We analyze the welfare properties of centralization versus decentralization
in a heterogeneous confederation which exhibits interjurisdictional externalities.
We take a different policy focus than the existing literature on fiscal
and environmental federalism and consider the coordination problem that
arises when jurisdiction members have to coordinate their laws, administrative
rules or foreign policies. More concretely, we consider a large class of
situations in which external costs are driven by the differences between local
policies. Notwithstanding Oates’ decentralization theorem, we show that the
cost of decentralization vanishes as coordination becomes arbitrarily important.
When coordination costs are sufficiently symmetric, decentralization is
socially preferred to centralization whatever the magnitude of externalities
and the heterogeneity of preferences.