ECO 4554

Economics of State and Local Government

Lecture Notes

ORGANIZATION OF SUBNATIONAL GOVERNMENT: OPTIMAL JURISDICTIONS

Key Points

1. There are multiple criteria for determining whether larger or smaller communities are more
efficient: homogeneity of preferences (the Tiebout hypothesis), returns to scale, and spatial
externalities.

2. There is an optimal size for a community, neither too small nor too large, based on each
criterion. Larger communities are not always more efficient than smaller communities. The
optimal size community according to one criterion may be different from the optimal size
community according to another criterion. There is a trade-off among the criteria. The
benefits of achieving efficient size according to one criterion must be balanced against the
costs of an inefficient size according to other criteria.

Synopsis

We first look at three criteria for determining the optimal size for a community or any government
jurisdiction: homogeneity of preferences (the Tiebout hypothesis), returns to scale, and spatial
externalities. We show what each criterion implies about the optimal size of a community.

What happens when the criteria conflict, when a community that is optimal according to one of the
criteria is not optimal according to another? We show how homogeneity of preferences as a criterion
for optimality may conflict with returns to scale and look at possible approaches to addressing or
resolving the conflict. When a homogeneous community encounters diseconomies of scale in the
supply of public services, production of the public service can be subdivided within the community or
the community can be divided into smaller communities. When a homogeneous community
encounters economies of scale, the supply of public services may be contracted out to a private
supplier or to another government or the community may enter into a joint service agreement with
other communities.

Then, we show that homogeneity of preferences may conflict with internalizing spatial externalities.
We look at intergovernmental grants as a possible solution to this conflict. We also show how the
inefficiency costs of non-homogeneous preferences can be balanced against the inefficiency costs of
uninternalized spatial externalities so that a community that is not optimal according to either
criterion alone may nevertheless minimize the sum of the inefficiency costs.

Consolidation of communities within a metropolitan area or consolidation of municipal governments

with a county government to form a single large metropolis is often proposed as an efficient “good
government” reform. We apply the analysis of optimal size jurisdictions to show that fewer larger
communities are not always more efficient than many smaller communities and may in fact be less
efficient.

Finally, whichever criterion of optimal size is used, there are many public services and the optimal
size of government for each public service may be different. To address this conflict, we introduce the
correspondence principle, which proposes a set of multiple overlapping jurisdictions, each responsible
for supplying a single public service. Following the correspondence principle, however, has high
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administrative costs so we introduce the concept of clustering, a non-scientific but useful way of
thinking about how to balance all the criteria for optimal jurisdictions while keeping administrative
costs relatively low.

Lecture Notes

I. Three measures of optimal community size

A. There are three efficiency criteria for determining the optimal size of a community or
government: homogeneity of preferences (the Tiebout hypothesis), returns to scale,
and spatial externalities.

B. Tiebout hypothesis

1. According to the Tiebout hypothesis, if there are enough communities so that

all individuals can find a community that provides their preferred quantity of
public services at a tax-price equal to their marginal benefit, individuals
choose among communities so that in equilibrium each community is
homogeneous (all residents have the same preferences) and the quantity of
public services in each community is efficient given the residents’
preferences.

2. The Tiebout hypothesis implies that the optimal size of a community or

jurisdiction is no larger than the number of individuals with the same
preferences for public services and that the optimal number of communities
equals the number of different preference types.

3. Even if real world communities are not perfectly homogeneous, the Tiebout
hypothesis implies that the quantity of public services in communities with
greater homogeneity is likely to be closer to the efficient quantity than in
communities with less homogeneity.

C. Returns to scale (or economies and diseconomies of scale)

1. Increasing returns to scale (or economies of scale)

a. If all inputs are increased in the same proportion so that the scale of
operation expands, output increases by a greater proportion. For
example, if a 100% increase in inputs increases output by 150%,
production is subject to increasing returns to scale. Increasing
returns to scale imply decreasing average total cost.

b. Applied to community size, increasing returns to scale means the

average cost of supplying public services in a larger community is
lower than the average cost of supplying the same quantity of public
services in a smaller community.

2. Decreasing returns to scale (or diseconomies of scale)

a. If all inputs are increased in the same proportion so that the scale of
operation expands, output increases by a smaller proportion. For
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example, if a 100% increase in inputs increases output by 50%,

production is subject to decreasing returns to scale. Decreasing
returns to scale imply increasing average total cost.

b. Applied to community size, decreasing returns to scale means the

average cost of supplying public services in a larger community is
higher than the average cost of supplying the same quantity of public
services in a smaller community.

3. The optimal size community or government is just large enough to take

advantage of all economies of scale but not so large as to encounter
diseconomies of scale. It includes just the number of individuals necessary to
achieve minimum average cost in the supply of public services. See
PowerPoint Slides Figure 4-1.

4. Illustration

a. In the diagram, the average cost of supplying public services

decreases up to a population of 20,000. For communities of fewer
than 20,000 population, there are economies of scale to increasing
the population.

Cost per unit of

public services

ATC

Population
20,000
b. The average cost of supplying public services increases as population
grows beyond 20,000. For communities of more than 20,000
population, there are diseconomies of scale to increasing the
population.

c. The optimal size community in this example is 20,000 people.

5. The empirical evidence suggests that the optimal size community based on
achieving maximum economies of scale is between 10,000 and 100,000
population. Economies of scale can be exploited up to about 10,000
population, but by about 100,000 population, diseconomies of scale set in.

D. Spatial externalities
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1. If there are interjurisdictional benefit or tax spillovers, also known as spatial

externalities, the quantity of public services supplied in each community is
inefficient even if there are no inefficiencies from either voting or the tax
system.

2. Benefit spillovers (positive externalities) See PowerPoint Slides Figure 4-2.

a. Assume

• two adjoining communities, A and B

• all residents in each community are identical in their
preferences for public services
• there are no interjurisdictional tax spillovers (only residents
of A pay taxes for public services in A, and similarly for B)
• there are interjurisdictional benefit spillovers (residents of B
benefit from public services supplied by A)
• the marginal cost of public services is constant and all
residents of A pay an equal share of the costs.

Cost of public
services

$25
MBA
$20

$10 MSC
B
MB
$5
MSB=MBA +MBB

Quantity of
100 125 Public Services

b. Residents in A compare their private MB, MBA, with the MSC and
vote for 100 units of the public service. But marginal social benefit
includes not only the marginal benefit to residents of A but also the
marginal benefit to residents of B, MBB. The efficient quantity of the
public service is 125 where MSB=MSC.

c. Problem: Residents of B benefit but they do not share in the costs.

They do not vote in A, and therefore they have no voice in deciding
how much of the public service to provide. Residents in A ignore, or
more likely are unaware, of the external benefits received by
residents of B. They vote for a quantity that is privately efficient but
socially inefficient.

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3. Tax spillovers (negative externalities) See PowerPoint Slides Figure 4-3.

a. Assume

• two adjoining communities, A and B

• all residents in each community are identical in their
preferences for public services
• there are interjurisdictional tax spillovers (both residents of
A and residents of B pay taxes imposed in A to pay for public
services in A)
• there are no interjurisdictional benefit spillovers (residents of
B obtain no benefit from public services provided in A)
• the marginal cost of public services is constant and all
residents of A pay an equal share of the costs.

Cost of public
services

$20

$10 MSC= MCA +MCB

$8 MCA
MSB=MBA
$2 MCB
Quantity of
100 125 Public Services

b. Residents in A compare their private MC, MCA, with the MSB, and
vote for 125 units of the public service. But the marginal private cost
to residents of A is less than the marginal social cost because part of
the cost, MBB, is externalized to residents of B. The efficient quantity
of the public service is 100 where MSB=MSC.

c. Problem: Residents of B contribute to the MSC of public services in

A but they do not share in the benefits. They do not vote in A, and
therefore they do not have a voice in deciding how much of the
public service to provide. Residents in A ignore, or most likely are
unaware of, the external costs imposed on residents of B. They vote
for a quantity that is privately efficient but socially inefficient.

4. The optimal size community is large enough to internalize all spatial

externalities.

a. Internalizing an externality: Taking action to correct an externality

by changing the incentives of the individuals who choose the
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quantity of the good or service. If the incentives are changed

appropriately, those individuals will choose the socially efficient
quantity rather than the privately efficient but socially inefficient
quantity.

b. The optimal size community is just large enough to internalize all

benefit and tax spillovers. It includes all individuals who benefit
from the public services supplied in the community and all
individuals who pay taxes to fund the public services supplied in the
community.

c. In the optimal size community, all spatial externalities are

internalized because everyone who either benefits or pays for the
public services is a resident of the community and participates in
decisions about the quantity of public services.

E. Problem: The three criteria are not always consistent with one another. An optimal
size community according to one criterion may be less than or greater than optimal
according to one or both of the other criteria. We look at several cases where the
criteria conflict.

II. Conflicts between homogeneity of preferences (the Tiebout hypothesis) and returns to scale

A. A homogeneous community satisfying the Tiebout criterion of optimality may be

either larger or smaller than the size necessary to achieve minimum average cost in
the supply of public services.

B. Case 1: Homogeneous communities that are larger than the size necessary to achieve
maximum economies of scale and minimum average cost

1. Suppose that the number of individuals with similar preferences for public
services is 40,000. That is the maximum size community that is optimal
according to the Tiebout hypothesis. But suppose the average total cost of
supplying public services is lowest in a community of 20,000. That is the
optimal size community according to the returns to scale criterion.

Cost of public
services

ATC

Population
20,000 40,000

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2. In this case, the solution is simple. Deconsolidation of the single large

homogeneous community into two smaller homogeneous communities
simultaneously allows satisfaction of the Tiebout criterion of homogeneity
and takes advantage of maximum economies of scale without encountering
diseconomies of scale.

3. But, suppose the number of individuals with homogeneous preferences is

larger than the number needed to minimize average cost, but is not a multiple
of the number needed to achieve minimum average cost.

a. For example, suppose the number of individuals with homogeneous

preferences is 30,000 rather than 40,000.

b. Then, the community can still be divided into two communities. One
community with a homogeneous population of 20,000 is optimal
according to both Tiebout and returns of scale. The other community
with a homogeneous population of 10,000 is optimal according to
Tiebout but is smaller than optimal according to returns to scale. We
consider homogeneous communities that are too small to achieve
maximum economies of scale next.

C. Case 2: Homogeneous communities that are smaller than the size necessary to
achieve maximum economies of scale and minimum average cost

1. Suppose the number of individuals with similar preferences for a particular

public service is 10,000. That is the optimal size Tiebout community. But,
the average total cost of supplying public services is lowest in a community
of 20,000 population. The optimal size community for achieving maximum
economies of scale is 20,000.

Cost per unit of

public services

ATC

Population
10,000 20,000

2. Now, there is a trade-off between the inefficiencies that arise in a smaller

community from increasing returns to scale and the inefficiencies that arise
in a larger community from less homogeneity. Smaller communities supply a
more efficient quantity of public services because of greater homogeneity of
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preferences, but they supply that quantity at higher average cost because they
are too small to achieve maximum economies of scale.

3. Resolving the conflict: Contracting out and joint service agreements

a. Contracting out for the supply of public services and joint service
agreements among communities offer possible solutions to the
conflict between homogeneity and returns to scale.

b. Definitions

(1). Contracting out: Each community contracts with a private

supplier or with another community to supply it with public
services. The producer of the public services supplies a
number of different communities, each of which is
homogeneous, but by serving multiple communities, the
producer is able to achieve maximum economies of scale.

(2). Joint service agreements: Several small jurisdictions join

together to supply public services so as to achieve maximum
economies of scale while maintaining their population at a
size consistent with homogeneity of preferences.

c. Contracting out and joint service agreements allow each community

to benefit from lower costs by achieving maximum economies of
scale in production while each community retains the ability to
provide a different quantity of the public service that is efficient for
its residents.

(1). The residents of each community are homogeneous in their

preferences for public services, but the residents in different
communities have different preferences for public services.

(2). Each community attains a Lindahl equilibrium that satisfies

the Tiebout hypothesis.

(3). Because the public service is supplied to multiple

communities, it is still possible to achieve maximum
economies of scale in production.

III. Conflicts between homogeneity of preferences (the Tiebout hypothesis) and internalization of
spatial externalities

A. The Tiebout hypothesis places an upper limit on the optimal size of a community but
no lower limit. Spatial externalities place a lower limit on the optimal size of a
community but no upper limit.

1. If a homogeneous community satisfying the Tiebout criterion of optimality is

larger than the minimum size necessary to internalize all interjurisdictional
benefit and tax spillovers, there is no conflict between the two criteria.

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2. However, if a homogeneous community satisfying the Tiebout criterion of

optimality is smaller than the minimum size necessary to internalize all
interjurisdictional externalities, the two criteria of optimality are in conflict.

B. Suppose there are two groups of 10,000 individuals each. The individuals in one
group all have a higher demand for public services than the individuals in the other
group.

1. The Tiebout hypothesis requires that each group reside in a separate

community. All the high-demand individuals reside in community A,
consume the same quantity of public services, and pay the same tax-price.
All low-demand individuals reside in community B, consume a smaller
quantity of public services, and pay a lower tax-price.

2. Now, suppose the residents of community B also receive some benefit from
public services supplied to the residents in community A.

a. The residents of A choose the quantity of public services that is

privately efficient for them. But, because there are external benefits
to residents of B, the privately efficient quantity is smaller than the
socially efficient quantity.

b. Each of the two communities is homogeneous. They are the optimal

size based on the Tiebout criterion. However, the quantity of public
services supplied in A is less than the socially efficient quantity
because of the uninternalized spatial externalities.

c. The analysis is essentially the same when costs are externalized

except that, with uninternalized cost spillovers, the privately efficient
quantity of public services is larger than the socially efficient
quantity.

C. Resolving the conflict: Intergovernmental grants

1. Intergovernmental grants from a higher level of government to a lower level

of government can compensate for interjurisdictional benefit spillovers while
allowing each community to maintain the size that satisfies the Tiebout
criterion.

2. Suppose A is an optimal size community according to the Tiebout criterion,

but suppose residents of B also benefit from the education provided to
students in A. Because residents of A pay the full costs of educating their
students, they choose to spend less than the socially efficient amount on
education.

a. If a higher level of government such as the state government

provides community A with a grant for education expenditure,
residents of A have an incentive to vote for more education
expenditure. If the grant is just enough to compensate for the
external benefits received by the residents of B, A’s voters have an

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incentive to increase education expenditure up to the socially

efficient amount

b. Each community is still homogeneous, but the spatial externalities

are internalized by the grant. It is not necessary to consolidate the
two communities in order to internalize the spatial externalities. The
grant encourages residents of A to increase their education
expenditure to the socially efficient level.

3. Theoretically, intergovernmental grants can internalize either benefit

spillovers (a positive grant or subsidy) or cost spillovers (a negative grant or
charge imposed by a higher level of government on a lower level of
government). However, in the real world, we do not observe negative grants,
so the device of intergovernmental grants is mainly useful for internalizing
interjurisdictional benefit spillovers.

D. Resolving the conflict: Balancing the costs of inefficiency

1. Suppose that grants are not feasible for internalizing spatial externalities.
Then, it may be necessary to compromise between a smaller size community
with homogeneous preferences and a larger, non-homogeneous community
that internalizes all the spatial externalities.

2. There is a trade-off between the inefficiency costs of less homogeneity in a

larger community and the inefficiency costs of uninternalized externalities in
a smaller community. See PowerPoint Slides Figure 4-4.

Cost

Total costs=Spillover+nonhomogeneity

Non-homogeneity costs

Spillover costs
Population
5,000 15,000 30,000

a. Suppose the optimal size community according to the Tiebout

hypothesis is 5,000. This is the largest number of individuals with
the same preferences for public services. As the size of the
community increases above 5,000, preferences become more and
more heterogeneous, fewer and fewer residents are on their demand
curves, and the quantity of public services deviates more from the

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efficient quantity. Therefore, the inefficiency costs of non-

homogeneity increase as community size increases beyond 5,000.

b. However, suppose the smallest size community that internalizes all

spatial externalities is 30,000. This is the minimum community size
that is optimal according to the criterion of internalizing
interjurisdictional spillovers. With multiple communities smaller
than 30,000, some spillovers remain uninternalized. The more
smaller communities there are, the more uninternalized externalities
there are. The inefficiency costs from interjurisdictional spillovers
increase as community size decreases below 30,000.

c. If it is not possible to satisfy both criteria simultaneously, an

alternative approach is to satisfy neither one, but instead to
compromise between them. We find a community size that
minimized the combined inefficiency costs of heterogeneity and
uninternalized spatial externalities. The community will be larger
than the optimal Tiebout size but smaller than the size that
internalizes all interjurisdictional spillovers. In the diagram, the sum
of the inefficiency costs is lowest with a population of 15,000. [Note
the similarity to balancing the administrative costs of voting against
the external costs of an adverse decision in choosing an optimal
voting rule.]

IV. Policy implications: Metropolitan consolidation and city-county government consolidation

A. Consolidation of several smaller communities in a metropolitan area into a single

larger community and consolidation of one or more city governments with a county
government to form a single metropolitan government are often proposed as “good
government” measures to enhance efficiency.

1. Examples of metropolitan consolidation: Modern New York City is the result

of metropolitan consolidation. In 1898 the cities of New York and Brooklyn
combined with the Bronx, Queens, and Staten Island to form the single city
of New York. The present city of Newport News, Virginia, is the result of a
consolidation of the separate cities of Newport News and Warwick.

2. Examples of city-county consolidation: The present city of Jacksonville is

the result of a consolidation of the original city of Jacksonville and Duval
County. For many government functions, the city of Miami and Dade County
function as the single consolidated Metro-Dade government. The cities of
Virginia Beach and Chesapeake, Virginia, are the result of consolidation of a
city and a county into a single city.

B. Government consolidation and economic efficiency

1. Consolidation of communities in a metropolitan area or consolidation of city

and county governments may enhance efficiency by internalizing spatial
externalities or by achieving greater economies of scale or by reducing
administrative costs.

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2. If consolidation of communities reduces the homogeneity of preferences

among the residents, however, the greater efficiencies from internalizing
externalities or from greater economies of scale are reduced or offset by the
inefficiencies from less homogeneity of preferences among the residents of
the consolidated community.

3. Consolidation of governments may also result in jurisdictions that are too

large. In other words, the consolidated jurisdictions may be larger than the
optimal size to achieve minimum average cost. The result of consolidation
may be a change from multiple communities that are inefficiently small to a
single consolidated community that is inefficiently large. Consolidation may
even result in a change from multiple smaller communities that are optimal
with respect to returns to scale to a consolidated community that is
inefficiently large.

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