A Welfare Analysis of Arbitration∗

The paper compares conventional and final-offer arbitration from the welfare perspective. By some existing contractual arrangement, one party is supposed to make a payment to the other party, depending on the state of the world. Under asymmetric information, one party has a better signal about the state of the world and the other party is aware about its informational disadvantage. Then the ranking of the two arbitration procedures depends on the informational assumptions about the arbitrator. If the arbitrator is no better informed than the less-informed party, final-offer arbitration dominates conventional arbitration in the sense that the probability of arbitration award is no higher in any pair of equilibria, and it is lower for some pairs. If the arbitrator is no worse informed than the more-informed party, the opposite conclusion can be drawn. It is slightly more ambiguous under which of the two schemes the existing contractual arrangements are better approximated. Under non-common prior, parties believe that their opponents have wrong signals about the state of the world. Then the conventional arbitration better approximates the existing contractual arrangement, and (if parties are risk-averse) it also results in a lower probability of arbitration award. ∗I would like to thank Orley Ashenfelter and Henry Farber for helpful conversations. †Department of Economics, Nothwestern University, Evanston IL 60208