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The Hotelling Theory: Student Journalism Part 3

[I asked my students to try writing an explanatory article. Ryan Doherty came up with this nifty piece about two drugstores that are side by side, an example of an economics theory develped by a certain Mr. Hotelling.]

Competition, Right Next Door

By Ryan Doherty

On Morningside Road in Scotland's capital of Edinburgh, the glass doors of competing drugstores stand next to each other like the front lines of troops waiting for battle. But Boots and Superdrug, drugstores found throughout the United Kingdom, are not allies, but rather enemies. A mere ten footsteps separate these rival doors, each promising to sell the cheapest female hair care products.

But the residents of Morningside Road are not overtly decrepit and ill, in dire need of medicines and foodstuffs. The residents of Morningside are your typical Edinburghers: they smoke, curse, and even eat fried Mars Bars, New Townies or not. And the companies aren't to blame; they did not place their stores poorly. Microeconomic theory is the culprit.

More specifically, the theory of horizontal competition causes businesses, vendors, and even, at times, beggars to convene directly next to their competition. A simple, common economic theory designed by Harold Hotelling (1929), a slick-haired, round-faced economist, explains the model.

Consider a hot, sticky summer day at the beach. Vendors sell Soda pop, cotton candy, and ice cream on the mile-long boardwalk, full of sun-kissed beachgoers. There are two ice cream vendors, let's call them Jack and Jill, present on the boardwalk. Out of courtesy for the competition, and to maximize their own profits, they set up their carts on opposite ends of the boardwalk.

The ice cream customers on the boardwalk are split in two; the people to the left of the half mile mark get their treats from Jack, and to the right of the half mile mark visit Jill for her cookies and cream.

It then dawns on Jill that if she just moved ten feet closer to Jack, she would capture an extra five feet of Jack's costumers, in addition to the ten feet now to her right. Her market shares have increased compared to Jack's. Her profits go up, and Jack is too far away to notice her cheating.

A couple minutes pass and Jack's customers are dwindling. He has the same epiphany. He cheats inward towards Jill, this time a bit further. Up go his market shares.

Jill gets greedy, cheats some more. Then Jack, Jill, Jack, and then Jill, again.

All of the sudden the competitors are back to back at the half-mile mark, selling the same amount of vanilla swirl they were selling at the beginning of the summer day.

This is a simple example of the Hotelling model, a key theory in horizontal competition of similar goods. When studying economic theory, an important assumption must be stressed: the idea of ceteris paribus. Ceteris paribus means that all other factors in this model are the same. The Jack and Jill example is a simple, but accurate, portrayal of Hotelling's model, yet it is important to remember that the clustering strategy described restricts the firms (in this case, Jack and Jill) to non-price competition.
Both Jack and Jill sell two scoops for three dollars. The model just would not work if Jack undercut a competitor that was situated right next to him.

Morningside Road is an offshoot of Princes Street, the busiest commercial street in Edinburgh. Day and night, foot traffic runs up and down Morningside. Although some consumers may have allegiances to a specific drugstore, a hungry Scot in search for an Irn-Bru and a packet of Maltesers is going to quench his fix in the first shop he stumbles upon. This is where Hotelling's theory comes into play. Put the shop in the middle, the customers will come.

You would think Jack and Jill would learn their lesson - return to the duo they once were when they went up that fateful hill - and cooperate by giving each other their competitive distance. But competition, especially with similar goods, causes people, and companies, to do whatever is possible to increase their market share.

If they could only learn to share the pieces of Jack's broken crown, they wouldn't need to bother with selling ice cream in the first place. -- R.D.

By Joel Achenbach  |  March 31, 2005; 3:06 PM ET
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