Arbitration versus settlement

Incomplete contracts and laws often lead to disputes. Before a dispute arises, parties can commit to arbitration. If they choose to do so, future disputes are resolved before an arbiter. Otherwise, parties will choose between settlement and litigation after a dispute has arisen. We analyze variables that might dictate the parties’ choices: the uncertainty of the case, the merit of the case, the costs of litigation, the probability of a dispute, and the amount at stake. Our results contrast with existing literature, which does not distinguish between contracts, where arbitration clauses are feasible, and torts, where they are not feasible. For example, we find that policies that reduce litigation in torts, such as a litigation tax, might either reduce or increase litigation in contracts. Finally, we note that arbitration clauses are akin to making a contract more complete ex ante, while settlement amounts to renegotiating a contract ex post. Using this framework, we derive implications for theories of litigation and incomplete contracts.