Federalism, equalization and risk aversion

What causes a group of countries to agree to form a federation? Other alternative arrangements, which often an chosen instead, are to form a unitary state or to remain autonomous. Federations usually allow for considerable freedom of movement among constituent regions. They also provide a fairly limited redistribution of any rents earned in these regions. These two features together imply that residents of poor regions can share in the rents in rich regions by migration. This fiscal migration may waste resources. Why not simply share the tents equally among residents of all regions? Such a unitary arrangement, although efficient, would not appeal to residents of a country which is likely to be the best-off region in a federation. Complete autonomy may expose residents of the separate countries to considerable idiosyncratic risk. Hen I demonstrate that federation may be chosen by a group of countries, even though it is a more wasteful arrangement than either other alternative, if asymmetries among countries, and the degree of risk aversion, are large. Federal states also often implement transfers among the regions. These transfers can be viewed as substitutes for fiscal migration. I also show that the possibility of transfers, even without any commitment to specifics, makes federalism a more attractive option. A federal constitution which requires transfers in excess of what would be made voluntarily may make federalism more attractive still. (C) 1998 Elsevier Science S.A.