Optimal Political Institutions in the Shadow of Conflict.

Two groups choose common political institutions, here modeled as an abstract mechanism aimed at generating investments and then distributing the resulting output. For example, two independent regions may consider creating a federation. Importantly, political insti- tutions are in the shadow of conflict: each group may, ex post, unilaterally withdraw from the common institution and trigger a non-cooperative game. The payoff in case of conflict depends on the players’ investment. It follows that the optimal political institutions may distort each player’s investment away from the first best level, as a way to discourage the other player from deviating. Distorting the players’ investment, however, also reduces the welfare in case of peace. It is possible that there is no political institution that can prevent deviations, and hence the only possible outcome is conflict.