Have you ever wondered why so many similar businesses seem to cluster together? Right next to their competition, surely this makes no sense. We see this in filing stations, coffee shops, burger joints, often with restaurants and many other retail shops. It begs the question, Why?

So a quick thought experiment. Imagine there is a long sandy beach, and you spot a business opportunity, to open an ice cream stall. The beach is exactly a mile long with easy access from either end, and let’s assume some cliffs, so no other access points.  So where to set up your new business? Right at the halfway point seems best, with no potential customer being more than half a mile away.

All goes well, then a competitor arrives, let’s call him Harold, and he sets about creating his own stall, selling a range almost the same as yours. So, what to do? Ok you negotiate with him and explain the best strategy is co-operation and that you should both now move your locations, you to the ¼ mile mark and Harold at the ¾ mile mark. That way you both get an equal share of customers. Also it’s a plus for the beach goers as they are never more than a ¼ mile from a stall. This outcome is known as being a socially optimal solution.

Unfortunately, after a couple of days Harold breaks your agreement and moves his stall closer to the halfway line, expanding his territory and encroaching on the area over the halfway point, and thus threatening your potential sales area. How do you react? Well naturally you are annoyed and in retaliation move your stall, to seek to gain business, towards the halfway line, and closer to his stall. This is now war, as you both compete to gain business territory from the other, and eventually you will both end up next to one another at the half mile point – pretty much a stalemate. Or in game theory terms you have both found the point at which neither of you can maximise further business without jeopardising some existing customer base – a so called Nash Equilibrium.

This makes sense for you and Harold, now your arch competitor, but some of the customers will be disadvantaged, particularly those at the extremes ends of beach, who now have to trudge up to ½ mile for that ice cream.

Many thoughts flow from this experiment know as the Hotelling Theory of Spacial Competition (named after Professor Harold Hotelling, whose name I have pinched here). Like all such thought experiments it may be rather oversimplistic (our old friend ceteris paribus looms large here), in that in the real world there could well be more than two players in the marketplace, and no doubt they will all look to develop different marketing and different product offerings. Additionally competitive pricing now comes to the fore after the geographic location battle has hit an equilibrium, and here again a price clustering effect (punctuated by short term price wars) starts to take hold.

One further observation, imagine loads of stalls start crowding on the beach, at some point some of the stalls will be unprofitable and will likely withdraw from the business. This leads to the conclusion that any cluster has a natural limit, with the least profitable player just about clinging on, and others less successful being driven out of business This marginal pricing phenomena is also often seen in the property market where people claim properties are unaffordable – whereas in fact the market price will likely settle at the point of the marginal affordability of the last available prospective purchaser. (Often, we hear people calculate how much they can borrow before looking at houses – we seem drawn to maximising this factor to the limit).

So businesses clustering together is often a very sensible strategy, and its quite amazing how this seems to seen throughout free market economies across a range of products. All of this may be blunted a great deal (if not negated) by the provision of virtual services, but in physical goods Harold Hotelling seems to rule.

For more on Harold Hoteling and his work see https://en.wikipedia.org/wiki/Harold_Hotelling

And for more on the Nash Equilibrium see https://www.britannica.com/science/Nash-equilibrium