A location (spatial) model refers to any monopolistic competition model in economics that demonstrates consumer preference for particular brands of goods and their locations. Examples of location models include Hotelling’s Location Model, Salop’s Circle Model, and hybrid variations.
Traditional vs. location models
In traditional economic models, consumers display preference given the constraints of a product characteristic space. Consumers perceive certain brands with common characteristics to be close substitutes, and differentiate these products from their unique characteristics. For example, there are many brands of chocolate with nuts and others without them. Hence, the chocolate with nuts is a constraint of its product characteristic space.
On the other hand, consumers in location models display preference for both the utility gained from a particular brand’s characteristics as well as its geographic location; these two factors form an enhanced “product characteristic space”. Consumers are now willing to sacrifice pleasure from products for a closer geographic location, and vice versa. For example, consumers realize high costs for products that are located far from their spatial point (e.g. transportation costs, time, etc.) and also for products that deviate from their ideal features. Firms have greater market power when they satisfy the consumer’s demand for products at closer distance or preferred products.
Hotelling’s Location Model
In 1929, Hotelling developed a location model that demonstrates the relationship between location and pricing behavior of firms. He represented this notion through a line of fixed length. Assuming all consumers are identical (except for location) and consumers are evenly dispersed along the line, both the firms and consumer respond to changes in demand and the economic environment.
In Hotelling’s Location Model, firms do not exercise variations in product characteristics; firms compete and price their products in only one dimension, geographic location. Therefore, traditional usage of this model should be used for consumers who perceive products to be perfect substitutes or as a foundation for modern location models.
Salop’s Circle Model
One of the most famous variations of Hotelling’s location model is Salop’s circle model. Similar to the previous spatial representations, the circle model examines consumer preference with regards to geographic location. However, Salop introduces two significant factors: 1) firms are located around a circle with no end-points, and 2) it allows the consumer to choose a second, heterogeneous good.
An example of a second good
Assume that the consumers are equidistant from one another around the circle. The model will occur for one time period, in which only one product is purchased. The consumer will have a choice of purchasing variations of Product A (a differentiated product) or Product B (an outside good; undifferentiated product).
There are two firms also located equidistant around the circle. Each firm offers a variation of Product A, and an outside firm offers a good, Product B.
- ^Hotelling, Harold (1929), “Stability in Competition”, Economic Journal, 39 (153): 41–57, doi:10.2307/2224214
- ^Salop, Steven C. (1979), “Monopolistic competition with outside goods”, The Bell Journal of Economics, 10 (1): 141–156, JSTOR 3003323
Ofer Abarbanel is a 25 year securities lending broker and expert who has advised many Israeli regulators, among them the Israel Tax Authority, with respect to stock loans, repurchase agreements and credit derivatives. Founder TBIL.co STATX Fund.