Valuing Exit Options

Abstract

This article examines an important aspect of federalism: the effect of a secession threat on the union's productivity. Productivity requires a compliance maintenance regime with credible punishment. An exit option gives a government the alternative of opting out of the union rather than suffer the disutility of a punishment. Equilibria are characterized over a continuous range of exit option values. The results indicate that only exit options that are superior to union membership improve utility; those of moderate value decrease net and individual government utility due to their harmful effect on compliance maintenance. A prescription that emerges from these results is that if the exit option is inferior to the benefit from a thriving union, member governments should voluntarily submit to measures that make exit as costly as possible.