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Political fragmentation is often considered superior for advancing allocation efficiency in the provision of public services. On the other hand, the multiplicity of local governments in a metropolitan area, acting alone, can produce diseconomies of scale and externality problems constraining Pareto-efficient supply of public services. Local governments in the U.S. federalist system address this dilemma by engaging in voluntary interlocal cooperation, typically formalized through interlocal service agreements. These service agreements provide an important but little understood aspect of horizontal federalism. Local governments' choice of interlocal cooperation, their resource commitment to interlocal cooperation, and the mechanism they utilize to sustain cooperation are constrained by the asset specificity and measurement difficulty problems they face in interlocal service exchange. This dissertation explains how asset specificity and measurement difficulty influence the choice and the level of interlocal cooperation, as well as how these transaction cost dimensions shape the structure of service agreements that offset the transaction risks and sustain the cooperation for efficient public service provision. Transaction cost analysis provides one approach to understand interlocal service cooperation since it involves exchange between local jurisdictions similar to the private exchanges that transaction cost economics was developed to explain. A national analysis of cities' interlocal expenditures across multiple services shows that interlocal cooperation increases with asset specificity, but it follows an inverted U-shaped relationship with measurement difficulty, implying increased service cooperation up to a certain level of measurement difficulty and then decline thereafter. The main reason for the increase in interlocal exchange is that a rise in transaction costs associated with greater asset specificity and measurement difficulty hinders market exchange. Interlocal cooperation, thus, provides the next best alternative for jurisdictions facing transaction risks. But what do local governments do to mitigate the increased transaction costs in order to maintain the interlocal agreements? The analysis demonstrates that they go beyond dyadic agreements and embed their exchange relationships to mitigate the transaction risks. The micro-level analysis of interlocal service agreements across multiple services for all the general purpose local governments in Pinellas County, Florida reveals that when transactions risks are relatively low, buyer governments tends to confine service relationships to a single provider government that can establish credibility of commitment to protect the buyers. As transaction risk increases with the potential for a reverse hold-up problem, however, buyers avoid dependence on a single provider. Instead, they develop a broader network of agreements with multiple providers to minimize the power of a single provider. This research develops a unique extension of transaction cost theory that includes exchange embeddedness to provide a stronger foundation for understanding interlocal service cooperation specifically, and the broader arena of self-organizing activities of local governments in politically fragmented systems more generally.