Why do most stores cluster together?

This very informative and interactive Ted-Ed video uses the principles of game theory and Nash equilibrium to help explain why competitors often open their stores next to one another. Many people do not understand how this decision can possibly benefit both parties. Ultimately, Hotelling’s Model of Spatial Competition and the principles behind Nash equilibrium can explain the existence of clusters of similar companies.

The example that was provided in the video was of two cousins who sell the same type of ice cream on a 1-mile beach. At first, only one of the cousins sells ice cream on the beach. In order to maximize his sales potential, he sets up right in the middle of the beach so that the maximum a customer would need to walk is .5 miles. The next day, the second cousin arrives at the beach hoping to sell ice cream. The two cousins agree to split the beach in half. To ensure that customers do not need to walk too far, one cousin sets up .25 miles north of the middle point of the beach and the other cousin sets up .25 miles south of the middle point of the beach. They each have their own .25-mile zone where the customers belong only to them. Together they share the area between the two shops, which is .5 miles. Game theorists consider this a socially optimal solution because it minimizes the amount customers must walk to buy the product. In an ideal world, this would be how companies would decide to choose the locations of their store. We will see why this arrangement does not usually occur in the real world.

While this situation is socially optimal, it is not sustainable because it is not a Nash equilibrium. Imagine that the next day, one of the cousins sets up shop at the halfway point instead of .25 miles away from the halfway point. If this happens, one cousin serves .5 miles plus half of .25 miles while the other serves .25 miles + half of .25 miles. We can imagine that the cousin would respond the next day by moving his shop to the halfway point of beach, back-to-back to his cousin’s shop. At that point, both cousins will serve 50% of beach goers and Nash equilibrium will have been reached. This means that neither cousin will stand to benefit from changing their current strategy. This situation is no longer a socially optimal solution because customers on the far ends of beach will have to travel far distances for ice cream.

The cousins-ice cream example was able to demonstrate how game theory and Nash equilibrium explain why large corporations like Shell and Mobil open locations next door to one another. While we can understand why it makes business sense for companies to do this, there are many situations where clustering competitors really hurt society. For example, food deserts are areas that have limited access to affordable and nutritious food. One of the main reasons food deserts exist is because supermarkets are often located very close to each other. Certain areas are left without sources for healthy food because they do not meet the demand for multiple supermarkets. While it may make more business sense to open supermarkets in areas that are densely populated with other supermarkets, I believe that large supermarkets like Wegmans and Shoprite need to make more of an effort to provide low-income Americans with access to healthy food. I don’t think that principles from game theory can be used to justify the decisions to cluster supermarkets in one area if it has such negative effects on our society.

This is something we all have wondered at some point in our life and we ask ourselves if this even makes sense. I myself used to think and ask - "Why can't the stores be opened at different places in the city? This way the competition would decrease and the store owner can target customers in a different location." Now, I know the reason. Let's understand the concept behind it.

In India, if you go to Chandni Chowk, you will find all the clothing stores at one location; all the houseware and hardware stores at one location and all food points at one location. Visit any city in the world, you will find a particular location where all the stores of a similar category will be placed in close vicinity.

This is the same with fast-food chains, gas stations, banks, or any other business - they are all located in a common area (very near to each other). But why?

Today we were having a discussion on the SticksKabab case study where we were to figure out a new location for the restaurant. Looking at the competitor data, our professor from Darden School of Business, Sir asked, "What can be inferred?"

One of my classmates answered, "We can open up the store near our competitor stores, as they have already analyzed the market and customers data. They are already in the prime location of the city where customers can easily be targeted."

Bang on. That was the right answer.

This phenomenon of clustering When competing firms are located close together it is called #clustering. This is explained by the “Hotelling’s Model of Spatial Competition.”

This model tells that - all the businesses want to be present in a location or area which is the prime attraction point for the customers. Every store owner wants their outlet to be in this prime location and get the maximum of market share. Hence competitors have their stores next to each other.

Let's assume two friends, A and B plan to open up restaurants in a city X. They decided that they would open the outlets in two different locations in a way that both of them can target an equal percentage of customers, which is 50-50%. After a few months, B moved his outlet to the center of the city targeting his 50% of already existing customers and also 25% of customers of A. In total, now B has a market share of 75% and A has only 25% market share.

This is a loss for A and he decides to do something and comes up with the strategy to move his outlet also to the center location of the city. What do you think happened?

Now both A and B running their outlets at the center of the prime location have equal chances of getting the customers, you can say both have a market share of 50% each. Both benefit from this by attracting the crowd and serving them. So you see here, this arrangement ensures that all the outlets have equal competition and chances of acquiring the customers.

This funda (strategy) is also referred to as "Spatial Agglomeration", which explains why competitors have their outlets next to each other. Next time you plan to open up a car showroom, which location would you have on your list to choose from?

Why are the same stores next to each other?

What is store clustering?

Why is it good to have many stores?

What principle can we use to explain why businesses cluster in groups instead of spreading evenly throughout a community?