C'est la rue la plus petite dans la ville. It's a specific road in a specific town so why is dans wrong? Just as it's not wrong in il y a une boulangerie dans la ville? (Your example)
This a comparative structure and ‘de la rue/ de la classe’ etc are required. Il y a … is purely descriptive. English often will use ‘in’ instead of ‘of’ with this form of comparative, but French sticks to “ de “.
Just to spell out what Maarten explained:
C'est la rue la plus petite de la ville.
Thanks Chris - I meant to write “ de la ville “ but, oh well, it’s late here !
Yes it is the prettiest or smallest but not the only street in the town -- this is why Maarten is right from a comparative point of view.
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