Bargaining and hold-up: the role of arbitration

This paper analyses arbitration as a surrogate for complete contracts. We embed this idea in a simple model of a long-term relationship between a firm and its workforce, in which they can make productive-enhancing, relationship-specific investments, and then negotiate over the division of the resultant surplus. It is shown that the mere presence of the arbitrator (in the background of negotiations) may enhance investment incentives ex ante by minimizing each partys ability to engage in hold-up behaviours ex post. Furthermore, we highlight notably that the partners should optimally commit to call an arbitrator ensuring a compromise by awarding a reasonable share of the surplus to the worker. Indeed, this type of arbitrator would harmonize the parties bargaining powers and then weight their investment incentives optimally.