Public Goods
Local provision

Decentralization of the supply of local public services is central to proposals for institutional reform in several European countries, which are now largely based on the theory of `fiscal federalism': that a layer of government should be established for each type of service unless there are clear advantages in combining the supply of several. In Discussion Paper No. 899, Oded Hochman, David Pines and Research Fellow Jacques-François Thisse develop a model in which clubs supply individuals with local public goods (LPGs). Individuals use their endowments of a composite good for private consumption, production of LPGs and transport. They derive utility from consumption of the composite good, housing and LPGs; consumption of the latter entails a `home-club' trip whose cost rises with distance.

This explicit incorporation of space into the model causes the total costs of providing LPGs for each `optimal complex' of clubs (with overlapping market areas) to exceed their total revenue from optimal user charges, so each club must be financed in part by land rent. The optimal provision of LPGs can therefore be achieved on a decentralized basis only by `metropolitan' governments, whose jurisdictions correspond to these optimal complexes, which supply the entire range of LPGs and finance their activities through both user charges and land rent.

The authors characterize the efficient provision of LPGs as the outcome of a two-stage process: first, metropolitan governments select their attributes (number, location and size of facilities); second, households choose location and consumption pattern, taking the attributes of the LPGs as given. They also demonstrate that competition among local governments under any other division of the territory results in an efficiency loss that even the imposition of lump-sum transfers cannot correct. Their sharing of land rents would provide them with incentives not to deliver LPGs unless they could capture the full land rents associated with their provision; intervention from central government to ensure this would undermine decentralization altogether. Hochman, Pines and Thisse conclude that these results provide grounds for considerable scepticism concerning the merits of fiscal federalism.

On the Optimal Structure of Local Governments
Oded Hochman, David Pines and Jacques-François Thisse

Discussion Paper No. 899, February 1994 (AM)