This weekend we decided to buy a new patio umbrella. As we drove down Hanley Rd. in St. Louis we had a few options: Home Depot, Menard’s (right across the street) and Lowe’s (less than 1/4 mile down the road). This a common phenomenon: competing firms locating their stores in close proximity to each other. It is very common with fast food stores, gas stations, banks, mattress stores, coffee shops, pharmacies, large retailers, etc.
It seems to make no sense, but its so common there must be a good reason for it.
When competing firms are located close together it is called clustering. Clustering can be explained by game theory and specifically by “Hotelling’s Model of Spatial Competition.”
Here’s the theory in a nutshell: businesses want to locate themselves near the center of their potential customer population to attract the greatest amount of customers. When multiple competitors exist it would make sense, if they were working together, to spread out so that each competitor would have a share of the customer population. But competitors don’t work together, so this sort of arrangement will not work (or, in game theory parlance, it hasn’t reached “Nash Equilibrium”). So, each competitor will simultaneously make the same decision to move to the best location. Nash Equilibrium occurs at “the point where neither of you can improve your position by deviating from your current strategy.” Nash Equilibrium will occur when all competitors have moved to the optimal location in terms of potential customers. Basically, for various population density areas there are only a few (maybe only one) optimal locations and the mathematics of competition drive all competitors to the optimal location.
As explained by Jonathan Becher of SAP:
If a retailer opens a new location away from the current clustering, there are two potential results:
1. It will fail to capture enough consumers and eventually close.
2. It will become successful causing competitive stores to locate nearby.
Either way, clustering remains the norm.
Here’s a great, but short, animated video explaining Hotelling’s Model of Spatial Competition and why clustering occurs (well worth watching IMO):