This paper examines the impact of the emergence of regional blocs (customs unions) on the patterns of inter-bloc and intra-bloc trade when firms have the option to engage in direct investment (FDI). The consequences of bloc formation for exogenously given external tariffs is examined first. When two regional blocs co-exist and firms have the option to engage in FDI, all inter-bloc trade may cease – complete trade diversion that is replaced by inter-bloc FDI – investment creation. In such an event the volume of world trade declines but this is more than offset by the increase in world output due to direct investment. Hence, total world output is the same as under free trade. Second, I investigate the optimal tariff that a trading bloc levies on imports from nonmember countries. The equilibrium tariffs resulting from a non cooperative game played by the trading blocs is restricted by the option to circumvent the tariff via two-way direct investment. Small set-up cost associated with FDI leads to low tariffs and the outcome is almost free trade. Moderate set-up cost restrains the regional blocs from mutually harming one another through an escalation in the tariff war. Finally, the formation of two regional blocs enhances the welfare of all countries.