Eric Posner has an interesting post up at VC on the optimal size of countries. His comments remind me of Douglas North’s discussion of the topic in Structure and Change in Economic History (a very cool book if you haven’t read it). One possibility suggested by North is that the optimal size of the state is determined by the extant military technology. States that win wars survive and states that lose wars don’t. Accordingly, states whose size is correctly calibrated to the best military tactics and technology — e.g. the ability to raise and finance armies using the best weaponry, etc. — win. As military technology shifts we would then expect to see shifts in the optimal size of a state.
Another possibility is the transaction costs imposed on economic activity by national borders. For example, I think that there is a pretty good case to be made that Africa has too many countries. It makes sense that most trade is generally with your immediate neighbors — e.g. Canada and the U.S. — but in Africa this trade is frequently hobbled by inter-African protectionism. Hence, many African economies are effectively excluded from their most natural markets. Of course, if one thinks of protectionism as a form of rent seeking — and I believe that it almost always is — then this argument about optimal country size is really just a reformulation of Madison’s argument in Federalist No. 10: big countries are better because they are harder for “factions” to capture.
The trade story about optimal country size, however, can get complicated. One can dramatically reduce the transaction costs imposed by national borders through diplomacy and domestic policy, a la NAFTA or the EU. Likewise, there is no necessary reason that having a market within a single country necessarily implies the absence of implicit or explicit tariffs. Hence, for example, P.S. Atiyah argues in The Rise and Fall of Freedom of Contract that the union of Scotland and England at the opening of the 18th century created the largest free trade zone in the world. Although he doesn’t discuss it, it is worth pointing out that France, for example, had a larger population than the United Kingdom. On the other hand, France was not an internal free trade zone. Rather, one of the French crown’s chief sources of revenue was the taxation of trade not when it crossed France’s international frontier but rather when it crossed regional boundaries within the country.