Why Do Competitors Set Up Shop Near Each Other?

I am a big fan of the Planet Money series on NPR. Any student struggling with the economic aspects of business associations can use Planet Money and NPR’s other financial series, Marketplace, to get grasp of what is going on. Marketplace tends to focus on the day’s events. PM takes a little time and explores topics. One that I just listened to was called Your Friend or Foe? As the show puts it “Planet Money examines an age-old but confusing question: why do businesses selling the same thing crowd around each other rather than stake out a bit of space on their own?” The piece reminds me of some of Frischmann and Lemley’s Spillover’s article, although I am not sure the idea of competing right next to each other maps to the article’s main ideas about innovation. Instead the story may fit better with ideas about healthy marketplaces and competition. Some of the arguments for setting up shop near competitors smack of free-riding. Yet, listen to the show. The shopkeepers are all engaged in the behavior, know it, and use it to their mutual advantage while still driving prices down. Some the reasons for these decisions may have more to do with search costs. Other issues seem to show that pure internalization of externalities is not always the choice. I’m not sure that this situation is a commons approach as Frischmann, Madison, and Strandburg describe it, but it seems to run parallel to the way I think the Netflix Prize operated (a mix of private incentives and common benefits interacting so that otherwise hard to explain behavior makes sense). In short, I found the podcast thought provoking and worth the listen.

You can listen to the podcast here.

As a side note, I have no idea why NPR does not allow an embedded stream feature a la YouTube or Imeem. If there is a way to do that, can someone please let me know? There are a few more podcasts I plan on highlighting, and I’d like to make it as easy as possible for folks to obtain the content.

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6 Responses

  1. A.J. Sutter says:

    I listened to the show on your recommendation, but I didn’t find it to be so profound. First, I’m not sure that some of the explanations given, such as that clustering makes it less likely to get held up, are “economic” decisions — nor that universal, outside violent societies like the US.

    Second, their explanations were way too pat. Their assimilation of Silicon Valley to the Diamond District was just silly: Google and Yahoo are not both in Silicon Valley because that’s “where their customers are.” The availability of talent was something the reporters just muttered under their breath, and such factors as availability of funding, legal talent (which I’d be remiss not to mention), culture, recreation, etc. were ignored.

    Third, and I’d think of particular interest to you, they didn’t mention the branding effect of location: e.g., if you have a “heeame” (a/k/a “hairmake,” hair and make-up salon) in Tokyo, then being in the ultra-chic Omotesando fashion/art/dining district is essential for prestige. This isn’t an issue of proximity to customers, since very few people can afford to live in that district, whereas tens of thousands of customers happily make a subway trip to come there to get their hair done.

    Fourth, while they mention that some service clusters would be a bad idea in theory due to the need for proximity to users (like laundromats), they ignored that in practice there are many bad clusters — and which are bad for other reasons. E.g., in the early years of this decade there was a proliferation of pearl tea (a/k/a/ bubble tea) shops near Castro Street in Mountain View, CA. Out of about 5 shops there at the peak, the original one was always packed (quality and ambiance were best, IMHO). A chain competitor was next to move in; and it was clear from their ‘grand opening’ banners that they thought they ‘owned’ the pearl tea business. They tried to undercut in price, but business was slow until shop morphed into an Internet and multi-player gaming cafe. The other shops, despite more visible locations, expensive design, etc., were empty. All shops were within a 2- or 3-block radius, in the business district of a city with a lot of Asian residents (so, close to biggest customer base). Yet in other Silicon Valley cities with majority Asian populations, like Milpitas and Cupertino, the dedicated bubble tea shops tended to be more isolated.

    As far as I can tell, the difference between the bubble-tea cluster and some of the clusters mentioned on the show was that the Mountain View case was a “zero-sum” cluster, and the established examples mentioned on the program were more “win-win.” A “zero-sum” cluster seems like a very bad idea, though it’s not uncommon in China, among other places. The proliferation of bars and cafes in Beijing’s HouHai district during 2003-2004 is a vivid example. These clusters seem motivated by hubris, opportunism, and bad judgment; they have high turnover, and sometimes short lifespans. The show was misleading in making it seem as if “economics” provides some sort of universality rule and happy equilibrium for clusters. By focusing on older, “win-win” clusters, it also falls prey to survivor bias. The show sets itself the task of explaining why clusters start, but winds up offering, at most, an ex post explanation of why some clusters persist.

  2. A.J. Sutter says:

    PS, apropos of hold-ups: BTW the tech business clustering in Silicon Valley actually makes it an attractive place for crime, especially theft and espionage.

  3. Jon says:

    Doesn’t Hotelling’s Law directly address this, or am I missing some part of the problem?

    http://en.wikipedia.org/wiki/Hotelling%27s_law

  4. A.J. Sutter says:

    Jon, you are indeed missing a lot of the problem. If you consider the examples in the NPR link (chess shops, diamond shops) and some of the examples I mention (Internet companies, bubble tea shops, personal care services), you’ll find that all of them involve product differentiation strategies. Hotelling’s Law per se does not, nor (in the Wikipedia hypo) does it even involve price differentiation. It’s too far removed from the real world to explain the phenomena described.

  5. Jon says:

    Yep, you’re absolutely right. That said, Hotelling’s Law provides some, if not complete, insight. It makes some sense for new entrants to locate next to each other, and in this respect avoid product differentiation (in terms of location). Intuitively — if there is a recognized “cluster” for some niche product/service that customers are prepared to seek out, it makes sense for new entrants to join that area. I think that explains the chess shop example (my favorite by the way, involves Thompson Street in the West Village, which is almost entirely devoted to chess shops). You may want to differentiate your product in some ways, for instance in terms of price or product offered. However, where there is an established cluster, it makes little sense to differentiate yourself in terms of location. Customers won’t find you, seek you out, etc.

    So the key factor in this becomes the relationship between the cost of the item and search costs. In the chess shop case, customers (as far as I can tell) seek out chess shops clusters. They’re willing to go out of their way to the cluster, because the purchase (or investment of time, if you’re playing) is major enough; they’re just not willing to go and seek out new chess locations that are not in the cluster, because the purchase is not quite so major. In the bubble tea example, the cost of the item is too slight. Customers would prefer a location that wouldn’t require them to go out of their way. In this sense, bubble tea is a lot like laundromats. Whereas for some items (cars come to mind), the cost of the item warrants a search even to inconvenient locations.

    All this to say (I do apologize for the rambling answer) — there seems to be a band for middle-priced items (chess shops, diamonds (excepting the very expensive)) for which location differentiation just doesn’t make sense because of customers’ search strategies.

    This has no application to Silicon Valley, and it also doesn’t address the branding effect. My thought is simply that Hotelling’s Law creates a subset of cases where a “win-win” and “zero-sum” analysis is misplaced.

  6. Deven says:

    Gents,

    Thanks for the discussion. To clarify, I never said it was profound. I just liked the chat. It is a short format on a specific topic aimed at a general audience. That is why I like the show. It provokes people to think about topics that may not cross their normal path. Of course when two folks such you all know more, it provokes thought too, but in different ways.

    As for the deeper issues about what area of economics addresses these ideas, my guess is that the show hosts were thinking of Hotelling. I am wondering whether there is a connection or perhaps overlap among the ideas I noted and the ideas of the radio show. As you both note, the idealize situation is, well, idealized. Put differently, someone has probably looked at Hotelling as it relates to real world problems and different industries. That would be good literature for further reading.