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Hotelling's Law

Hotelling's Law

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Published by Paul Muljadi

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Published by: Paul Muljadi on Sep 29, 2012
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Hotelling's law1
Hotelling's law
 Not to be confused with Hotelling's rule.
Hotelling's law
is an observation in economics that in many markets it is rational for producers to make theirproducts as similar as possible. This is also referred to as the
principle of minimum differentiation
as well asHotelling's "linear city model". The observation was made by Harold Hotelling (1895
1973) in the article "Stabilityin Competition" in
 Economic Journal
in 1929.
The opposing phenomenon is product differentiation, which is usually considered to be a business advantage if executed properly.A 1979 Econometrica paper, "On Hotelling's 'Stability in Competition'" by Aspremont, Gabszewicz, and Thisse,
argues that while the price competition in Hotelling's paper correctly addressed the Bertrand paradox, explaininghow firms can compete in prices and still make positive profits, Hotelling made an error in reasoning in the secondpart of the paper where he attempts to endogenize the locations of the firms in his model and establishes his "law".The abstract of Aspremont et al. reads: "The purpose of this note is to show that the so-called Principle of MinimumDifferentiation, as based on Hotelling's 1929 paper 'Stability in Competition' is invalid."
Two pharmacies on the main street in Mrzeżyno. Possibly aneffect of Hotelling's location competition.
Suppose that there are two competing shops located alongthe length of a street running north and south. Each shopowner wants to locate his shop such that he maximises hisown market share by drawing the largest number of customers. In this example, the shop itself is the 'product'considered and both products are equal in quality andprice. There is no difference in product to the customers.Customers are spread equally along the street. Therefore,considering the prices are exactly the same, eachcustomer will always choose the nearest shop becausethere is no difference in product.
One shop
For a single shop, the optimal location is anywhere alongthe length of the street. The shop owner is completely indifferent about the location of the shop since it will draw allcustomers to it, by default. However, from the point of view of a social welfare function that tries to minimize thesum of squares of distances that people need to walk, the optimal point is halfway along the length of the street.
Two shops: halfway
Hotelling's law predicts that a street with two shops will also find both shops right next to each other at the samehalfway point. Each shop will serve half the market; one will draw customers from the north, the other all customersfrom the south.Another example of the law in action or practice is to think of two food push-carts at a beach. Assume one starts atthe south end of the beach and one starts at the north. Again assuming a rational consumer and equal distributionalong the beach, each cart will get 50% of the customers, divided along an invisible line equidistant from the carts.But, each cart owner will be tempted to push his cart slightly towards the other, in order to move the invisible line sothat it encompasses more than 50% of the beach. Eventually, the push cart operators end up next to each other in the
Hotelling's law2center of the beach.
Social optimum elsewhere
Obviously, it would be more socially beneficial if the shops separated themselves and moved to one quarter of theway along the street from each end
each would still draw half of the customers (the northern or southern half) andthe customers would enjoy a shorter travel distance. However, neither shop would be willing to do thisindependently, as it would then allow the other shop to relocate and capture more than half the market.The original model assumes that each consumer along the street will consume at least a minimum number of goodssold in the shops, and that the price of these goods are fixed by an external authority. When these assumptions arenot met, companies have incentives to differentiate their products. When not all people along the street, or along therange of possible different product positions, consume a minimum number of goods, companies can position theirproducts to sections where consumers exist to maximize profit; this will often mean that companies will positionthemselves in different sections of the street, occupying niche markets. When prices are not fixed, companies canmodify their prices to compete for customers; in those cases it is in the company's best interest to differentiatethemselves as far away from each other as possible so they face less competition from each other.
The street is a metaphor for product differentiation; in the specific case of a street, the stores differentiate themselvesfrom each other by location. The example can be generalized to all other types of horizontal product differentiationin almost any product characteristic, such as sweetness, colour, or size. The above case where the two stores are sideby side would translate into products that are identical to each other. This phenomenon is present in many markets,particularly in those considered to be primarily commodities, and results in less variety for the consumer.Businesses in fact follow both product differentiation and Hotelling's law, as contrary as they may seem. Take forexample JetBlue. The low cost airline markets itself as a revolutionary type of airline
cheaper airfare, nicer planes,better locations. As JetBlue tries to differentiate its product from its competitors, it also adopts similar flightschedules and similar service.An extension of the principle into other environments of rational choice such as election "markets" can explain thecommon complaint that, for instance, the presidential candidates of the two American political parties are"practically the same". Once each candidate is confirmed during primaries, they are usually established within theirown partisan camps. The remaining undecided electorate resides in the middle of the political spectrum, and there isa tendency for the candidates to "rush for the middle" in order to appeal to this crucial bloc. Like the paradigmaticexample, the assumption is that people will choose the least distant option, (in this case, the distance is ideological)and that the most votes can be had by being directly in the center.
[1]Hotelling, Harold (1929), "Stability in Competition" (http:/ 
Industrial Organisation/ 
Hotelling- Stability in Competition.
 Economic Journal
(153): 41
57, doi:10.2307/2224214,[2]"On Hotelling's 'Stability in Competition'" by Aspremont, Gabszewicz, and Thisse (http:/ 
phdcourse/ DAspremont_Gabszewicz_Thisse_On_Hotellings_Stability_in_Competition.

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