Natural Trading Blocs

Natural Trading Blocs: A Closer Look

It is occasionally argued that the formation of trading blocs between geographically proximate countries should be encouraged because positive welfare effects are more likely to outweigh negative welfare effects. This paper presents a simple differentiated products model that allows to test whether the formation of a ‘natural’ trading bloc, first, is indeed increasing world welfare and, second, is welfare-superior to the formation of an ‘unnatural’ trading bloc. Simulations show that, while the removal of trade barriers always improves world welfare, ‘unnatural’ bloc formation may, under some conditions, be welfare-superior to the formation of trading blocs along ‘natural’ lines. The concept of ‘natural’ trading blocs is therefore a misguided prescription. (JEL Classification: F15)