The private sector is responding to the demand for resolution of a widevariety of disputes by offering a wide variety of specialized dispute resolutionoptions. Specialization has desirable consequences in the production of mostgoods and services. It is reasonable to expect that this is also true for theproduction of justice. Indeed, many of the efficiency-based arguments againstarbitration (e.g., that it will produce "low quality" biased judgments, that itcannot efficiently produce precedent) are undermined by the flexibility ofarbitration and other ADR options. Furthermore, while there is evidence thatappears to support some arguments against at least some arbitration, such as thehypothesis that its availability raises the transactions costs of negotiation, itappears that the evidence is also consistent with other hypotheses. Thus, theevidence to date does not provide strong reasons to be discouraged by the factthat arbitration is being substituted for litigation and legislation.


I wish to thank Barry Hirsch, Brad Smith, Stephen Ware, Lisa Bernstein, and ananonymous referee for very helpful comments.

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© Copyright 1998 Bruce L. Benson

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