Adapted from Final-Offer Arbitration by Stephen Goldberg in the August 2005 issue of the Negotiation newsletter.

Traditionally, the arbitrator is not limited to selecting one of the parties’ contract proposals but may determine the contract terms on his own. If negotiators know that impasse will lead to traditional arbitration, they typically assume that the arbitrator will reach a decision that’s an approximate midpoint between their final offers.

To move the midpoint as close as possible to a preferred outcome, each side will propose the most extreme final offer it can justify, thus reducing the likelihood of a negotiated agreement.

As an illustration, let’s use the example of salary negotiations between you and your CEO, in which you demanded $200,000 and the company offered $125,000. If you assume that the arbitrator will split the difference, her decision is likely to be about $162,500. You are likely to assume that if you increase your final offer to $250,000, and the company remains at $125,000, the midway point would move to $187,500, thus motivating you to submit $250,000 as your final offer.

Following the same reasoning, your CEO is likely to submit a final offer of $90,000, rather than the $125,000 he proposed in negotiations. Now agreement is even less likely, with both parties separated by a vast gulf of $160,000. A provision for the traditional arbitration as the endpoint of negotiations can thus be expected to have a chilling effect on the likelihood of the two sides reaching an agreement.

If, however, the negotiating parties have given up hope of reaching a voluntary agreement and would rather have any agreement than none at all, traditional arbitration will achieve that goal.

Another example is the negotiation between the New York Metropolitan Transit Authority and the New York Jets. Unable to reach agreement on the price the Jets should pay for the West Side rail yards, both sides agreed to submit the issue to traditional arbitration. (That agreement was subsequently undone when a second potential buyer, Cablevision, made a better offer than the Jets, and the Port Authority resume negotiations with both parties).

Arbitration is not appropriate for the resolution of all disputes about contract terms. Sometimes the differences separating the parties’ positions on key issues may be so great that neither would agree to allow an arbitrator to select the other side’s final offer. Other times, so many issues may separate the two sides that arbitration is impractical. Still, in many cases, particularly when agreement is blocked by disagreement on just one or two issues, you’d do well to consider a provision for final-offer arbitration, perhaps with an opt-out clause, in the event of impasse.