Testing Implications of Spatial Economics Models: Some Evidence from Food Retailing

Testing Implications of Spatial Economics Models: Some Evidence from Food Retailing A major implication of standard economic theory is that adding firms to a market will increase competition and reduce prices. Adding space to the economic problem complicates the analysis and possibly alters this result. Specific sites are strictly limited in that a site cannot be replicated. If only one firm can occupy a given site, then each firm has locational characteristics that cannot be exactly copied by other firms. Thus, the standard assumption of the ability of identical firms to enter and exit the market does not hold. One of the interesting questions addressed by spatial economics models is the effect on product price (termed mill price in the models) when new firms enter a given spatial market area. Does product price fall, as predicted by standard (nonspatial) economic theory, or is there a different result? Food retailing is an excellent market in which to study this issue. Consumers make frequent visits to retail food outlets, and location of the outlets is important to consumers' transportation costs. The purpose of this paper is twofold. First, theories of spatial economics are reviewed for their implications about the effect of new entrants on product price, and application is made to food retailing. Second, the effect of an entrant on retail food prices in a given spatial market is tested using a unique data set from supermarkets located in Raleigh, North Carolina. REVIEW OF SPATIAL THEORIES The spatial economics problem has been modeled as an oligopolistic market. Due to the small number of firms, it is assumed that each firm must take into account the potential responses of competing firms before settling upon a market strategy. Two conjectures about the potential responses of rival firms dominate the spatial economics literature: the Hotelling-Smithies (H-S) conjecture (Hotelling 1929; Smithies 1941) and the Loschian conjecture (Losch 1954). H-S assumes that each firm conjectures the prices of competitors to be fixed. (1) Under normal assumptions, the model gives results consistent with standard, spaceless theory: the entry of new firms lowers product price. Capozza and Van Order (1978) show that entry in the H-S conjecture can have the opposite result of raising, rather than lowering, prices. This occurs when firm density is low and consumer transportation costs are a large proportion of total product price at the edge of the market. Capozza and Van Order (1978) also show that the results of the H-S conjecture are qualitatively unaltered for any price conjectural variation between one and minus one, that is, firms react to the price changes of competitors, but they don't react on a one-to-one basis. The Loschian conjecture assumes that each firm matches price changes by competing firms on a one-to-one basis. (2) Loschian conjecture results in new entrants raising, rather than lowering, product price for the following reason. The Loschian firm assumes its market area is fixed and consequently sets prices like a monopolist within its market area. Firms are subject to demand elasticities that are net of transport costs. When a linear consumer demand is assumed, price elasticity for any given firm increases when transport costs are subtracted from consumer demand. Higher transport costs result in an increase in price elasticity. As new firms enter the market, each firm loses its most distant customers, resulting in a decrease in average transport costs for consumers, a decrease in aggregate price elasticity, and an increase in product price (Benson and Faminow 1985). This Loschian result, however, is dependent on the assumption of a linear demand curve. Benson (1980a) shows that when a negative exponential demand curve is assumed in the Loschian conjecture, product price falls as new firms enter. The H-S conjecture as modified by Capozza and Van Order (1978), in which firms react to the price behavior of competitors but not on a one-to-one basis, would seem to be the more applicable spatial economics model for food retailing. …