Arbitration with Uninformed Consumers

Mark L. Egan, Gregor Matvos, Amit Seru

NBER Working Paper No. 25150
Issued in October 2018, Revised in February 2021
NBER Program(s):Corporate Finance, Law and Economics

This paper studies the impact of the arbitrator selection process on consumer outcomes when firms hold an informational advantage in selecting arbitrators. Exploiting data on arbitration cases and randomly generated lists of potential arbitrators presented to both parties over the past two decades in the securities industry, we establish several motivating facts. These facts suggest that firms hold an informational advantage over consumers in selecting arbitrators, resulting in industry-friendly arbitration outcomes. We then develop and calibrate a quantitative model of arbitrator selection in which firms hold an informational advantage in selecting arbitrators. Arbitrators, who are compensated only if chosen, compete with each other to be selected. The model allows us to decompose the firms’ advantage into two components: the advantage of choosing pro-industry arbitrators from a given pool, and the equilibrium pro-industry tilt in the arbitration pool that arises because of arbitrator competition. Selecting arbitrators without the input of firms and consumers would increase consumer awards by $60,000 on average relative to the current system. Forty percent of this effect arises because the pool of arbitrators skews pro-industry due to competition. Even an informed consumer cannot avoid this equilibrium effect. Counterfactuals suggest that redesigning the arbitrator selection mechanism for the benefit of consumers hinges on whether consumers are informed. Policies such as increasing arbitrator compensation or giving parties more choice would benefit informed consumers but hurt the uninformed.

Acknowledgments

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Document Object Identifier (DOI): 10.3386/w25150