Arbitration with Uninformed Consumers

68 Pages Posted: 15 Oct 2018 Last revised: 3 Feb 2021

See all articles by Mark Egan

Mark Egan

Harvard University - Business School (HBS); National Bureau of Economic Research (NBER)

Gregor Matvos

Northwestern University - Kellogg School of Management

Amit Seru

Stanford University

Date Written: January 10, 2021

Abstract

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.

Keywords: Arbitration, Financial Advisers, Brokers, Consumer Finance, Financial Misconduct and Fraud

JEL Classification: G24, G28, D14, D18

Suggested Citation

Egan, Mark and Matvos, Gregor and Seru, Amit, Arbitration with Uninformed Consumers (January 10, 2021). Harvard Business School Finance Working Paper No. 19-046, Available at SSRN: https://ssrn.com/abstract=3260442 or http://dx.doi.org/10.2139/ssrn.3260442

Mark Egan

Harvard University - Business School (HBS) ( email )

Soldiers Field Road
Baker Library 365
Boston, MA 02163
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Gregor Matvos

Northwestern University - Kellogg School of Management ( email )

2001 Sheridan Road
Evanston, IL 60208
United States

Amit Seru (Contact Author)

Stanford University ( email )

Stanford, CA 94305
United States

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