The institutional framework of community formation: the law and economics of municipal incorporation in California

This research explores the organizational and budgetary consequences of alternative institutional structures governing the creation, alteration, and dissolution of municipal corporations. The primary hypothesis is that the legal structure governing the formation of communities will significantly affect (1) the number of cities, and (2) the efficiency with which existing cities provide taxpayer/residents with public goods and services. A conceptual basis for such a presumption is presented. The local government literature suggests two alternative perspectives concerning the possible effects of institutional structures that restrict entry into the market for local public goods. One view suggests that entry restrictions will be efficiency inducing, thus resulting in reduced public outlays after their institution. The alternative perspective suggests that entry restrictions are a method by which managers of existing governmental units increase their monopoly power, and provide themselves with the tool to stabilize the formation of a market-sharing cartel. These two hypotheses are tested by using data from California, as this state provides a useful setting for a positive analysis of alternative institutional arrangements.

Prior to 1963, California could be classified as a free-entry state, as residents were easily able to form new communities. After 1963, California established Local Agency Formation Committees (LAFCOs), whose membership is from existing governmental units, which were given broad discretionary veto powers over the formation of new municipal corporations. A model of community formation was estimated and the empirical evidence suggests that the alteration in community formation regulations in California resulted in a reduced rate of new municipal incorporations by 56 percent, supporting the hypothesis that the institutional structure affects the number of cities created. Further, a model of public expenditures was developed and a comparison of the budgetary levels for California counties, pre- and post-LAFCO, suggests that the impact of the entry restrictions on the expenditure behavior of cities is substantial, with per capita expenditures 13 percent higher after the introduction of LAFCOs into the local government market.