Optimal Political Institutions in the Shadow of Conflict
Two players with conflicting interests make investments and then decide whether to trigger a conflict or maintain peace. In case of conflict, these investments determine the players’ fighting strength and hence their payoffs. In case of peace, preexisting common political institutions determine the players’ payoffs as a function of their investments. We show that the most efficient political institutions may maintain peace by distorting the players’ investments away from the first-best profiles. It is also possible that these distortions are so large that either peace cannot be maintained, or it can be maintained but it is no better than an ex-ante inefficient conflict