Local governments allow people to vote with their feet to choose the policy regimes they want. For example, this week, defenders on a ban on McMansions in Boulder argued that there are lots of other jurisdictions in the metro area where they are available if someone prefers that option. But, it is also true that "individuals and firms locate in cities in order to get the benefits of being near one another."
A recent article argues that policies the encourage sorting by policy preference undermine the benefits of letting people be near one another, while policies that encourage people to be near one another undermine the ability of people to sort themselves by policy preferences. This tradeoff, the author argues illuminates urban policy.
This idea is alluring but I'm not sure that it holds up well. Washington Park offers a choice between high rise living and single family homes, and several intermediate options, in the space of a half a mile.
The high density enclave city of Glendale, in Arapahoe County, which is surrounded by less dense neighborhoods in Denver provides another example. It offers regulated adult entertainment, high density housing, and intense commercial uses that the City of Denver would probably not have permitted in that location, without requiring people to travel far to get that choice. Hong Kong is another example of the intense impacts that sorting style policy choices can provide without detracting from the benefits that cities provide by concentrating people, using very little space.
One could have a functional large city with lots of autonomous microgovernments. It is rare that a metropolitian city has fewer than dozens of local governments. No law of nature requires that central cities not be subdivided into autonomous subunits.
Also, the analysis seems to imply that local governments have more regulatory power than they choose to exercise in practice. For the most part, local governments provide municipal services. They are commonwealths that overcome collective action and commons problems involved in buying things that benefit many people that aren't most efficiently limited to user fee paying patrons. Local governments do regulate land use, but even then, they tend to do so by cementing a status quo established by developers, not by being regulatory visionaries themselves; and they routinely change the rules on land use when someone comes along with a popular enough alternative.
State and federal law and practical limitations and custom also greatly reduce the potential of local governments to be policy actors (which may be a good thing).