Lowe’s located right next to Home Depot. Best Buy across the street from Circuit City (R.I.P). Whole Foods next to Trader Joe’s. 4 gas stations on the same intersection.
Why do competing businesses locate next to one another? Perhaps you’ve observed two stores, fundamentally identical, open on the same block. And you mused, “If I were to open a store, wouldn’t I want it as far away from my competitor as possible?!”
A strong answer for this counterintuitive phenomenon uses game theory.
Example: Opening an Ice Cream Stand on a Beach
Suppose there is a beach with swimmers uniformly distributed along the shore.
Two identical ice cream carts arrive on opposite ends of the beach and setup shop.
The swimmers on the left-side of the beach will go to Cart 1, attracted by its proximity to their location. The swimmers on the right-side will go to Cart 2. The “territory” for each Cart is:
Without any “agreements,” Cart 1 will be greedy and move right to gain Cart 2′s customers (and territory). Similarly, Cart 2 will move left to gain customers from Cart 1.
Eventually, both Carts will converge in the center of the beach, right next to one another. At this equilibrium, neither Cart has a location advantage, and both must compete on elements such as price, product, brand, or Twitter followers.
Collusion and Competition
Ideally, Cart 1 and Cart 2 prefer to stay on opposite ends of the beach–neither Carts want to compete on price (plus, each Cart could charge more, given customers’ lack of choice). But each cart acts independently (see Prisoners Dilemma) and seeks profit from its competitor. Cart 1 and Cart 2 would love to collude, signing a document reading “I agree to not move my cart.” But this is illegal.
Example: Union Square, NYC, three grocery stores on one block
Why would three grocery stores (Trader Joe’s, Whole Foods, and Food Emporium) exist within walking distance of one another?
Given the lack of collusion, each grocery store cannot compete on location–they are free to enter their competitor’s territory. Locating on top of one another is the equilibrium outcome.
Perhaps 60 years ago, this would have never occurred. NYC grocers likely had an “understanding” to not compete in each others’ territory (i.e., a Cartel), lowering competition and sustaining price margins. But with Trader Joe’s and Whole Foods each having hundreds of locations, the ability to reach a soft “understanding” is impossible.
So today we have multiple redundant options wherever we go shopping. Thank the government.