In this paper we have analyzed the inter-relationship between endogenous trading bloc formation and innovation of a vertically differentiated good in a threecountry world economy. Trade bloc formation unambiguously increases the endogenous level of innovation by a patent holder monopolist MNC both in absence and presence of intra-country taste diversity. In the context of formation of a Free Trade Area (FTA), given the assumption that taste is less dispersed in the poor country relative to the middle-income country, the rich country is more likely to prefer the middle-income country over the poor country as its FTA partner when the formation of such FTA is feasible with or without side-payments. But the poor and middle-income countries will always prefer to form a customs union between them over FTA with the rich country. The joint welfare maximizing tariffset by them may be less than the Nash equilibrium tariffschosen unilaterally by them under no trade bloc formation. Most of these results are robust with respect to the extent of coverage of different markets by the MNC.

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