Locations can be affected by government policy, the policies can either work for or against the firms. The government’s policy is usually introduced to try and alter locations of industries in order to secure equitable distribution of income and employment and reduce costs of congestion, occasionally financial incentives are offered for not locating in areas therefore making them more attractive and profitable.
Economists focus on transport and labour costs when looking at location. Locations where both labour and transport costs are at a minimum are preferred locations. Firms also have different objectives, some want to maximise sales some want to maximise their profits. When firms are looking for locations to locate their businesses they are not able to confirm that the particular location they have chosen is the best one, this is due to a lack of information. A firm may locate at the best possible location now, but this location may not necessarily be the optimum one in the future. This location will become satisfactory in the future, most firms are therefore satisficing, Economists also assume interdependence of firms (ignoring other firms around them).
Location can have a great effect on prices firms can offer therefore enabling them to have a competitive advantage. There are three forms of spatial pricing, free on board pricing, uniform delivered and base point. When rival producers and consumers are dispersed geographically from each other transport costs become important in the pricing decision. Transportation costs may be passed on to the consumer, in this case the consumer pays the producers price at place of production and then incurs the transportation cost to get the product delivered. The cost of transportation would increase the further you were from the firm, this is free on board pricing (diagram a).
(a)
Buyers can usually supply transportation for cheaper than the seller will, dispersion of sellers and buyers over geographical space is known as spatial competition. Particular consumers may be quoted different prices by different suppliers because of some combination of different prices, different transportation costs per mile and different transportation distances arising from suppliers in various different locations. To secure a sale to a particular customer the seller must have the lowest delivered price with other things being equal.
Diagram (a) shows buyers spread evenly along the horizontal axis, which measures distance. Sellers are at points A,B,C and D, the vertical axis measures delivered price. For simplicity factory prices are the same at base price and face same transport costs per mile. Curved lines show price buyer will have to pay at any distance. As the distance increases so does delivered price but at a decreasing rate. The limit to each firm’s sales is where price lines intersect with neighbouring sellers. Buyers at each intersection have a choice of two sellers each quoting same delivered price all other buyers have one seller offering price lower than its rival owing to its transport cost advantage. Delivered prices are a form of price discrimination as buyers are discriminated on the basis of their distance from the supplier.
Base point pricing is a form of delivered pricing, the base price here is the factories door price of a particular firm at a particular location. The agreement of all firms to set some base price amounts to an agreement to share market based on geographic proximity of the buyers to the sellers this is similar to a cartel.
Suppliers in a competitive market who have similar production costs and face similar transportation costs must use a delivered pricing scheme to compete for sales in a spatial market. Their base prices will tend to be equal to their marginal and average cost of production like oligopoly. A lower base price in this case will increase market share at the expense of other firms. In diagram (b) the dotted line represents an old pricing schedule an increased efficiency in transportation will cause firms delivered price lines to be flatter and thus lower at any particular location allowing it to be lowest priced supplier further from its plant than it was before and gain sales at the expense of their rivals. In the long run the firm may relocate to a less crowded part of the market or build a second plant in another location to gain more market. In diagram (b) firm B crosses over into firm C and D’s market. This is called cross hauling.
(b)
When cross hauling occurs customers of firm C and D may not necessarily move to firm B with extra market share they have gained. This is because some buyers buy off more than one supplier as an insurance policy against one firm’s inability to supply at busy times. The extra transportation cost paid is like a premium paid for an insurance policy. A buyer will also incur search costs to find out that firm B is cheaper and in a market were prices may change frequently information held may not be correct. If a particular firm has a better quality product, product buyers will pay more to receive that product.
If firms were to use uniform delivered pricing, the price charged would be the same to wherever the product has to be delivered to. Distance in this pricing method has no effect. This pricing can be beneficial, if a firm were to switch pricing methods for example to free on board pricing, local customers would gain from this by paying less but customers who are further will be at a disadvantage because they will be paying more than they were before.
The Hotelling model also looks at locational interdependence, his theory is based on free on board pricing, and he assumes there are only two firms (duopoly) and that all firms are producing a homogeneous product. There are no economies of scale, the demand is inelastic and all consumers are evenly spread across space. Consumers visit the two firms regularly to buy products, there are also no positive or negative externalities produced by either of the firms.
(1a)
Consumers are located along the straight line, firms react depending on each other if firm A moves location firm B will then react depending on firm A’s move. Initially firms locate randomly, the product they produce and the price they charge is identical for both firms. At point X in diagram (1a) people here are indifferent from firm A and firm B, at this point consumers are the furthest away from both firms. This is the market boundry and cost for consumers at this point is maximised. X equal distance from firms A and B. The main priority of the firms here is to gain the biggest market share because the closer consumers are to a firm the cheaper it is for the consumer to buy off that firm. As the transportation costs are lower. Re-location is possible and is costless in this model in practice it would not be.
If firm A were to move next to firm B as seen in diagram (1b), firm A would now have more of the market share this would motivate firm B to move.
(1b)
Firm B which has same objectives as firm A will now move on to the other side of firm A (diagram 1c)
(1c)
Now firm B has the bigger market, this continues until eventually both firms meet in the middle of the market, any move by any firm after ending up in the middle of the market would put the relocating firm in a worse position than before. When firms eventually stop in the middle of the market they are in Nash-equilibrium. Firms agglomerate and firms only do as well as rival firms let them and vice versa.
Diagram (1c) shows a Pareto optimal position, but diagram (1d) shows a Pareto improvement as consumers become better off because transportation costs become lower as firms are closer to the consumers.
(1d)
In diagram (1d), on average consumers have to travel less, so transportation costs decrease. This situation would only occur if there were some sort of government policy.
If firms started to charge different prices demand would become elastic, this would affect the market of the firms.
(2a)
In diagram (2a) firms are located in the middle of the market, no one will pay more than the price set (price ceiling) this causes the market to be limited to X and Y.
If a third firm were to be introduced (Firm C) in diagram (2b) it could shut out Firm A’s entire market share.
(2b)
The best solution for all firms is to spread out, there are no economies of scale as there are price differences, a Nash equilibrium is unlikely to occur in this situation.
Location can give firms a competitive advantage but not on entirely on its own, a location can initially give a firm an advantage but in the long run other firms are likely to follow. If firms want to be competitive they need to consider other strategies such as trying to be cost leaders or try and produce a better quality product, advertise or differentiate their product from other products. Firms end up satisficing, unless inside information is known. If one firm acts first others tend to follow and crowd out the market.
Bibliography
- Evan. J. Douglas, Managerial economics, analysis and strategy, Fourth edition 1992
2) Howard Davis, Managerial Economics for Business Management and Accounting, second edition, 1991
