Finance & economics | Free exchange

Corporate sardines

How incumbent firms pack markets to deter entry

THE modern high street can give an overwhelming sense of déjà vu. Fans trundling to the football stadium of Tottenham Hotspur, a team from north London, pass six William Hill bookmakers on the main approach. Tourists traipsing along a half-mile stretch of 23rd Street in New York pass five Starbucks outlets. In Tokyo, 7-Eleven boasts 15 stores within a similar distance of Shinjuku station. The crush of chain stores frustrates those who like one-off boutiques. Economists fret for another reason: firms may be cramming markets in order to keep rivals out.

One of the first studies of the way firms compete for space was published in 1929 by Harold Hotelling, then of Stanford University. He showed that firms face trade-offs: locate too near a rival and ferocious competition hits profits; edge too far away and too large a chunk of the market is lost. Since the trade-off will vary by market, Hotelling’s theory explained why firms in some industries cluster, while others scatter.

When firms own multiple outlets new tactics are possible and new trade-offs arise. If a franchise adds a new outlet it will “cannibalise” the profits of existing ones, pinching its own customers as well as rivals’. But there are upsides: more outlets soak up demand, so that outsiders’ gains from entering fall. When there are big costs to setting up shop, “pre-emption” can keep rivals out.

This helps explain not just the physical proximity of some firms’ outlets, but also the similarity of products sold by a single company. Breakfast cereals are an example: in 1950 America’s six big producers offered around 25 types of cereal; by 1972 it was around 80. Trust-busters suspected that the proliferation was not just a response to shoppers’ varied tastes. Rather, the market was being crammed with options in order to reduce the “space” for new entrants.

If anything, worries about proliferation are greater today, as waves of mergers have left fewer, larger firms. Ubiquitous chains like 7-Eleven and Starbucks face protests when new stores open. To establish exactly how firms choose a location, a recent paper by Mitsuru Igami and Nathan Yang of Yale University tests a simple market: burgers. First, the authors trawled through archived telephone directories to track the number and location of burger joints in Canada between 1970 and 2005. In the 256 local markets they identified, the average number of outlets rose over that period from 1 to 2.5 as five big chains, including Burger King, McDonald’s and Wendy’s, expanded.

The researchers’ statistical tests confirm the theory: if a rival burger joint is already in place, the return falls; own-brand cannibalisation hurts too. The impact of location on profits was particularly strong between 1970 and 1988 (when markets were first filling up) and in Vancouver (where there are few burger joints), suggesting a fiercer race when there is space to play for.

Despite cannibalisation, opening multiple outlets might be profitable for a chain as a whole if that keeps rivals at bay. To test this theory, the researchers modelled the number of stores in each market that would have yielded the highest profits for McDonald’s, had it and its competitors reacted only to variables like income and population, and ignored one another’s presence. They concluded it would never have opened a new joint in a market where it already had two outlets. Yet about half of openings by McDonald’s between 1970 and 2005 fit that description, suggesting they can be pinned on pre-emption.

Different products lend themselves to different forms of competition for space, as a paper published in 2011 by Nathan Wilson, an economist at America’s Federal Trade Commission, shows. Mr Wilson collects financial data on hotels in Texas, supplemented by data on quality, location and brand. Plotting them on a map allows him to identify 94 separate markets. Looking across the Lone Star state as a whole suggests concentration, with six firms accounting for 91% of the branded hotels in the sample.

Yet there is little geographic clumping. A new hotel in a Texan city is much more likely to be an outlet of a brand not already present, rather than a twin. Mr Wilson’s analysis explains why. Customers tend to favour particular brands. This makes pre-emptive investment to fill the market less worthwhile: since an incumbent has its own natural customer base, a rival’s entry dents profits by only 5%. For the same reason, opening a twin is painful: cannibalisation means a 10-12% profit drain.

Instead, hotel chains seem to “fill” the market another way. Rather than opening lots of the same joint, they open differentiated lodgings, with the six largest hotel groups operating 32 brands. Though some of these vary in quality, many compete head-to-head: Courtyard and Fairfield, both owned by Marriott, cater to similar budgets, as do Comfort Inn, Econo Lodge and Quality Inn, all part of Choice Hotels. Mr Wilson finds that this approach softens cannibalisation, and can make pre-emption a more profitable strategy.

Blame the shoppers, not the shops

Although this number crunching gives a good picture of how location strategies can dissuade entry, it is not clear that regulators should fret. Clearly, the underlying motive—to keep rivals out—is the sort of thing antitrust watchdogs are supposed to worry about. Yet to achieve that aim, the big chains use means that their punters value. In markets where customers value proximity over brand, outlets mushroom; when shoppers like more options, differentiated brands proliferate. Those that would like a rustic high street packed with artisans should blame their fellow shoppers. To keep rivals out, a firm has to mop up demand. That means giving customers what they want.

Studies cited in this article can be found at www.economist.com/pre-emption

Economist.com/blogs/freeexchange

This article appeared in the Finance & economics section of the print edition under the headline "Corporate sardines"

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