Coordination in Heterogeneous Federal Systems

We compare centralized and decentralized policy making in a federation in which policy heterogeneity is inherently costly and preferences vary across jurisdictions: all jurisdictions agree that some harmonization is desirable but no one agree on the direction of harmonization. This type of collective choice problem arises when members of a federal system have to coordinate nonbudgetary policies such as laws, regulations, standards, or diplomatic policies. Contrary to the common wisdom, decentralization becomes optimal when coordination becomes very important. When coordination costs are symmetric, decentralization dominates centralization irrespective of the magnitude of externalities and the heterogeneity of preferences. In the case of discontinuous network effects, standardization never Pareto dominates decentralization.