Valuing Exit Options
Jenna Bednar
University of Michigan
## email not listed ##
August 22, 2006
Abstract
This paper 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 mediocre to moderate exit options decrease net and individual government utility
due to their harmful effect on compliance maintenance; only exit options that are
superior to union membership improve utility. 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.
In federalism we observe no perfectly harmonious unions; instead, even the most stable—the
United States since 1865, Switzerland—are characterized by near-constant quibbling and,
periodically, more serious disputes. Others, such as Canada, seem to be perennially at the
brink of rupture. An emerging body of work studies the institutional design supporting
effective federations (Filippov, Ordeshook, Shvetsova 2004; Volden 2005; de Figueiredo and
Weingast 2005; Bednar 2006b). In this paper I take up a special aspect of federalism’s
problem: the effect of an exit option on the productivity of the union and the utility of the
governmental members.
A significant literature describes the opportunity provided by the exit option, generally
coming to the conclusion that exit options are beneficial for those holding them. They substi-
tute for voice (Hirschman 1970) by being an option to use instead of within-system protest;
without contradiction, they also increase (complement) voice (Hirschman 1993, Gelbach
1
Page 1 of 24 
Convention