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MARKET AREAS I

AND FIRM
LOCATION ANALYSIS

The success or failure of many urban professionals hinges on their


understanding of why firms locate where they do. Location can make or
break a business. Realtors who know location theory sell and present
properties more effectively. Public officials and economic developers
recognize that enticing firms to an area creates jobs and increases wages,
incomes, local tax bases, and property values. A firm‘s location choice thus
affects a region‘s quality of life.
What factors does a firm consider when it decides where to locate? The
answer is very simple: business owners will locate where they can maximize
the return on their investments. For some entrepreneurs, a good location is
where they will maximize profits or just minimize costs. For others,
proximity to specific inputs or customers will thus be the primary criterion
for the choice of a location. For a final set of business owners, the optimal
place depends on the amenities offered.
Transportation costs play a fundamental role in this choice. Firms that
pay more to transport their output are defined as market oriented. Market-
oriented firms produce goods with short shelf lives or goods that are
expensive to transport, such as newspapers, fresh vegetables, bakery
goods, or products that gain weight in the production process. In contrast,

19
input-oriented firms pay more to transport inputs. Some firms cluster in a
region and thus influence the cost structure of all enterprises in the same
area, generally by lowering the production costs. Then, even more firms will
be attracted to the region because of the cost advantages resulting from the
agglomeration. Lower production costs that benefit firms clustered together
are called agglomeration economies.
This part examines various models of firm location behavior. Chapter 2
and Chapter 3 focus on what Fujita and Thisse (1997, 2002) call ―shopping
models.‖ Shopping models are appropriate for studying the competitive
behavior among firms that sell consumer goods, as opposed to shipping
models, which describe competition among producers. Shopping models
assume that the costs of labor and other inputs are the same everywhere.
The only factors that change with the location are the number of consumers
that the firm can attract and the number of rival firms.
A model of urban hierarchy that determines which cities more efficiently
provide what services stems from the simple model of market areas. Chapter
3 explores theories that explain the relationships among neighboring cities
of different sizes, that is, theories of hierarchies, networks of cities, and
central places. The concept of a central place is rooted in the fact that each
type of product requires a market area of a certain size. The combinations of
products sold in a city changes with its size. Consumers in smaller cities
need to travel to an urban center to find specialized products.
Chapter 4 and Chapter 5 explore ―shipping models.‖ In Chapter 4, when
we relax the assumption that the costs of production are equal everywhere,
we discover that the costs of the inputs and transportation costs produce a
predictable effect on the location of enterprises. Chapter 5 concentrates on
the effects of agglomeration economies on firm location. Agglomeration
economies, along with the theory of cumulative causality, help shape the
foundation of the endogenous growth theory, (New Growth Theory) that is
supported by development economists, international economists,
and macroeconomists.
Chapter 6 concentrates on spatial pricing patterns. These pricing patterns
refute the myth that monopoly is the only market structure capable of
practicing price discrimination. Price discrimination consists of selling the
same product at different prices and to different consumers without incurring
any increase in cost. The chapter also reveals the ineptitude of some antitrust
laws, such as the Robinson-Patman Act, which actually create and sustain
local monopolies while claiming to encourage competition. Chapter 6
highlights the inconsistency between a basing-point pricing system—which
is now illegal but which the American steel companies used until 1924—and
the ―legal by definition‖ basing-point pricing system that the U.S. federal
government uses to establish prices. The steel mills in Europe currently use a
basing-point pricing system despite Article 85 of the Treaty of Rome that, in
principle, forbids commercial restrictions in the European Union.
Chapter 2

Linear Market Areas

To determine where a firm will locate, we will start by delimiting a market


area for a spatial monopolist. By delimiting the potential market area, we
find the optimal location for a firm depending on the consumers‘ pattern of
dispersal and the product‘s elasticity of demand. The underlying assumption
in these models is that all inputs are sold everywhere for the same price.
According to Fujita and Thisse (1997, 2002), the models in this chapter and
in Chapter 3 are known as shopping models. Shopping models allow us to
study the competitive behavior of firms that sell directly to consumers. They
apply principally not only to the retail trade and service industries, but also
to the manufacturing firms if input costs are identical wherever a firm
locates. Shopping models assume that the consumers pay all transportation
costs, that is, if all firms use free on board (f.o.b.) pricing policies.
In this chapter, we first note that if a firm starts as a spatial monopolist, it
may not remain so for long if the local market is profitable. Profits attract
entry. Entry changes a monopoly into a duopoly or an oligopoly. We will
next determine where the new enterprises will locate, and then we consider
pricing strategies and other games that duopolists or oligopolists play.
Finally, we will expand the theory to explore commuter shopping, multi-
purpose, and multi-stop shopping behavior.
The distance consumers are prepared to travel to buy a product
determines the market area. The traditional demand curve for a product
shows the quantity of a good that people are willing and able to buy at a
specific price. However, the real amount that consumers pay is more than the
sum they pull out of their wallets. The delivered price (full price) equals

21
the store price, also called the mill price (or gate price for agricultural
products), plus the transportation costs that are incurred in traveling to the
store. This transportation cost includes more than the cost of gas, oil,
insurance, and depreciation for an automobile, or than the cost of bus, taxi, or
subway fares. The most important component of transportation cost is the
opportunity cost of the time involved in traveling to and fro m the store.
We assume that the spatial monopolist imposes an f.o.b. mill price,
which means that consumers pay the mill price (the price that the store
charges) plus all transportation costs. Under f.o.b. pricing, if the consumers
do not go to the store to buy the product, they can order the product from
the dealer and pay all shipping charges. The opposite of f.o.b. pricing is
uniformed delivered pricing, also known as cost, insurance, and freight
(c.i.f.) pricing. Under uniform delivered pricing, the firms pay all trans-
portation costs. Firms that offer free delivery (for goods such as flowers,
pizzas, prescriptions, or groceries) employ a uniform delivered pricing
strategy, and thereby become price discriminators.

From Demand Functions to Price–Distance Functions


One way to determine the distance that consumers are prepared to travel to
shop is to examine transportation costs in light of the demand curve.
Economists generally start with the most restricted, and the simplest models
that still explain the effects of the variable under study. Little by little, we
relax the stringent assumptions, making the model more realistic. The
simplest models in spatial economics require the following assumptions:
First, the transport costs are constant and consist of both out-of-pocket
costs and psychic costs, that is, costs that represent the additional stress or
the opportunity cost of the time. Second, assuming that the transportation
costs per unit of distance are constant, the price-distance function shows the
total cost incurred by the consumers in traveling from their residences to the
store. Finally, we assume that each of them only buys one article, that they
do not stock up or buy in bulk, that they have no other reason to go to the
store, and that they have no other errands to do along the way.
The delivered price (full price) that consumers pay is the mill price
plus transport costs. The limit price is the maximum price that the
consumers are willing and able to pay for a good. It is the price at which
a linear demand function intersects the y-axis. For the demand curve in
Panel B of Figure 2.1, the limit price is $10. Note that the demand curve
represents a typical household, regardless of its location. A market demand
is the summation of all the individual demand curves. Because the goal of
this exercise is to determine the maximum distance that individuals or
households will travel to shop, the market demand curve would not be
appropriate.
Think About It.
Determine your “full price” for going to get . (sub-
stitutions are possible)
1. An ice cream cone
2. A single loaf of bread, or
3. A cup of “designer” coffee
Store price #1.
Transport costs (for drivers)
Distance to store (in miles) multiplied by 2a
40.5¢ per mile
Parking fees 2b
Time to drive there, park, and return 2c
home multiplied by hourly wage
or (for users of public transportation)
3a
3b

Total transport costs (either 2aC2bC2c or 3aC3b)


#2.
Full price of purchased item (#1C#2)

Panel A Panel B
Price-distance function
Price
Price
$10

$4
Demand

8 Distance 5 Quantity

Figure 2.1 Price-distance function and demand function.


Figure 2.1 shows the distance that a consumer is prepared to travel. Panel
A isa price-distance function. The slope of the price-distance function is the
transport cost per unit of distance (block, mile, or kilometer). In Figure 2.1,
consumers who live eight miles from the store do without the good or
service rather than travel that far because the delivered price is higher than
their limit price ($10). Those who live fewer than eight miles away will
patronize the store in town, albeit rarely. (Calculations associated with
Figure 2.1 are in the Mathematical Appendix.)

Dynamics of Market Areas


The market area for a spatial monopolist is a function of its demand curve
and the price-distance function. The radius of the market area varies when a
store changes its prices or when transportation costs change for consumers.
When a store changes the price of its product, the price-distance function
will shift upward or downward, parallel to the original function. If the mill
price increases, say from $4 to $6, as in Figure 2.2, the radius of the market
area drops to 5.33 miles. A decrease in the price to $2 increases the radius of
the market area to 10.67 miles. (See Appendix for details.)

Think About It.


Consider again your trips to just get an ice cream cone,
a loaf of bread, or a cup of coffee. How would the
following affect your full price and your decision to go
for the items?
1. Store price doubled (mill price increases)
2. Gas prices (or fares) went up 25 percent (trans-
portation costs increase)
3. Congestion increased the time to get to the facility
by 25 percent (transportation costs increase)
4. You want to celebrate your best friend’s birthday
with this good (demand increases)

The spatial monopolist cannot control all market area changes. Road
construction, considerably higher gasoline prices, or more traffic congestion
increase the transportation costs per mile, making the price-distance
function steeper. In Figure 2.3, for example, if the price of the product is
PD2
Price PD1 Price
PD3

$6

$4

$2

Demand

5.33 8 10.67 Quantity

Distance

Figure 2.2 Price-distance functions and demand when the mill (store) price
changes.

$4, but the transportation costs per mile double to $1.50, the market area
radius shrinks from 8 to 4 miles. However, if one constructs a more efficient
road system that cuts down the time needed to drive to the store and the
transportation costs per mile fall by 50¢, then the market area radius
expands to 12 miles. (Details are in the Appendix.)

The Debilitating Effect of Decreased Trans-


portation Costs for Small Banks
Rosser (1991) blames the decline in the number of
banks at the end of the 1920s on the proliferation of
the automobile. As more people owned automobiles,
their marginal transportation cost fell because consu-
mers could go farther in less time, which increased
the market area of banks. Greater competition from
banks in neighboring cities forced inefficient banks
out of business.

Rosser (1991)
PD2 PD1
Price Price
PD3

$4
Demand

4 8 12 5 Quantity
Distance

Figure 2.3 Price-distance functions and demand when transport costs change.

Finally, the market area changes when the demand curve shifts. If
demand for the product increases, pushing the limit price to $12 (rather
than $10), the market area boundary will increase from 8 miles to 10.67
miles. If instead the limit price falls to $6, the boundary decreases to 2.67
miles. The graph of this instance is left for the reader to draw and analyze.
(See the Appendix for a hint.)
In summary, the mill price, the cost of transportation, and the demand
for the firm‘s product determine the market boundary for a spatial monopo-
list. Market boundaries shrink if the firm charges a higher price, if travel costs
increase, or if demand decreases. Market area boundaries expand when the
firm lowers its price, when travel costs decrease, or when demand increases.

Price Elasticity of Demand and Distance


The price elasticity of demand for a product increases with distance to the
store. Consumers who live farther from the store are more sensitive to price
changes. They have more elastic demand curves than those living closer to
the store. The price elasticity of demand measures the responsiveness of
consumers to price changes. The formula for elasticity of demand is

%DQ
. ð2:1Þ
. %DP .

Along a linear demand curve, the absolute value of the elasticity


of demand ranges fromN(at the limit price) to zero (at a price of zero).
Price
Price
$10
Slope=1
Elastic demand

Unit elastic demand


5
$4

Inelastic demand

Demand

Distance Quantity

Figure 2.4 Price-distance function and elasticity of demand.

The midpoint on a demand curve is the point of unit elasticity because the
percent change in quantity equals the percent change in price. Above this
point, the elasticity coefficients are greater than one, and the demand is
called ―elastic.‖ The demand is ―inelastic‖ when the elasticity coefficients
are less than one on the lower portion of the demand curve.
Because the limit price is ten and half of ten is five, at a price of $5 the
demand curve of Figure 2.4 is unit elastic. Therefore, because consumers
who live right next to the firm pay $4 for the product, their demand is
inelastic. If customers living 1 mile from the point of sale incur $1 in
transportation costs, they face a delivered price of $5, and consequently,
have a unit elastic demand. Consumers who live farther pay yet a higher
delivered price and have an even more elastic demand. Those who live 8
miles from the firm are the most responsive to price changes and face a
nearly perfectly elastic demand. Knowing this, firms try to decrease
delivered prices for distant consumers for whom the demand is elastic,
while increasing prices for local customers who have inelastic demand. We
will see in chapter 6 some examples of spatial price discrimination
conditional upon distance from the point of sale.

Hotelling’s Linear Markets


Market area analysis is traced to a model developed by Harold Hotelling
(1929). Economic theory asserts that excess profits invite entry. Hotelling
tried to determine whether a firm that enters a market endowed with excess
profits would locate close to the original firm or away from it. The traditional
answer from Hotelling‘s theory is that the location depends on the elasticity
of demand.
To understand Hotelling‘s answer, let us assume that consumers are
equally spaced along the linear market area. To picture this market area,
think of the main street of a town with individual houses on equally sized
lots. This assumption means that as market area changes, sales change
proportionally. Let us then, assume that the demand curve for the
homogeneous product is perfectly inelastic. Perfectly inelastic demand
curves are vertical and thus have no limit price. An example of a good
with a perfectly inelastic demand would be insulin. If the price of insulin
increases, diabetics cannot substitute a cheaper medicine. In contrast, if the
price of insulin drops, firms do not increase sales. Diabetics cannot
consume more insulin and other patients will not substitute insulin for
another prescription.

Think About It.


Look at a detailed map of your city or neighborhood.
Pick out the locations of the following types of stores:
1. Convenience stores
2. Video stores
3. Gas stations
4. Large grocery stores
5. Used car shops
6. Major employers
7. Restaurants
8. Clothing and apparel stores
Which stores cluster together and which stores are
dispersed? Is there a pattern of dispersal along a
transportation network?

Spatial Duopolies with Perfectly Inelastic Demand


Besides a perfectly inelastic demand, Hotelling assumed that consumers are
equally distributed along the linear market area and every consumer buys
only 1 unit of the product. He also assumed that they incur all transport
costs. According to Hotelling, firms behave like lemonade stands on
wheels—they move up and down the street costlessly. A single firm can
locate anywhere, and because of perfectly inelastic demand, it will not lose
any customers because they are ready to pay any expense to obtain their
good. However, when the consumers have a choice between two firms,
they buy from the firm with the lowest delivered price. Finally, Hotelling
assumed that consumers don‘t have any reason to prefer one store over
another for better quality products or better service.
Firm A in Figure 2.5 is a spatial monopolist located at the first quartile. If
FirmB decides to enter the market, that firm will locate just to the right of the
original firm. Firm A would retain all consumers located to the left of the
store (the entire first quartile) and half of the consumers between it and Firm
B. The market area of Firm A is the small region on the left. Firm B controls
the large area on the right.
Because consumers purchase from the firm with the lowest delivered
price, Firm B controls three-fourths of the market. However, to increase its
market share, all that FirmA has to do is to move just to the right of B. FirmB
retaliates and moves to the right of A.
Because moving is costless, the two firms continue leapfrogging until
they reach an equilibrium location in the middle of the market area. In this

A B

First quartile Median or Third quartile

second quartile

Figure 2.5 Unstable market areas for a duopoly.


fashion, every firm will control half the entire market. Consumers in
quartiles one and two will shop at A and consumers in quartiles three and
four will shop at B, as shown in Figure 2.6. Both firms face the same
transportation and production costs.
Notice that according to Hotelling‘s model, when the firms locate
together in the center of the market, neither firm thinks to lower its price.
This price stability is the key to a stable equilibrium in this model. Once they
locate in the market center, there is no other place where either firm can
relocate and increase its revenues.
Hotelling called the tendency for the firms to cluster in the middle of the
market area the principle of minimum differentiation. He used this
principle to explain not only geographic advantages, but also the behavior
of candidates in electoral campaigns and the absence of radical innovations
in retail goods.
Hotelling justified the difficulty in distinguishing one politician from
another during election time by using locations along a continuum of
preferences for or against specific issues. Politicians from the far left or
the far right will collect fewer votes that those who agree with the median
voter. Therefore, Hotelling observed,

Every candidate ‗pussyfoots,‘ replies ambiguously to questions,


refuses to take a definite stand in any controversy for fear of
losing votes. (Hotelling 1929). (The italics are in the original.)

A’s market area B’s market area

A B
Distance

Figure 2.6 Market areas for a duopoly under perfectly inelastic demands.
Hotelling also used the principle of minimum differentiation to justify
why ―buyers are confronted everywhere with an excessive sameness‖ in
retail products. If we consider ―location‖ with respect to the attributes of a
product, the principle of minimum differentiation establishes that firms
producing heterogeneous products can alienate certain groups of consu-
mers. Retailers, consequently, will tend to

make only slight deviations in order to have for the new


commodity as many buyers of the old as possible, and to get,
so to speak, between one‘s competitors and a mass of consumers
(Hotelling 1929). (The italics are in the original.)

Think About It.


When you find you lack a key ingredient for tonight’s
dinner, you have two choices: (1) change your menu, or
(2) buy the ingredient.
If you decide to purchase the good, under what
conditions do you go to the closest store? When do
you go to a more distant one?

Spatial Duopolies with Elastic Demand


Hotelling‘s theory continues by supporting the hypothesis that most firms
will locate far from each other because the demand for most goods is not
perfectly inelastic. Firms that sell goods with an elastic demand tend to
disperse. Figure 2.7 shows that our spatial monopolist ―A‖ is located in the
center of Main Street. If the limit price is $10, the spatial monopolist will have
a market area just under 8 miles in either direction from the store. Because
all the consumers have identical demand curves and because they are
spaced equidistant from one another, our monopolist could locate
anywhere within 8 miles of either end of Main Street and maintain the
same quantity of sales.
Figure 2.8 shows that if two firms are located at the first and third
quartiles along a linear market area, if these duopolists sell identical
products for $4, and if transportation costs are 75¢ per mile for both
firms, they will divide the market equally. In this way, no consumer will
pay more than the limit price of $10. The consumers will frequent the store
that offers them the lowest delivered price. Consequently, a customer at
$

$10

$4

16 8 0 8 16
A
Distance

Figure 2.7 Market area for a monopoly when the demand has a limit price.

$11

$9

$7

i Firm A k j Firm B
Q1 Q2 Q3

Figure 2.8 Market areas for duopolists when their demand curves have a limit price.
point i shops at Firm A. The consumer at point j prefers to shop at Firm B
and pay a delivered price of $7 rather than $11 at Firm A. Customers located
at the median point of the market area (point k) are indifferent between A
and B. Point k is therefore referred to as the break-even location. At either
store, the delivered price for consumer k is $9. The market area for FirmA is
on the left of the market and Firm B‘s market area is on the right.
From the previous diagram, it seems that consumers always shop at the
nearest establishment. This assertion is true if the stores sell identical
products at the same price and if their consumers face identical trans-
portation costs. However, Figure 2.9 shows one situation where consumers
may wish to avoid the nearest store and shop at a store farther from their
house. Why?
Firms C and D are located on quartiles of the bounded market area.
Both stores charge the same price ($4) for identical products. Trans-
portation costs for Firm D are $1.50 per mile, but only 25¢ per mile for C.
Firm D may have either inadequate parking or difficult access. Because of
the high transportation costs, only consumers within approximately 2
units of distance around Firm D will shop there. Consumers who reside
more than 2.34 units of distance to the right of D will actually save on
transportation costs by shopping at C. The market area of Firm D
resembles an island inside C‘s market area. (Calculations are in the
Mathematical Appendix.)

C D
Distance

Figure 2.9 Demand curves for a duopoly when one has higher transport costs.
B" C’ A B A" C B' A' C ''

Figure 2.10 How three firms relocate to share the market.

Three’s a Crowd
Hotelling‘s model was extended by Lerner and Singer (1937) and Eaton and
Lipsey (1975) to explain how more than two firms (carts on wheels)
compete for the same market. If more than two firms sell identical products
in a linear market, competition forces them to eventually disperse. If three
firms try to locate next to one another, the firm in the center will have too
narrow of a market for survival. Because moving is costless, the firm in the
middle of the trio will move down the street, leapfrogging over the other
firms until the three share one-third of the market area equally
(Figure 2.10). In the same way, four firms would share one-fourth of the
market, and so forth. Entry will continue as long as each firm‘s share of the
market permits it to cover its costs including a normal rate of return. The
minimum market area needed to limit a firm to a normal profit is called its
threshold size.
What happens to entry if each of the firms faces a slightly greater than
normal rate of return but the sum of the excess profits is not enough to
sustain the coexistence of one more firm? The excess profits continue
until (1) the market grows large enough to permit an additional firm to
eke out a living, (2) a new firm benefits from lower production costs, or
(3) a new firm benefits from an owner who is content with less than a
normal profit.

Challenging the Principle of Minimum Differentiation


Hotelling implicitly assumed that the firms only have to choose the
location—they never choose what price to charge. Price was exogenous
and fixed. However, in reality, oligopolists have some control over price.
For example, if Firms A and B are located at the market center and A
decreases its price, even by a penny, but Firm B does not, then Firm A
captures the entire market.
Influenced by an article by d‘Aspremont, Gabszewicz, and Thisse (1979),
researchers now question the principle of minimum differentiation for spatial
$

Firm E Q2 Firm F
Q1 Q3

Figure 2.11 Duopoly when one firm lowers its price.

duopolists producing homogeneous products. d‘Aspremont, Gabszewicz, and


Thisse (1979) concluded that Hotelling‘s model will havea stable equilibrium
only if the established firms are certain that their competitor (competitors) will
adopt the same established price when they enter the market.
If the firms can change both their locations and their prices, the principle
of minimum differentiation does not result in a stable equilibrium. The
stores are spatial monopolists to be sure, but to keep their market share,
they must worry about the prices that the other firms charge. Figure 2.11
shows Firms E and F. This time, both firms have the same transportation
costs. If FirmE lowers its mill price from $4 to $2 and FirmF keeps the same
price, F‘s market area will decrease. Conversely, if FirmE increases its prices,
F‘s market area will expand.
However, if, we see in Figure 2.12, Firms E and F sold products with an
inelastic demand and if they were jux\taposed in the center of the market
area, one firm (e.g., Firm E) could theoretically lower its price by 1 cent to
capture the entire market.
In the Bertrand model of oligopoly behavior, when one firm lowers its
price, it does so assuming that its rival‘s price won‘t change. 1 The Bertrand

1
For more information about subgame perfect Nash equilibrium concepts in game
theory, Drew Fudenberg and Jean Tirole, Game Theory (and London: MIT Press, 1991).
$

Q1 E F Q3

Figure 2.12 Price shading.

model assumes that all goods are homogeneous and that all consumers buy
from the seller with the lowest price. Firm A chooses its price assuming that
FirmB will not react. Once FirmA sets a new price, FirmB has three options.
(1) It could keep a higher price (and lose all sales); (2) it could set an equal
price (and share the market), or (3) it could set an even lower price and
capture the entire market itself. In Figure 2.12, the last choice is the most
profitable and the one that FirmB will choose—again, assuming that FirmA
will not respond.
Of course, Firm A reacts and faces the same three choices, Firm A is
going to surprise Firm B by choosing to set an even lower price. The price
wars wage on until the point where all prices equal the marginal cost of
production. Prices may even dip below the marginal cost for short periods
of time if one firm tries to drive its rival out of business.
As the Bertrand theory suggests, stores along a well-traveled route practice
price shading, that is, they set a price just below that of their competitors.
Price shading increases market share as long as the price charged is higher than
the marginal cost. The store that begins this price war hopes that in the end
some firms will go out of business and others will not dare to enter the market.
As rival firms leave the market, demand for the remaining firms
temporarily increases until the supernormal profit attracts other entrants.
Firms will realize above normal profits, according to d‘Aspremont,
Gabszewicz, and Thisse (1979), only if they locate as far away from each
other as possible. The greater the distance separating firms the more control
they have over their own price because a longer distance makes comparison
shopping more difficult. The resulting dispersion is by no means nirvana,
however. Firms farthest from the market center discover that their customer
base is smaller and are lured back toward the center. At the market center,
they will again be pressured to disperse by fierce price wars. Firms will
never be satisfied with their location.

Think About It.


Do you always shop at the store offering the lowest
delivered (full) price for each good you purchase?
What besides price influences your decision to shop
at a particular establishment?

One way for firms to achieve equilibrium i na linear market is to produce


heterogeneous products (products for which there are different models, styles,
colors, etc.) Firms that differentiate their products tend to cluster in the market
center. The prices will not be identical because the products are not identical.
The clustering of firms results in a retail agglomeration that decreases search
costs for consumers, thus creating economies of retail agglomeration.
These lower search costs increase the probability that consumers will buy
from one of the firms in the cluster. Thus, equilibrium now exists in the form of
a possibility (‗that the consumers will choose to shop ata certain store) rather
than a prediction from an exact mathematical relationship. 2
The proximity of firms selling similar but not identical goods gives
consumers the chance to comparison shop. Retail agglomeration economies
explain why clothing stores, used car lots, and antique dealers locate close
to one another. They also explain why many shopping malls have food
courts where food vendors group together.

Consumer Search Behavior and Firm Location


Vendors selling identical products tend to disperse, but product differen-
tiation creates overlapping market areas. In contrast, a large variety of
choices forces consumers to pay more attention to specific attributes of

2
de Palma et al. (1985); Claycombe (1991).
products rather than transportation costs. 3 Consumers may not purchase a
good with the lowest delivered price if they are willing and able to pay more
for a good with a specific attribute. For example, a shopper looking for a
pair of shoes to exactly match the color of an evening gown will search
where there is a large number of shoe stores. The result will be larger
selections and lower prices.

Travel to Shop Behavior


Traditional location theory assumes that the manufacturers sell directly to
the consumers and that consumers buy one and only one product per trip.
In reality, determining the delivered price of a good is more complicated
than adding the transportation cost to a mill price. Transportation costs
accrue per trip and cannot be equally and consistently allocated among
various goods and services. The marginal transportation costs incurred by a
consumer bringing home one more compact disk or one more apple are
effectively zero. Consumers who stop at a store on their way home from
work pay virtually no additional transportation costs except for the
opportunity cost of their leisure time.

Three’s Company: Multipurpose and Multi-Stop Shopping


The value of a consumer‘s time is the largest component of transportation
costs. When a shopper stops at several places on the same trip, the trip is
defined as a multi-stop shopping trip. Multipurpose shopping, on the
other hand, occurs when the consumer reduces transportation costs by
grouping purchases into only one stop. 4 Why stop to see the hair stylist and
then the dry cleaner, pay the light bill, cash a check at the bank, and finally
get groceries at the supermarket if all errands could be completed at one
location? Anything that makes a shopping trip more pleasing or less time-
consuming will either add to the marginal benefit or decrease the marginal
cost of shopping. Consumers will frequent the facility that gives them the
largest net marginal benefits.

Agglomeration and Dispersion in Action


Fischer and Harrington (1996) investigated interin-
dustry variations in the tendency for firms to

3
Dudey (1990).
4
Thill (1992).
agglomerate. Antique dealers, shoe stores, and used
car dealerships tend to cluster together. Antiques are
objects that are very difficult to compare, and collectors
are often open to all possibilities and any good deal.
Likewise, finding the correct pair of shoes requires
physically inspecting them and trying them on. Used
automobiles are heterogeneous and a costly invest-
ment. Determining their quality requires both visual
inspection and testing.
On the other hand, Fischer and Harrington found that
video stores, movie theaters, gasoline stations and
supermarkets are more widely dispersed. For these,
there is little product differentiation and no reason to
comparison shop. Video stores may differentiate them-
selves by specializing in a specific type of film, but all of
them carry the same new releases. As for cinemas,
consumers who chose their movie, see it in the
closest theater. Customers who merely want to fill up
their gas tanks consider all vendors of gasoline as
sellers of homogeneous products. Likewise, those
who just need a gallon of milk will treat all stores that
sell dairy products, including service stations,
as homogeneous.

Fischer and Harrington (1996)

Empirically, Multipurpose Shopping


Predominates
Multipurpose shopping behavior is much more
common than single-purpose shopping. In Upsala,
Sweden, 61 percent of all shopping trips are multi-
purpose. Likewise, between 63 percent and 74
percent of all shopping trips in Hamilton, Ontario,
Canada, are multipurpose, depending on whether the
primary errand was for grocery or nongrocery items.

Hanson (1980); O’Kelly (1981)


Commuter Shopping Behavior
Competing stores are not necessarily adjacent. Commuters are equally
likely to shop in any store along the entire commute from work to home,
ceteris paribus. They will avoid stores with difficult access or limited
parking in favor of those with easier access. Those who live close to their
workplace might pass by only one store, if any, on their way home; while
others who have longer commutes could choose from a dozen or more
stores with equal probability. The number of stores in competition depends
on the commuting distance of the potential customer. The larger number of
stores for consumers with long commutes increases the number of
substitute products, hence demand becomes increasingly more price
elastic.

Commuters Increase Congestion but


Decrease the Price of Beef
One would think that prudent retailers would adjust
their prices to those of their rivals. Thus longer
commutes should lead to greater competition
between grocery stores and lower grocery prices.
Claycombe and Mahan (1993) tested this hypothesis
by tracking the retail prices for beef in various MSAs
in the United States. To explain these price variations,
they analyzed the effects of mass transit and
carpooling, average commuting distance, average
wage, and a four-firm concentration ratio on retail
prices of beef.
Their results support the hypothesis that in cities
where a greater proportion of workers use mass
transit, retail stores charge more for beef. This is
because people who use mass transit are not as
inclined as those who commute by automobile to
shop at any store along the commute. In contrast, a
longer commute by automobile causes the retail price
of beef to fall, presumably due to competition among
a larger number of stores.

Claycombe and Mahan (1993)


Shopping Centers and Retail Agglomeration
The first suburban shopping mall in the United States opened in 1956 in
Bloomington, Minnesota, near where the Mall of America is now. Dayton‘s
and Donaldson‘s department stores jointly constructed an enclosed shop-
ping center to reduce construction costs. Rather than compete for a portion
of the customers who shopped at the mall, the two rivals (who sell
heterogeneous goods) both discovered increased sales as the same custo-
mers bought goods from both stores.
By reducing search costs for consumers, stores in a shopping mall can
prosper, as in the case of Dayton‘s and Donaldson‘s, or perish because of
externalities generated by the other stores. Externalities include prices in
rival stores as well as the possibility that the anchor stores (the large
department stores that dominate a shopping center) succeed in attracting
consumers. If one store in a shopping mall increases its price, neighboring
stores benefit in the short run because of an increase in their sales if they
offer similar products. In the long run, however, consumers will equate this
price increase to an increase in the total cost of shopping at this center.
Consumers will shop where they can take care of all their errands with the
least total cost. Of course, the opposite will happen if a store lowers
its prices.
Anchor stores generally pay very low rents if they pay rent at all because
they generate positive externalities for neighboring firms. The anchor stores
act as magnets for the shopping center. If an anchor store in a mall closes,
the smaller specialty stores endure significantly lower sales.

Summary and Conclusions


This chapter examined market areas and shopping models—models that
highlight the rivalry among firms that sell consumer goods. The first set of
models concerned linear market areas. The linear market areas were
obtained by combining the demand function with the distance between
the customer‘s house and the store. Consumers pay the delivered price, that
is, the mill price plus transportation costs.
A firm‘s market area will expand if the firm lowers its price, if the
transportation costs decrease, or if demand for the product increases.
Similarly, a contraction of the market boundary occurs if the firm increases
its price, if transportation costs increase, or if demand falls.
The elasticity of demand for the product increases with the distance that
the consumer needs to travel. Consumers who live farther from the store are
much more responsive to changes in price than consumers who live nearby.
Thus, if a firm would decrease transport costs only for distant customers, it
would expand its market area as we will see in Chapter 6.
With Hotelling‘s model we examined why some firms group together
and other firms disperse. The traditional response, according to the
principle of minimum differentiation, is that firms with perfectly inelastic
demand for their product aggregate in the middle of the market area. Firms
that face demand curves that are not perfectly inelastic (those that have limit
prices), tend to disperse. The principle of minimum differentiation also
explains why rival politicians all say the same things as Election Day
approaches. This principle justifies why retail products are so similar.
D‘Aspremont, Gabszewicz, and Thisse (1979) introduced game theory
into Hotelling‘s model, and contested the principle of minimum differen-
tiation. In Hotelling‘s model, the existing firms do not change their price
when a new firm enters the market. If firms cluster, game theory asserts that
they tend to undercut one another‘s price and thus expand their markets.
Prices fall to or even below marginal cost in this conflict. Accordingly, firms
cluster at the market center if they sell heterogeneous products rather than
homogeneous ones.
When firms that sell similar products cluster together, they create retail
agglomeration economies. The consumers can comparison shop more
easily. Certain types of retail industries are more likely to group together
than others. Firms that sell heterogeneous products like used cars, shoes,
and garden supplies tend to cluster while firms that sell homogeneous
products tend to disperse.
The assertion that consumers purchase each good with the lowest
delivered price has also been modified by models of multi-stop, multi-
purpose, and commuter shopping behavior. Most shopping trips are for
more than one purpose. Consumers combine many errands in one trip,
either stopping at a number of places or finishing several errands at one
location. A consumer‘s highest cost is the opportunity cost of time. Any
agglomeration of stores that decreases the number of stops or a store that
improves its ambiance creates a more pleasant shopping experience,
thereby attracting more consumers. Many errands are taken care of on the
way to and from work. All stores selling the same product that locate along
commuting routes are in direct competition with one another regardless of
their proximity to residential areas.
Commuters who travel by automobile expand the number of rivals if
they pass more stores along their commute. Cities where commuters travel
long distances by automobile benefit from lower prices for grocery or
other daily necessities because many stores are in competition over a
long route.
Each store in a shopping center potentially influences the number of
customers for every other firm in that center. If a firm lowers its price, that
particular firm attracts more customers. These customers then tend to do
their errands in the same place. Overall, consumers equate a decrease in the
price of one good with a decrease in the overall cost of shopping at that
center. The opposite result happens if a firm in a shopping mall increases
its prices.

Chapter Questions

1. Determine the market area radius from the following price-distance


function/demand curve relationship:
a. List three ways that the firm could increase its market area and
draw each of these on a graph similar to the one below.
b. If demand decreases so that the limit price is $7 rather than $9,
draw what happens to the market area radius of the firm.
c. Which is more elastic, demand from a consumer 10 blocks from
the store or demand from a consumer one block from the store?
Show graphically.

Price Price

Demand

Distance Quantity

2. Frank and Jessie James have started up convenience stores that are
almost identical. They are located at quartiles in a linear market area.
The only difference is that Frank‘s prices are higher than Jessie‘s, and
Frank‘s transportation costs are also greater than Jessie‘s. Diagram
this case and determine the market areas for both Frank and Jessie.
3. According to Harold Hotelling, in an election campaign ―Every
candidate ‗pussyfoots,‘ replies ambiguously to questions, and
refuses to take a definite stand in any controversy for fear of losing
votes.‖ Depict this phenomenon graphically using Hotelling‘s model.
4. Pat Jevons from Hardly Burgers has decided that because a large
enough market exists, it would be profitable to open a kiosk-
restaurant next to the university. Pat‘s problem is that Chris Señior
of Windful Sandwiches had also chosen a site in the same market area.
The demand for fast food around campus at noon is perfectly inelastic,
and surveys conclude that consumers consider Hardly Burgers and
Windful Sandwiches to be basically the same thing. Changing
locations is costless. Production costs for both firms are equal.
a. Using Hotelling‘s traditional theory, where should Pat locate?
Diagram and briefly explain your answer.
b. According to the argument made by d‘Aspremont, Gabszewicz,
and Thisse (1979), is this location a stable equilibrium? If not, what
if anything could Pat and Chris do to make their existence in the
market more stable?
5. Differentiate between multipurpose and multi-stop shopping. How
does commuting influence these shopping patterns? If you were
designing a shopping mall, where in your city would you suggest it
be located and what types of stores would you require to take
advantage of travel-to-shop behavior?
6. Claycombe and Mahan (1993) determined that beef prices are lower in
areas where commuting by automobile is highest. Would you predict
the same type of behavior for clothing, furniture sales, and automobile
sales? Why or why not?

Research Assignments

1. Check out the Web site for travel times to work and means of
transportation to work for your city or county through the census
at http://www.census.gov (QT-P23; from ST-3 data) and compare
these data to others in your class.
a. When do most people leave home to go to work in your area?
b. What is the mean travel time to work?
c. What proportion of commuters drive alone?
d. If your city is in a metropolitan statistical area (MSA), check out
the American Chamber of Commerce Research Associates
(ACCRA) Cost of Living Index for the average price of a T-bone
steak in your area and compare it with other MSAs that the class is
studying. Do you notice a trend in beef prices and ―proportion of
commuters who drive alone‖ when comparing your data to that
of others in the class?
2. Describe a retail center in the city that you are studying. Which stores
sell complementary goods? Which stores sell substitute goods? How
could your retail center increase the marginal benefit for its
customers?

Mathematical Appendix
Algebraically, Panel B of Figure 2.1 is a demand function for the product.
The limit price, the maximum price that consumers will pay for any quantity
of the good, is $10. The equation for the demand function for this example is
QZ5K1⁄2 P, where Q is the quantity demanded and P is the price. By solving
for P, we will get the inverse demand function: PZ10K2Q. The inverse
demand function allows one to easily graph a demand function with price
on the vertical axis. If the mill price is $4 and transport costs are 75¢ per mile,
the price-distance function as graphed in Panel A of Figure 2.1 is PZ4C
0.75D, where D is the distance from the store to the consumer‘s residence.
To find the radius of a market area, set the price-distance function equal to
the limit price of the demand function and solve for D. In this example,
where $10 is the limit price, 4C0.75DZ10 and DZ8. Thus, the farthest
distance that people will travel at the current mill price is eight units.
The equation for PD1 in Figure 2.2 is PZ4C0.75D. When the mill price
increases to $6, the equation for PD 2 becomes PZ6C0.75D. A drop in the
mill price to $2 changes the equation for PD3 to PZ2C0.75D. Setting each
of these three equations equal to the limit price of $10 generates the market
area radii of 8, 5.33, and 10.67, respectively.
In Figure 2.3, the equation for the price-distance function for PD1
remains at PZ4C0.75D, but the equation for PD2 becomes PZ4C1.5D
because transport costs per mile are $1.50 and people will no longer travel
even 4 miles to the store. However, if transport costs per mile decrease to
50¢, the equation for the price-distance function becomes PZ4C0.5D, as in
PD 3. The market area radius expands to 12 miles.
Market areas also change with demand. When the equation for the price-
distance function (PZ4C0.75D) equals a limit price of $12 instead of $10,
the radius of the market area extends to 10.67 [(12K4)/0.75]. But when the
limit price is $6, the radius drops to 2.67 [(6K4)/0.75].
The price-distance function for the monopolist in Figure 2.7 is still PZ
4C0.75D. Setting this equation equal to $10 limit price, 4C0.75DZ10,
creates a market area radius of 6/0.75Z8 units of distance.
In Figure 2.9, if the price-distance functions for C and D intersect at $6.55,
then the break-even point is 10.2 units of distance right of C (where 4C
0.25DZ2.55 or DZ2.55/0.25Z10.2) and 1.7 units to the left of D (where
$4C1.5DZ2.55 or DZ2.55/1.5Z1.7). Similarly, the price-distance func-
tions equate to the right of D at $7.57, a point 2.38 units to the right of D, and
14.28 units right of C.
Questions to Mathematical Appendix

1. Assume that the demand curve is QZ5K1⁄4 P. The mill price is $5 and
transportation costs are 50¢ per mile.
a. Find the inverse demand function.
b. Find the price-distance function.
c. Find the radius of the market area.
2. What is the new radius of the market area in Question 1 if the
transportation costs increase to $1.00 per mile? What if they decrease
to $0.25 per mile?
3. What is the new radius of the market area in Question 1 if the mill
price drops to $2.50? What if it increases to $7.50?
4. What is the new radius of the market area [(12K4)/0.75] in Question 1
if demand changes to QZ7.5K1⁄4 P ?
5. What is the new radius of the market area if demand for the firm in
Question 1 changes to QZ2.5K1⁄2 P ?

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Chapter 3

Market Areas and Systems of


Cities

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