Federations, coalitions, and risk diversification

We investigate the optimal size of a nation in the context of a portfolio choice model under uncertainty. With an equal sharing rule, we characterize the equilibrium coalition structure, which is shown to depend on income, risks, and market correlations. Specifically, coalitions are likely to form among regions with similar variance in income and among regions with negative market correlations. The conditions that yield a grand coalition, two sub-coalitions of different sizes, and singletons are derived. Moreover, the equilibrium coalition structures are also examined when geographical contiguity is required.