Arbitration with Uninformed Consumers
69 Pages Posted: 15 Oct 2018 Last revised: 11 May 2021
Date Written: May 05, 2021
This paper studies the impact of the arbitrator selection process on consumer outcomes. Using data from consumer arbitration cases in the securities industry over the past two decades, where we observe detailed information on case characteristics, the randomly generated list of potential arbitrators presented to both parties, the selected arbitrator, and case outcomes, 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 pro-industry equilibrium effect. Counterfactuals suggest that redesigning the arbitrator selection mechanism for the benefit of consumers hinges on whether consumers are informed. Policies intended to benefit consumers, 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: Suggested Citation