I. Introduction One of the salient features of the preferential trading arrangements (PTAs) that have proliferated in recent years is that the member countries tend to be located in the same geographic region. The European Union, NAFTA, and Mercosur, which are among the most prominent examples of PTAs that have initiated or expanded market integration in recent years, all consist of countries that are located in the same geographic region. It has become common to refer to countries that are close in geographic proximity as being "natural trading partners," because the lower costs of transporting goods to nearby countries would reduce the amount of cost difference required to generate trade between the countries.' A common feature of the models of natural trading partners is that the level of transportation costs is taken to be exogenously given, with transport costs being lower between nearby countries? However, it may in fact be quite costly to transport goods between two nearby countries if the transportation infrastructure between the countries is not well developed, a problem which is frequently 'The concept of natural trading partners was first used by Wonnacott and Lutz (1979), and has been popularized recently by Krugman (1991). A somewhat stronger statement is frequently made, which is that there is a presumption that preferential agreements between natural trading partners are welfare improving. Frankel, Stein and Wei (1995) provide a systematic simulation analysis of this issue in a model that allows for intra-continental transport costs that are lower than inter-continental transport costs. They find evidence that "unnatural" trading blocs between countries on different continents typically reduce welfare, whereas "natural" trading blocs between countries in the same continent will raise welfare if intercontinental transport costs are not too low. If intercontinental transport costs are very low, then continental blocs may also be welfare reducing. It should be noted that the usefulness of the concept of natural trading partners to characterize trading blocs that are welfare-improving is not without controversy. Bhagwati and Panagariya (1996) argue that these results are highly sensitive to functional forms, and provide examples in which it is more desirable to form a link with more distant country.

2Frankel, Stein, and Wei (1995)) use a gravity model to explain trade patterns and find evidence that the volume of trade between countries is negatively related to the distance between them, which is consistent with a role for transport costs. Furthermore, they include dummy variables for regional groupings as a proxy for the effect of preferences, and find some significant coefficients. In contrast, Amjadi and Winters (1997) construct a direct measure of transport cost from trade data for Mercosur countries. They find that transport costs average approximately 6% of intra-Mercosur trade for Brazil and Argentina and 12% of trade with the rest of the world (excluding Chile). They point out that the differential of approximately 6% between within bloc and outside bloc trade is well below the differential found by Frankel, Stein and Wei to represent natural trading blocs in their simulations.

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