The purpose of interest arbitration is to encourage two bargainers to reach a mutually agreeable settlement. In the event of impasse, an independent arbitrator determines the settlement. In conventional arbitration (CA), each of the bargainers submits an offer. The arbitrator may select one of the two offers or one of his or her own choosing as the settlement. Critics have argued that arbitrators split the difference between the offers to enhance their chances of being rehired in future cases. This gives each bargainer an incentive to submit an extreme offer to increase its expected gains from arbitration. As a result, CA "chills" rather than encourages productive negotiation.
Final-offer arbitration (FOA) was created by Stevens (1966) to remedy the chilling effect. He proposed that arbitrators select one of the two submitted offers as the award. Unable to compromise between the offers, the arbitrator will presumably choose the "most reasonable" offer as the award.
Ironically, arbitrator compromise may exist even in FOA. According to theory, FOA arbitrators maximize their chances of being rehired by formulating a notion of the ideal settlement (the preferred award) and selecting the nearest offer. Importantly, Bazerman and Farber (1985), Farber and Bazerman (1986), and Gibbons (1988) noted that the preferred award is not exogenous but reflects the perspectives of the bargainers. Consequently, although FOA arbitrators may not compromise by splitting the difference between the offers, they may formulate preferred awards that compromise between the bargainers' perspectives.
Because Farber (1980) and Gibbons (1988) showed that submitted offers should be strategically aligned around the arbitrator's preferred award, an empirical analysis of final offers should reveal any compromises implicit in the preferred award. To test the compromised preferred award hypothesis, this study examines FOA offers in Major League Baseball.
Unique characteristics in baseball FOA allow for a test of the compromised preferred award. Baseball players become eligible for FOA after completing roughly three years of Major League service. During these first three years, the players bargain in a purely monopsonistic environment. The players may not freely negotiate with other clubs until they have completed six years of service. The coexisting monopsonistic and oligopsonistic (free agency) markets have led to extraordinary differentials in player salaries that have been well documented in economic literature, as in Kahn (1993). Although players with three to six years of experience continue to be bound to one club, they may unilaterally opt for FOA. Consequently, the arbitrator must determine the appropriate payscale for an eligible player. Because the clubs prefer to extend monopsony salaries into the arbitration-eligibility years, they are likely to stress the importance of the player's prior salary (i.e., the size of the raise a player is entitled to receive), whereas the players would rather have the arbitrators rely on free agent salaries to determine the proper wage. Although the arbitrators could side with one of the positions, theory predicts the preferred award will reflect a compromise between the two perspectives.
The results strongly support the existence of compromised preferred award. The submitted final offers are a weighted average between the mean free agent salary and the player's salary in the previous season. The notion that the preferred award represents a compromise between the two perspectives is strengthened when one examines the weights of losing offers. Specifically, for both hitters and pitchers, the losing player offer does not differ significantly from the mean free agent salary for a comparable player. Winning player offers, on the other hand, are less than the comparable free agent salary. Perhaps the most intriguing finding is that by compromising between the perspectives of players and clubs, baseball FOA has generated its own unique labor market through which player salaries lie between the monopsony and free agent levels. …