Basically, what happens in arbitration is that two parties get a third party to settle a dispute for them. The third party (the arbitrator) imposes a settlement for the dispute and the two parties to the dispute are required to abide by that settlement.
Arbitration is typically used in disputes between labor unions and management. Often, these two sides cannot come to an agreement when negotiating a contract. When this happens, they often turn to arbitration.
What happens is that the arbitrator is selected and holds hearings. During these hearings, the two sides each present their case to the arbitrator. They will typically each propose a solution to the problem. The arbitrator then makes a decision. The arbitrator decides which side’s solution is more appropriate or the arbitrator takes parts of each side’s solution and combines them into a compromise solution. Either way, once the sides have agreed to arbitration, they must accept whatever solution the arbitrator chooses to impose.
Thus, arbitration is a process in which a disinterested third party is called into to issue a binding settlement regarding a dispute between two parties.