A Coalition-formation Approach to Equilibrium Federations and Trading Block s

We develop a model in which states may choose to form coalitions to capture efficiency gains from policy coordination. Joining a coalition entails setting the policy variable to maximize the coalition's aggregate payoff at a Nash equilib- rium against non-members, and to commit to a transfer scheme to share the gains. With two states, the unique equilibrium structure is complete federation; with more than two states, incomplete federation can be the unique equilibrium. Interpreting this result in temrs of customs unions, the trend to trading bloc formation may be equilibrium behavious even with cooperation and transfers within customs unions.