AGEC 603. Introduction. Theory of Retail Competition. Retail Location and Market Competition

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1 AGEC 603 Retail Location and Market Competition Introduction Role of locations change when firms sell products strictly to local customers Shift in focus in firm s location decisions Household behavior Shift from commuting costs Urban transportation costs influences purchases Data tends to show Retail firms are widely dispersed Hierarchy to the distribution of retail establishments Theory of Retail Competition Stores compete in two dimensions price and location Market power Closer competitors are more intense competition Longer run maximize market power Consumers economize on transportation costs Multiple purchases on a single trip Reason for having stores cluster Fundamental property of shopping behavior Households make more frequent and shorter trips to neighborhood centers and less frequent, longer trips to the regional centers. 1

2 Goods and Shopping Frequency Consumer s choice of shopping frequency is an inventory problem Total annual costs of consuming CC = Pu + kv + i Pu 2v where u unit of the good consumed annually P purchase price per unit k transportation costs / trip v frequency of trips / year i storage costs / year including foregone interest Q quantity purchased / trip Inventory Costs i Pu 2v Total purchased = trips * quantity purchased / trip u = v Q Trip frequency is v then time between trips = 1/v Average inventory = Q/2 but Q = u /v Q 2 = u 2v Inventory costs = purchase value of the average inventory * cost of storage (i) Average amount on hand i Pu 2v Consumer Minimizes Total Costs Minimize CC wrt v CC = Pu + kv + i Pu 2v Take partial wrt to v and set equal to zero CC Pu = k + 1 i v 2v 2 = 0 Solve for v ipu v = 2k P, i, and u increase v increases k increases v decreases 1/2 2

3 Classical Retail Competition Theory Objectives explore density and pricing behavior Assumptions Each type of good is purchased at a separate location Consumers are located evenly along a line of uniform density, F households per mile Stores are located along this line at even intervals of distance D Focus on one retailer who sells the standardized good at P when competitors sell at price P 0 All retailers face the same costs, mc marginal costs, and C = fixed costs Consumer purchase the good at frequency = v Consumers delivered price includes price of the good and travel costs Travel costs = k * distance between consumer and retail store T market area boundaries Retail Market Areas Uniform Buyer Density Delivered Price P 0 T P T P 0 D D Distance Market Area Boundaries Market area will extend to the distance T (does not have to be ½ D) such that the delivered prices to a consumer are equal Solve for T P + kt = P 0 + k(d T) T = (P 0 P + kd) (2k) Note P increases => T decreases P 0 increases => T increases k increases => T? 3

4 Annual Store Sales Recall assumption one purchase / trip S = 2TvF Market area * number of trips * buyer density Substitute in T S = vf (P 0 P + kd) k Price Determination Local retailers set price to max profits max P π = P mc vf (P 0 P + kd) C k (price /unit mc /unit) * units sold fixed costs Take partial wrt to P and set equal to zero gives and solve for P skip steps P = (P 0 + kd + mc) 2 Price Determination - Equilibrium Equilibrium values P = P 0 substitute in gives P = kd + mc, T = D, and S = DvF 2 Competitive price results Price involves a mark-up over wholesale costs Price increases as stores are farther apart, D increases Price increases as travel costs increase, k increases Reasons how market power changes as spacing and travel costs change More inelastic demand curves 4

5 Entry & Store Density Long Run Long run zero profit condition and P = P 0 π = 0 = P mc vfd C, P = kd + mc, T = D, S = DvF 2 Solve system of equations gives D = C kvf 1/2, and P = mc + 1/2 kc vf Goods purchases more frequently will generate store networks that are denser, with increased competition, and tighter profit margins When C increases - sparser store networks will emerge with higher profit margins (P - mc) Neoclassical Retailing Classical provides insights does not consider / explain the tendency of retail facilities to cluster Forces that link business of different stores Joint purchase trips Interdependent product demand Retail mix and center leases Prices all goods Joint Purchase Trips Consumer shopping time and costs Reduced if purchases can be made with a single trip if available at a single site Lower costs consumers more apt to purchase at that cluster and can purchase more 5

6 Interdependent Product Demand Multiple purchase trips demand for a store s product depends not only on its own pricing policy but the general drawing power of the center as a whole Likelihood of a given consumer purchasing an item from an individual store Store Demand = Probability of coming to the center x Probability of a purchase at the store Retail Mix and Leases Success or failure of any individual store depends on the center s overall mix of stores One type of leases to provide incentives to center management Ground rent fixed - set amount per unit of space Overage rent - variable - based on gross receipts of the tenant How to attract the right mix? Rent price discrimination Anchor stores Deny / accept renters Department Stores Price Discrimination Volume of traffic depends on collective pricing policies of all stores Link between prices provides rationale for the emergence of diverse product department stores Large concentration of many different individual stores Problem part of marginal revenue of pricing strategy goes to the other stores externality Single owner of all the stores Benefits captured by offering a range of goods in a single store department store 6

7 Shopping Center Attraction Center s attributes in comparison to those of other centers Center s location relative to its competitors Spatial distribution or location of households Summary There are distinct patterns to the location of retail facilities. A dense pattern of small, neighborhood shopping centers coexist with a sparse distribution of large, regional centers. Shopping trips to neighborhood centers are more frequent and of shorter length while trips to regional centers are longer, but less frequent. Shoppers purchase different items with quite different frequencies that depend both on the inherent rate of use and also on the cost of inventorying or storing the item. The density of stores that provide certain items will depend positively on the frequency of purchase and negatively on the costs of establishing a retail facility. Thus, the mix of neighborhood and regional centers emerges naturally in reaction to shopper behavior. Summary Retail stores often cluster together, historically in business districts, and more recently in shopping centers. Clustering occurs because consumers can visit many stores and purchase different items with a single trip, greatly economizing on retail travel. The mix of stores that cluster together can be quite different in a business district than in a shopping center. The single ownership of a shopping center allows the cluster or mix or stores to be specifically designed to complement each other. Competition among shopping centers largely is a zero sum game. One center s sales gains occur at the expense of other centers. 7

8 Summary Department stores are an outgrowth of the externalities associated with stores sales depending on the pricing policies of all stores in a cluster. 8