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An Economic Analysis of Arbitration versus Litigation for Contractual Disputes

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This paper considers the efficiency of arbitration clauses when the firm can choose a degree of bias in the arbitration process and only some fraction of consumers can observe this bias. If the proportion of informed consumers is not too small, then there is an equilibrium at which all consumers trade, there is some pro-firm bias, and, as a result, there is excessive breach. The paper then compares the firm’s incentive to include an arbitration clause with the social incentive. The firm’s incentive does not mirror the socially optimal incentive: it could have either an excessive or insufficient incentive to include an arbitration clause, but under fairly broad conditions the firm will not choose an arbitration clause when court adjudication would be more efficient.

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