Centralization versus Decentralization as a Risk-Return Trade-Off

Abstract

This paper characterizes the choice between centralization and decentralization as a risk-return trade-off and examines it in a model that integrates ideas from committee-decisionmaking and portfolio theories. Centralization, by pooling expertise, rarely yields erroneous decisions; however, when it fails, the consequences are global. In contrast, in a decentralized system, erroneous decisions are more frequent but their consequences are locally confined. We assess the relative desirability of (de-)centralization in various scenarios with independent versus interdependent risks. We further discuss the robustness of the model and the relevance of our results for policymaking.

Keywords: centralization, decentralization, federalism, Condorcet Jury Theorem, risk diversification

JEL Classification: D72, K00, K33