A Theory of (de) Centralization

This paper compares the efficacy of a centralized and a decentralized rights structure in determining the size of an externality generating project. Consider a central authority and two localities. One locality can operate a variable-size project which produces an externality that affects the other locality. Each locality may have some private information concerning its own net benefit from the project. Under centralization, localities are vertically integrated with a benevolent central authority who effectively possesses all property rights. Under decentralization, localities are separate legal entities (endowed with property rights) who bargain to determine the project size. We examine the performance of these two regimes and show how one or the other may dominate depending on the distributions of private and external benefits from the project. The effect of the size and variation in the externality on this trade-off is of particular interest. JEL: Organizational Behavior; Transaction Costs; Property Rights; Externalities; Asymmetric and Private Information; Structure, Scope, and Performance of Government (D23, D62, D82, H11). ⇤We thank Robin Boadway, Faruk Gul, Lu Hu, Eric Maskin, Dilip Mookherjee, Stefan Reichelstein, Mike Peters, Patrick Rey, Jacques Robert, Lars Stole and Francois Vaillancourt for comments and thank a number of seminar and conference audiences. The first version of this paper was written while the second author was visiting the MEDS Department at Northwestern University. He would like to thank MEDS for its hospitality and support during his visit, and also C.I.R.A.N.O., C.R.S.H. and F.C.A.R. for their financial support. †MEDS, Northwestern University ‡Sciences economiques, Universite de Montreal