A theory of international unions with exits

Abstract

The dwindling popularity of globalization and international cooperation poses the issue of exiting an international union. An individually made exit decision is inefficient, as it neglects the losses of the other members. Fiscal transfers inside the union eliminate socially inefficient exits and restore the first-best outcome. When fiscal transfers are impossible, the union benefits from introducing exit costs during the formation process. Those costs are Pareto-optimal despite being a deadweight loss. If the union cannot fully commit to imposing exit costs ex post, it can use the anticipation of further exit decisions to increase its credibility. The paper also explores the scope for post-exit cooperation between the exiting country and the union. I show that both parties prefer a soft exit over a no-deal exit. However, the union might be reluctant to agree to a deal if it forms a precedent for the other union members. The model sheds light on Brexit and the UK-EU negotiations but also applies to other international unions.