Retail location theory: the legacy of Harold Hotelling.

Sixty years ago Harold Hotelling's seminal paper, Stability in Competition, "was published in The Economic Journal. Known to generations of students as the locational problem faced by ice-cream vendors on a beach, Hotelling's principle of minimum differentiation" has generated a prodigious amount of academic research. This paper reviews Hotelling's much criticized conceptualization and explores alternative theoretical explanations of the agglomeration of similar retail firms. It also examines the extent to which the principle of minimum differentiation has stood the test of time and assesses both Hotelling's contribution to retail location theory and the likely direction of future research activity.

INTRODUCTION

It has often been said that the three most important properties of a retail store are location, location, and location (Dickinson 1981; Jones and Simmons 1987). Like most of retailing's aphorisms, this is not entirely true; all sorts of other factors besides location influence the success or failure of retail outlets (Davidson et al. 1988; Mason and Mayer 1987). Location, nevertheless, is crucial. As Ghosh and McLafferty (1987) point out,

 
  It is through the location that goods and services are made 
             available to potential customers. Good locations allow ready 
             access, attract large numbers of customers, and increase the 
             potential sales of retail outlets. In the extremely competitive 
             retail environment, even slight differences in location can 
             have a significant impact on the market share and profitability. 
           Most importantly, since store location is a 
           long-term fixed  investment, 
           the disadvantages of a poor location are difficult to 
           overcome. 

Given its significance, the issue of retail location has generated a prodigious amount of academic contemplation, conceptualization, and indeed contention (for a review see Craig et al. 1984; Wrigley 1988). Central place theory, bid rent theory, and "the law of retail gravitation" are perhaps the most familiar theoretical contributions, but equally important is Harold Hotelling's (1929) "principle of minimum differentiation." Known to generations of students as the problem of ice-cream vendors that contrive to cluster together in the center of a beach, the principle of minimum differentiation provides a simple and easily remembered illustration of the agglomerative bent of similar retail firms. The department stores of Boulevard Haussmann in Paris, the outfitters of London's Oxford Street, the electrical retailers of Akihabara in Tokyo, and the theaters and cinemas of Broadway are among the better known examples of this phenomenon. But the clustering of similar outlets is a truly universal trait, ranging from the hamburger alleys and automobile rows of most American cities to the pronounced clusters of goldsmiths and banana sellers in the periodic markets of the third world.

Although the principle of minimum differentiation is widely and irrevocably associated with the agglomeration of retail outlets in general and jostling ice-cream vendors in particular, the reality of the concept-as originally formulated and subsequently developed-is quite different from the popular myth. Apart from the fact that Hotelling never mentioned ice-cream vendors or allowed his sellers to leap-frog each other in order to capture the prime, central locations in the market, his seminal study was not even addressing the issue of retailing location, incredible though this now seems.

Given the widespread misconceptions about the principle of minimum differentiation; the recent and dramatic revival of interest in the concept among economists; and, perhaps most appropriately, the fact that this year is the sixtieth anniversary of the publication of Hotelling's original paper, it is arguable that the time is now ripe for an examination of his regularly referenced but rarely read contribution to retailing thought. Accordingly, this paper will review, in a nontechnical fashion, the often highly technical literature on the principle of minimum differentiation, noting that contrary to popular perception, the concept does not in fact explain the agglomeration of similar retail firms. The paper then goes on to examine the alternative theoretical approaches to the clustering phenomenon and describes some of the important conceptual advances that have taken place as a result of the introduction of agglomeration economies, uncertainty reduction, and multipurpose shopping behavior. Finally, the paper will endeavor to assess both Hotelling's contribution to location theory and identify some potentially fruitful avenues of future research activity.

STABILITY IN COMPETITION

In his classic paper "Stability in Competition," Harold Hotelling was, as noted above, not directly concerned with retail location. He was actually trying to show that price stability was possible in the case of two-firm competition (duopoly) without resort to collusion. The then received wisdom from Cournot (1897), Bertrand (1883), Edgeworth (1925), and others, maintained that as all buyers patronize the cheapest seller, a price cut by one firm would capture the entire (spaceless) market. This gives rise to price instability as the competitors undercut each other, except of course when prices are driven down to cost.

Hotelling, however, challenged this view, arguing that in practice a price cut by one firm would only result in the loss of a few customers to the other, because many purchasers prefer to do business with a supplier despite small differences in prices. These preferences, he contended, stem from a variety of factors including the sellers' respective standards of in-store service, merchandise mix, quality of goods, methods of doing business, and even the religious or political persuasions of both seller and buyer. Most importantly for the model that he went on to develop and, indeed, for subsequent spatial analysis, customer behavior was held to be influenced by the cost of transportation and the relative locations of purchaser and purveyor.

Dealing initially with two profit maximizing firms, selling identical products (with zero production costs) at f.o.b. prices, from fixed locations in a bounded linear market where transport rates are constant, demand is completely inelastic and identical, utility maximizing consumers are evenly distributed, bear the costs of distribution, and patronize outlets solely on the basis of delivered prices, Hotelling showed that an equilibrium existed where neither outlet could increase profits by altering its prices.

Having thus demonstrated price stability in noncollusive, duopolistic competition, albeit under highly restrictive assumptions, he argued that if one seller is free to relocate, it would maximize its hinterland (and hence its profits) by setting up shop adjacent to the other on the "long" side of the market. If, as Chamberlin 1933) subsequently noted, both sellers are footloose, a process of mutual leap-frogging to the longer side of the market ensues. The upshot of this is the classical back-to-back arrangement in the center of the market, not the socially optimum pattern of two spatially dispersed firms at the market's quartiles.

There is more to the principle of minimum differentiation, however, than the agglomeration of duopolists in the center of a bounded linear market under conditions of inelastic demand and uniform population density. Elaborating his finding, Hotelling (1929) maintained that the clustering phenomenon is discernible on a plane as well as a linear market and could be established when consumers are unevenly distributed. What is more, it holds good when more than two sellers are involved and it also helps explain the standardization of most aspects of daily life including furniture design, house styles, fashion trends, education systems, and the policies of political parties. It is, in short,

 
  a principle of the utmost generality. It explains why all the 
             dime stores are usually clustered together, often next door to 
             each other; why certain towns attract large numbers of firms of 
             one kind; why an industry, such as the garment industry, will 
             concentrate in one quarter of a city. It is a principle which can 
             be carried over into other differences than spatial differences. 
             The general rule for any new manufacturer coming into an 
             industry is,  Make your product as like the existing products 
             as you can without destroying the differences." It explains 
             why all automobiles are so much alike and tend to get even 
             more alike . . . It explains the importance of brand names in 
             commercial, social, and even religious life . . . and . . . it 
             also explains the importance of advertising, for a great part of 
             advertising…