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Regional & Urban Economics (EC3511)

[Regional Location Theory Essay]

“(I) USING THE HOTELLING MODEL, DISCUSS

IN DETAIL HOW FIRMS CAN USE THEIR

LOCATION DECISIONS AS PART OF THEIR

STRATEGIC BEHAVIOUR.

(II) IS THE RESULTING NASH EQUILIBRIUM THE

SOCIALLY OPTIMAL SOLUTION?”

CONTENTS

1. INTRODUCTION

2. KEY THEORIES.............................................(i) Regional Location Theory

...........................................................................(ii) Game Theory & Nash Equilibrium

...........................................................................(iii) Spatial Competition

3. THE MODEL..................................................(i) Outline and Assumptions

……………………………………….……….….…(ii) Construction of Model

...........................................................................(iii) The Case of Oligopoly (Fixed Prices)

...........................................................................(iv) Price Competition

4. CONCLUSIONS

5. REFERENCES

INTRODUCTION

Location plays a crucial role in determining the life cycle of any organisation. No firm or
business unit can profit maximise, or survive, without having initially determined its optimal
operating location. A firm will seek to position itself geographically where it can foresee
economic (and perhaps social) benefits. Ideal locations are ones which are, for example, in
proximity to input markets and resources (offering lower transport costs to move raw
materials); in proximity to output markets (which offer reduced delivery costs to consumers);
in regions with similar industries (allowing for knowledge spill-overs and other mutual benefits)
or in regions that offer lower prices for input factors (lower wages, rental rate of capital, land).
A firm can also derive locational benefit from being positioned closely to its direct competitors.
Positioned near rivals allows firms to have some degree of Monopoly Power.

The study of firms and their Location Behaviour as a whole is referred to as Regional Location
Theory, which looks specifically at why certain economics activities are located (or in some
cases, concentrated) in a specific region or why they are more dispersed. It comprises a set of
theories and models that seek to explain why firms choose to locate and/or relocate themselves
where they do, and how they behave in their respective locations to ensure survival. One model
of this sort is called the Hotelling Model.

KEY THEORIES

(i) THE HOTELLING MODEL AND THE THEORY OF SPATIAL COMPETITION

The Hotelling Model is fundamentally a “Location Decision Model” that is based on a paper
written by an American Economist, Harold Hotelling, in 1929. The paper came about as a result
of Hotelling’s observations on competition, and its associated stability. The model was an
attempt to try and explain why certain businesses (shops, restaurants) are located so close
together rather than being dispersed equally along space and is based on the basic premise that
firms are acting (competing) to profit Maximise.

Spatial Competition, then, refers to competition over a designated space, in this case, to obtain
the maximum possible Market Share.

Hotelling states that firms that produce undifferentiated goods and services benefit from being in
close proximity to their competitors. Firms with identical products have identical prices (when
the good or service is consumed at the location), so spatial competition is the only way firms can
maximise profits. The model shows that competing in such a way also gives each firm some
Monopoly Power over their respective locations (market areas), which would not be possible if
the firms were to dispersed further away.

(ii) GAME THEORY AND NASH EQULIBRIUM

Game Theory is a core component of the Hotelling model and is related to the competition
involvevd. In essence, firms in the model are behaving as opposing players in a “non co-
operative game” situation. Each is competing for a greater share and monopoly power over the
market area which is referred to as a Location Game. Each firms’ respective location behaviour
is characterised by a set of sequential movements where location itself is the strategy.

In this framework, the final location of either firm, or firms, will be determined by Nash
Equilibrium, which in a game setting, is a stable state (equilibrium) for players in a game. In
this state, neither player (firm) can gain any more from changing its strategy (e.g. relocating),
unless the other player changes its strategies first. Not engaging in this competitive game can
lead to one firm sacrificing its monopolistic power and subsequent market share.

BUILDING THE MODEL

(i)ASSUMPTIONS AND OUTLINE

For simplicity, assume that there are two firms in the market: Firm A and Firm B

- Both firms are located along a Linear Market Area, OL (E.g. Beach)
- Both produce identical goods (so there is no product differentiation)
- Each firm’s final good has to be transported to the consumer’s location, so the final prices
reflect the cost of delivery
- The final price is then the price of the good plus the delivered price
- The further away the consumer, the higher the delivered price
- The lower the delivered price the more of the market that can be captured
- Transport Costs overall, therefore, are crucial to the model
- A firm can only capture ALL of the market if its Transport Cost are equal to zero
- Consumers are Evenly Distributed across the O-L Space and will buy from the firm that
supplies the good to their location at the lowest price
 - The lower the firm’s production costs and transport costs, the larger the firm’s
market share
- In terms of Game Theory, each firm assumes that it will move, but the other firm will
remain at its location

(ii) CONSTRUCTING THE MODEL

- The Production Costs of producing Good A is equal to the Distance of a (a)

- The Production Costs of producing Good B is equal to the Distance of b (b)
- Transport Costs are diagrammatically represented by the Slope(s) of the “Transport
Rate Function” (tA) and (tB)
- The Transport Costs (tA) and (tB) are upward sloping because of the fact that the further
away you are from Firm A or Firm B, the higher the final price, or costs to transport
- At any location, the Delivered Price of firm A’s good is

PA + tA dA

Where:
PA = The Production Price of Good A
tA = The Cost of Transporting Good A t where the Consumer is
dA = The Distance to the Consumer

As a starting point, the Linear O-L Space is divided into two equal regions

- The O-X Space and the X-L Space, where each represents Market Share
- Firm A has Monopoly over the O-X Space
- Firm B has Monopoly over the X-L Space

NB: Within the O-X space, the price of Firm A’s good is always lower than the price of Firm
B’s good and within the X-L space, Firm B’s good is always lower than Firm A’s:

(PA + tA dA) < (PB + tB dB) (PA + tA dA) > (PB + tB dB)
[Consumers pay less for respective goods in their respective locations]
It is important to note here, that in the diagram, Firm A has a lower production cost of producing
one unit of Good A, than Firm B. (PA) < (PB). The distances vary slightly.

From an economic perspective this implies that Firm A is more efficient than Firm B (as it is
producing the same level of output, but at lower costs).
In theory, this would lead to Firm A having a relatively larger market share. However, as
mentioned earlier, transport costs are crucial to the model and despite this discrepancy each firm,
initially, has equal market share.

This is because location itself gives each firm some Monopoly Power over the area it has.
Consumers will buy the good from the firm closest to him/her, as the further away he/she is, the
more he/she will have to pay for the good. So Monopoly Power derives fundamentally from the
associated Transport Costs.

Furthermore, in reality, it is normally the case that transport functions are not equal,

tA ≠ tB so the model should reflect different slopes for tA and tB.

(iii) THE CASE OF OLIGOPOLY (NO PRICE COMPETITION)

With the basic model constructed, we can look at how the two firms use their Location Decisions
as part of their Strategic Behaviour. As a starting point in the analysis, we have:

- Two firms, A and B, Producing undifferentiated products

- PA = PB (Both firms have equal production costs)
- tA = tB (Both firms have equal transport costs)
- Each has an equal market share
- A has more monopoly over O-X
- B has more Monopoly over X-L
- Each firm makes a competitive decision based on the assumption that the other firm
will NOT change its behaviour
So here the firms are not engaging in price competition and (prices are fixed) and the only way a
Firm can gain Market Share is by changing its Location.

For the purposes of simplicity, we also assume here that there are zero relocation costs

Figure 2. reflects the initial position of both firms.

Wanting to maximise profits, A makes move to increase its market share:

- At a Time Period, T1, Firm A makes the decision to relocate

- Firm A moves to point C (Figure 3.)
 - In doing so, Firm A increases its market share from O-X to O-C
- Subsequently, Firm B’s market share decreases from X-L to C-L

This first movement triggers the beginning of the Location Game:

- At time period T2, Firm B assumes that A will now remain at location C
- Firm B tries to regain its share of the market
- Firm B moves to point D (Figure 4.)
- Firm B now has a larger market share, A’s share has reduced significantly
Both firms know that is they don’t participate in this spatial game each time, they will sacrifice
market share, and with Firm A’s market share reduced, the location game continues until both
have no more to lose:

- At time period T3, A responds to this move by moving left of firm B

- A moves to E
- D moves to F
- This movement continues until both firms are located at X (Figure 5.)
- Leads to a Nash Equilibrium
At point X, the location game stops. Both firms have effectively returned to having equal market
share. Neither of the firms now has any incentive to relocate. In a game situation, Point X is the
Optimal Solution in the location problem.

Hotelling’s model, therefore, demonstrates that location decisions are used by firms as a strategy
to determine optimal operating locations. This type of market analysis also serves as a basis for
explaining the reasons why certain restaurants, supermarkets and multi-national firms locate in
proximity of each other. Spatial arrangements of this sort allow firms to monopolise the area that
they position themselves in, which would be difficult if the firms were spread out further apart.

(iv) PRICE COMPETITION AND THE HOTELLING MODEL

The result above is not the same when firms are competing in terms of price.
In firms operating under price competition:

- Firms decrease their prices at each time period to stimulate demand

- Both firms are now engaging in a price game.
- This will continue until both firms end up selling at zero profits, where both are still
located at X
- However, neither firm wants to sell at zero profits
- Rather than move closer together, firms need to disperse further apart to avoid losses
- In the interest of protecting itself, neither firm’s is willing to make a move first, as the
first firm that moves first will lose its market share
- In this situation, both firms make a deal to move at the same time, which eventually leads
to “Prisoners Dilemma”
- In Prisoners Dilemma, neither firm will do what it says it will do, so neither will move
- Therefore, under price competition, you do not get an optimal solution

- Firms can only locate in close proximity of each other if there is NO price
competition

THE SOCIAL OPTIMUM AND CONSUMER WELFARE

So Hotelling’s model successfully explains how firms use location to determine an Optimal
Operating Position for themselves, a stable Nash Equilibrium at point X. However, the move to
point X leads to a fall in Consumer Welfare. So this optimal solution to the location game is
optimal only to the firms.

The reasons behind this are:

- That a relatively larger proportion of consumers now pay higher prices than those that
pay lower prices
- At X, consumers are worse off than they were when they were located at their the
original positions
- Consumers located at the periphery (Nearer to O, or Nearer to L in the O-L Space) are
much further away from both firms
- Welfare Loss at the periphery is greater than anywhere else
- They will have to pay higher delivered prices due to the increased distance they now face
 - Consumers situated at the centre of the O-L Space are relatively well-off as they are
situated in proximity to both firms so they gain from lower delivered prices
- Though there are gains, the total welfare loss is greater than the gains

The Hotelling model offers an optimal solution that unfortunately is not a socially optimal
one. It is important to note, however, that this only holds when there is price competition,
so in oligopoly, the location game has losses

Figure 6. Shows this diagrammatically:

- Consumer 1 (C1) is closer to firm A, so originally he/she paid, Price P1C1

- At point X, C1 now pays a higher price of P2C1
- The consumer is worse off at the edge of the model

- Consumer 2 (C2)
- Consumer 2 is closer to both firms now so will face lower delivered prices
- At point X, C2 pays much less now than if it were buying from Firm A at its original
location
So while optimal point X has a few gains, it also has relatively many more losses, especially for
consumers at the ends of the O-L Space.
 CRITICISMS OF THE HOTELLING MODEL

On the whole, the model is a successful one in explaining firms’ location behavior and is a
general tool for market analysis. Drawbacks, however, do exist:

1. The Model has been criticized for being oversimplified and too general
2. The set of assumptions as a whole are too relaxed. For example:
- It is assumed that there are no relocation costs, which is unrealistic
- Consumers are assumed to be evenly distributed
- The market space is linear
- Each firm assumes that the other is not going to participate in the location game
initially which is misrepresentative, firms are not naïve about the behavior of its
competitors as the model suggests1.
3. The Game Theory involved tells us what players are likely to do, but it is clear that the
results are not socially optimal.
4. There are many other factors associated with location decisions such as personal
preferences, environmental constraints, personal circumstances2. The model could benefit
from incorporating these factors.
5. Vickrey (1964), d’Aspremont, Gabszewicz and Thisse (1979) show further that
hotelling’s argument is flawed stating that “no pure strategy price equilibrium exists for
such locations”3
6. The model only incorporates two firms only whereas in actuality many firms tend to
compete on a spatial level. It has also been shown empirically that when larger numbers
of firms are incorporated into the model, the firms that lie on the periphery in fact have a
greater advantage in terms of market power than those located in the central region4. This
contradicts the results above.
7. Increases is networking possibilities (more and more is becoming computerized),
telecommunications and globalization have changed the nature of location theory itself5.
Transport possibilities have increased, and firms can transport goods over larger distances
and at lower costs to a wide variety of developments5.
8. Lastly, empirical research has also shown that the model exhibits a circular structure as
opposed to a 1 dimensional flat 1, where demand and market areas are represented by a
“Demand Cone”, which is a more realistic approach1.

CONCLUSIONS

Overall the model is useful tool for market analysis and successful in demonstrating how
markets behave in regions they choose to locate in. The key elements of the model have
served as a foundation for further locational analysis. The model has also been adapted and
applied into Politics, by Anthony Downs in 1957, from his book “An Economic Theory of
Democracy”. The spatial theory in the model has been used to make predictions on how
Politicians will interact during elections, and has so far also been successfully applied.

However, the optimal solution for firm locations are clearly not always solutions that offer
social benefits for society as a whole, and the basic assumptions of the model have limited its
applicability to real life economic situations. With changes in socio-economic trends,
classical location theories are in need of updating to incorporate the shift in location decision
making, which if done, could prove as a very powerful economic tool of analysis.
 BIBLIOGRAPHY

1. Hoover, E. M, and Giarratani, F., (1984), An Introduction To Economics, [3rd Ed.],

Harvard Press.
http://www.rri.wvu.edu/regscweb.htm

2. Williams, H. C. W. L. and Senior, M. L.(1976), “A Retail Location Model with

Overlapping Market Areas: Hotelling’s Problem Revisited.”, Working Paper 137, Dept.
of Geography, University of Leeds January 1976

3. Osborne, M. J. and Pitchik, C., (1987), “Equilibrium in Hotelling Model of Spatial

Competition”, Econometrica, Vol. 55, No. 4, pp. 911-922.

4. Brenner, S. (2005), “Hotelling Games with Three, Four and More Players”, Journal of
Regional Science , Vol. 45, No. 4, pp. 851 – 864:

5. Assink, M and Groenendijk, N, (2009) “ Spatial quality, Location Theory & Spatial
Planning”, Paper presented at Regional Studies Association Annual Conference 2009;
“Understanding and Shaping Regions: Spatial, Social and Economic Futures” Leuven,
Belgium, April 6 – 8, 2009

6. Fujita, M, Schweizer, U, Gabszewicz, J. J, Thisse, J. F. (1986) “Spatial Competition and

the Location of firms”; Harwood Academic Publishers GmbH
7. McCann, P. (2001) Urban and Regional Economics; Oxford University Press, pp. 27 –
35

8. http://www.horton.ednet.ns.ca/staff/jptrites/APHumanGeog12Folder/notes_presentations/
notes_econ_location_models.pdf

Advancecd Global Geography12, Advanced Placement Human Geography, Location

theories and models. [Accessed 2/3/11]

9. Dickie, H; (2011). Regional Location Theory [Topic 2 – Lectures 5 & 6]. University of
Aberdeen