Lett Spat Resour Sci DOI 10.

1007/s12076-010-0041-9 O R I G I N A L PA P E R

Spatial competition and consumer exclusion: social welfare perspectives in central-place system
Daisuke Nakamura

Received: 9 September 2009 / Accepted: 14 May 2010 Springer-Verlag 2010

Abstract The condition of unutilized space has been excluded from the existing framework of central-place theory, while there are several cases where spatial structures are not entirely fullled and certain empty areas are identied. First, it is shown that this scenario can be found when a producer is involved in extremely high level of assembly transportation cost or in enormous size of market area. In this case, producers tend to pursue their cost minimization behavior than that of revenue maximization, which allows the presence of spatial consumer exclusion. Secondly, it is argued that the existence of unutilized area attracts potential new entrants to join the market competition, which may have benet of reduction or elimination of the problem of consumer exclusion. Together with this alternative spatial formation approach, the analysis further attempts to evaluate the impact of decision-making of producers on welfare level of consumers. Keywords Spatial competition Market areas Social welfare Industrial location policy JEL Classication D43 L13 Q56 R38 1 Introduction The presence of consumer exclusion can be observed within the framework of central-place system, which was originally formalized by Lsch (1938, 1954) in
D. Nakamura ( ) Instituto de Economa Aplicada Regional (IDEAR), Departamento de Economa, Universidad Catlica del Norte, Avenida Angamos 0610, Antofagasta, Chile e-mail: dnakamura@ucn.cl D. Nakamura Regional Economics Applications Laboratory (REAL), University of Illinois, 607 S. Mathews, #318, Urbana, IL 61801, USA

D. Nakamura

terms of market areas. Since the long-run spatial competition and formation process were the main concern in his analysis, the consumer exclusion, which was generally found in short run or medium run, has not been taken into account. In such a case, Condition 2 in Lsch (1954:95), which states that the entire space is always sufciently occupied by numerous locations, becomes invalid. There is an alternative central-place framework originated by Eaton and Lipsey (1976, 1978, 1979, 1982), which rms optimize their location according to their own production scale decisionmaking. Their methods also enable the analysis to include the notion of agglomeration economies to central-place theory, which has not been fully considered except Parr (1978), Mulligan (1984) and other certain limited literature. An unutilized space is observed when the producer is involved in an extremely high level of assembly transportation cost or enormously large radius of market area. In this scenario, it can be anticipated that producers tend to more focus on their objective to cost minimization than revenue maximization, which allows economic plane to have empty space therefore areas of consumer exclusion are identied. It is intuitively unnatural to assume cost minimization behavior, since Lschian analysis provides Condition 2. However, once this particular condition is removed, the strategy of producer may be replaced by cost-minimization behavior. One of the solutions of consumer exclusion has already been demonstrated by Huff (1963) as probabilistic shopping models based on the law of retail gravitation by Reilly (1929, 1953). However, for instance, local regions in developing countries or remote islands in developed countries have certain limitations of selection of goods and services or delay of delivery in a realistic world. From the following section, this paper continues to explore the mechanism of consumer exclusion within the framework of central-place theory. The consumer exclusion can also be caused by other possibilities on the consumption side such as insufcient resources and incomplete information of households. Also, on the production side, the presence of very high xed costs may cause certain exclusion of space due to immobility of rm location. Due to limitation of the scope of this paper, these are implicated as further extensions of analysis. Lsch (1954) proved that the hexagonal market area was the ideal shape of region when compared with circular, triangular or square economic regions in terms of the utilization of space. For the circular form, the demand of a smaller circle is more advantageous than the larger form as increasing shipment costs reduce the average benets of the area. Although the circular form is the greatest with respect to the demand of the curtailed sales areas, the hexagon is better in terms of eliminating empty corners. Considering the above economic situations, the unused corners of the circle are utilized in the long run. This is shown in Fig. 1 as the difference between circular and hexagonal spatial conguration in each area. The Lschian framework was attempted to generalize with respect to spatial competition of the market area (Mills and Lav 1964), detailed with implicit price function (Denike and Parr 1970), and more recently expanded as price-conjecture model (Mulligan and Fik 1994). For the accessibility of households, Mulligan (1983) provided implications of multipurpose shopping behavior under certain budget constraint for simple two-level and two-bundle city system. However, in the existing literature, the impact of change in spatial conguration on welfare level of consumers has not been

Spatial competition and consumer exclusion: social welfare Fig. 1 Formation process of the hexagonal market areas

fully analyzed. It is also noted that welfare analysis in spatial markets has already been examined by several approaches. Stern (1972) analyzed the optimal size of market areas in terms of producer and consumer surplus, and he measured the difference between the Lschian solution and a socially optimal solution. Beckmann (1976) formally compared and contrasted social welfare level under the mill pricing, uniform pricing and discriminatory pricing conditions in spatial terms. In terms of consumer theory, an existence of unutilized area implies that consumers in this area are unavailable to obtain certain types of goods and services. It may be discussed that consumers can make their own decision whether a particular good is purchased or not under the condition of demand and supply curves as long as a market mechanism works properly. However, in spatial model, the supply curve may not exist in some areas and households have no choice to select. It will occur when the market area is enormously large, which exceeds producers protable quantity of output level. Also, that is more evident when signicantly high level of assembly transportation costs are observed, since it reduces optimal output level of the producer. This may have a potential issue of location problem to be solved with socially optimized welfare levels. In the main sections of the paper, a hypothetical model is initially examined on the appearance of spatial consumer exclusion. Secondly, the impact of spatial competition on reformation process of space in particular cases is revealed. Finally, the analysis compares and contrasts welfare levels, which are generated by two different types of spatial competition of the market area. The simultaneous location adjustment of rms can be occurred when one of the following condition is identied; namely, either rms earn higher prots elsewhere or there are new entrants to fulll empty space. Since rms are presumed to maximize their prots, the former case can be excluded from the analysis and the latter scenario is more plausible to consider in this circumstance. Also, it is noted that this will be applicable except the spatial conguration is a spatially-optimized regular hexagon.

D. Nakamura

2 The model In this section, a hypothetical model is examined in order to reveal how unutilized areas are formed in an economic plane under certain conditions of spatial cost mechanism. Regarding the additional entry of new rms, it is assumed in this analysis that economic plane has already been dominated by incumbent rms. However, some parts of consumers who locate away from the centre cannot obtain goods and services, which are distributed by existing rms due to the problem of physical distance. In that case, these excluded areas are potential territorial space for new entrants. Once new entrants occupy such excluded areas, spatial conguration will be reformed and certain space of incumbent rms may be lost by spatial competition against these additional rms. As a result, incumbent rms are necessary to consider a strategy whether they block new entrants or not. If the entry is blocked, new entrants cannot enter to the market. At the same time, the incumbent rms may lose certain revenue as a result of price reduction. By contrast, if the entry is allowed, they do not have to reduce price level but revenue will be lost to some extent by new entries of additional rms. For reasons of simplicity, this analysis assumes that such adjustment is taken place simultaneously therefore not sequential. Also, market areas are exclusively dominated and never overlapped. For further avenues of study, spatial competition and free-entry market system should be referred to Beckmann and Thisse (1986) and Eaton and Lipsey (1976, 1978, 1979, 1982). The following conditions are assumed in the model. First, there are three competing producers 1 , 2 and 3 , engaging in the nal processing and these nal products can be substitute to each other. Secondly, each market area is exclusively occupied by one of three producers and no overlapped area is observed. In addition, producers have identical technology and cost structure, employing input x for processing the product. Finally, in spatial terms, they have uniform density of demand and have constant unit transportation cost for shipping their products under the f.o.b. price setting. The structure of factor cost C(x) of the producer is expressed as a simplied form: C (x) = (w + ) x + b (1)

where w = unit input price, = assembly unit transportation cost and b = xed cost. The relevant production function q = f (x) is assumed to dene as: q = f (x) = 1 x A (0 A 1) (2)

where q = quantity of output and A (0 A 1) = an index of technical loss or friction during the processes. From these conditions, the total cost curve C(q) can be expressed by substituting (2) into (1): C (q) = A (w + ) q + b (3)

If these producers fulll the entire space under the condition that the regularly formed hexagonal conguration, the market-area formation can be illustrated as a set of regular hexagons without any empty space.

Spatial competition and consumer exclusion: social welfare Fig. 2 Market-area boundary B and FLD restriction

Fig. 3 The relationship between hexagon and circle

When there are enormously large market areas or are extremely high level of assembly transportation costs, each producer may have a constraint of the maximum distance for distribution or expressed more simply as feasible level of distribution (FLD). As illustrated in Fig. 2, each feasible market-area radius is reduced up to the level of FLD line, which is lower than the level of original market-area boundary B. In this circumstance, the alternative spatial formation can be a set of identical circles, which each market area is smaller than the original market-area conguration. As a result, there exists certain empty space and consumers who are locating those areas are unable to obtain the product therefore cause spatial consumer exclusion. Smith (1966) introduced the notion of spatial margins to protability (SMF) to optimal location analysis and this may have certain similarity with the FLD indicator. Since the SMF is applied to location decision-making of the producer and the FLD indicator to distribution of goods and services under given immobile location of the producer, both approaches have no relationship to each other. However, those may be incidentally similar concept. The empty area can be calculated, if the spatial conguration is regular shape of hexagon and circle, as shown in Fig. 3. Applying Pythagoras Theorem on the gure, the difference of areas between hexagonal and circular spatial congurations therefore the rate of consumer exclusion is shown as: 2 6 3 3 0.0931007 (4) Consumer exclusion = 6 3 This can be interpreted that approximately 9.3% of the area is unavailable to obtain goods and services under the situation of restricted distribution. The percentage of space fullled level becomes: 2 6 3 3 Space fullled level = 1 6 3 100 90.6899 (5)

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Under the analysis in Lsch (1954), such a problem cannot be considered, as a new entrant joins the market and entire space is always fullled with this process. However, this hypothesis is valid only if empty space is large enough to enter for new entrants.

3 New entry and incumbent reaction It is now shown that spatial competition may have possibilities to reduce or eliminate the area of consumer exclusion. The presence of unutilized area has an incentive for potential entrants joining the market. It is assumed that a potential entrant has the identical structure of factor cost and technology to the incumbent producers 1 , 2 and 3 . As indicated in the previous section, this potential entrant needs enough space to achieve certain level of economies of scale on his production. If this condition is satised and there is no entrance deterrent behavior by incumbent producers, the producer may enter to the market and entire space will have no empty area. In this way, spatial competition may contribute to reduce or eliminate the area of consumer exclusion. Moreover, this spatial reformation process provides economic activity more efcient, as each market area becomes smaller during the competition. This can be referred to Condition 4 in Lsch (1954:96), which states that smaller sizes of area, supply, production and sales are preferred for any economic activity. However, this is also an incentive for incumbent rms to block the entry of the potential entrant to the market, as the additional market entry reduces each size of market area and revenue level. According to this scenario, three incumbent producers have incentives to block the entry and this unable the economic system to solve the consumer exclusion problem. Hitherto, it is apparent that the additional market entry of producer reduces each market area of incumbent producers 1 , 2 and 3 . However, it should be noted that losses of each incumbent producer are less than the difference between potential maximum each incumbent market area and that of anticipated market area after the entry. This is due to the existence of the FLD. If the degree of FLD is higher, the amount of losses will be lower, as shown in Fig. 4. In other words, each incumbent producer loses revenue level by B B when there is no FLD restriction. By contrast, if each market area is remarkably small before entry due to high levels of input price, assembly transportation costs, technical friction or xed cost (i.e., at FLD in the gure), the losses of revenue will be solely the difference between FLD B , which is much lower than B B . As a result, the choice whether the incumbent producers permit or block the new entry depends on the extent of the degree of FLD. In this way, the FLD can be one of indices of improving
Fig. 4 Alternative market-area boundary B and FLD

Spatial competition and consumer exclusion: social welfare

the issue of consumer exclusion by the spatial competition behavior, dened as ICX, working with the market boundary B. ICX = B 100 FLD ICX > 100: Empty space and consumer exclusion may exist ICX 100: Space fullled and optimal state may be brought It is now apparent that the larger ICX causes more difculty for the reduction of consumer exclusion by means of spatial competition of producers. (6)

4 Spatial competition and consumers welfare Hitherto, the solution of the problem on consumer exclusion solely depend on the prot maximization behavior of the producer. However, it is also important to consider the consumers and producers surplus, in addition to the prot level of producers. As the approach is spatial framework, there faces certain difculties to employ the aggregate notion of supply and demand. In order to avoid this potential issue, the benchmark of welfare is assumed to measure with respect to each market area. This method is valid as long as all market areas have the identical conguration both in spatial and economic terms. Figure 5 shows the consumers and producers surplus, as commonly expressed in conventional economic theory. In the gure, the consumers surplus is a triangular area HIJ and producers surplus is the area GHI. The total surplus is dened as the sum of consumers and producers surplus, which is denoted as the area GIJ. The gure shows the case where the total surplus is maximized. Now this notion is applied to a case where the FLD is present. As illustrated in the gure, there are areas of dead-weight loss as the area MIN and unutilized loss as the area KMNL, if the presence of FLD restricts the output level from qS to qL . Moreover, in such a circumstance, both consumers and producers surplus are reduced by the area GMK and LNJ, respectively. As a result, total surplus is lost by the amount of the area GIJ (GMK + LNJ), which is equivalent to the area KMINL as the summation of deadweight loss as the area MIN and unutilized area KMNL. The gure also shows the aggregate effect of the market entry of the additional entrant, which has three separate effects in terms of cost and revenue. One is a change in the market-area boundary B, which is reduced by an increase in the number of
Fig. 5 Aggregate effect of the entry and surplus

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rms in the economic plane. Second is a change in the form of supply curve, which is increased due to the reduced opportunity of the economies of scale by additional market entry. Third is a change in the form of demand curve, which is reduced due to the reduction of individual market area by the additional entrant. The consumers and producers surplus can be measured with respect to one of market areas before market entry and after the entry of the additional producer. The feasible output levels before and after the market entry are shown as qL and qL , respectively. From the gure, it is apparent that the impact of market entry of the new entrant on the total surplus depends on the extent of changes in demand and supply curves after the entry. As a result, it may be concluded that incumbent rms should permit the entry, if (GMK + LNJ) < G I J from the standpoint of social-welfare maximization. As examined earlier, the permission of entry also brings a reduction or elimination of consumer exclusion, in addition to this increase of the total surplus. However, the entry is blocked unless LNJ < H I J , since the concern of the producer is solely whether producers surplus is increased or not. In such a situation, it is necessary to let incumbent producers permit the entry by means of external forces, such as subsidiary payments from the local authority, if the improvement of consumers surplus and reduction or elimination of the area of consumer exclusion is the initial priority of public policy. However, such policy should be taken under the well-evaluated environmental impacts of industrial development in unutilized area, since those locations tend to be commonly identied as potential natural protection areas.

5 An extension In the previous section, it is found that the possibility of a reduction in consumer exclusion by the additional market entry relies on the extent of changes in demand and supply curves. Since the hypothetical approach has a limitation to specify these attributes, it may need to employ the numeric examination, such as price and location conjectures in Mulligan and Fik (1994). Once the nature of these congurations is claried, the entry decision of the rm can be investigated by the application of more formal game representation. In addition, as these supply and demand curve changes also include a trade-off interaction between economies of scale and transportation costs, the analysis can also be extended to the framework of fragmentation of production which is investigated by Jones and Kierzkowski (2005). Since this notion involves the structure of vertical integration, it may be necessary to apply the analysis for internal activity within the rm in terms of single-plant and multi-plant operations. The location decision-making process is examined by means of principal-agent theory in Silva and Hewings (2007), taking into account of a relationship between the owner and manufacturing plant. While their approach focuses on the structure of ownership within the rm, the analysis in this paper deals with economic activity among unrelated rms. As a result, an application of the Stackelberg leadership game (von Stackelberg 1948) in the model framework with a spatial four-rm setting condition may be considered. However, it should be noted that these are solely investigating a particular single producer and this paper attempts to examine spatial

Spatial competition and consumer exclusion: social welfare

competition between different producers. As a result, it may be necessary to provide strict assumptions such as symmetrical technological changes of all producers and removal of location sunk-cost problem of individual producer. In this paper, the scope of the analysis is limited to the framework of simultaneous location adjustment in a particular case in order to clarify the methodological relationship between entree deterrence and social welfare in spatial terms. However, it should be reminded that there is another type of approach called sequential analysis. This can be referred to Lsch (1954). According to Lsch, the market area of rm is formed circular if there is no obstacle across the plane and also is no immediate neighbor competitor. However, if several competitors try to dominate market areas exclusively, each area will be narrower due to presence of territorial boundary. In this way, market-area conguration becomes regular hexagon or truncated circle. Although this paper will have no attempt of further extension, the reader should refer to representative existing literature such as Lsch (1954), Beckmann (1968) and Parr (1993).

6 Concluding comments In this paper, spatial formation process is detailed by focusing on medium-term economy, which is between short-run and long-run terms. During the examination, it is revealed that the presence of consumer exclusion is brought by operational decisions of the producer under certain spatially constrained circumstances in terms of costminimization behavior. While the area of consumer exclusion can be eliminated by spatial market competition, this relies on the expected producers surplus level regardless the presence of anticipated improvement in consumers surplus. As a result, external remedy for encouraging additional market entry is needed, if the reduction of consumer exclusion has a high priority in public policy. Regarding transportation costs, the existing new economic geography literature solely concerns with the assembly criterion. By contrast, it is indicated in this analysis that consumer exclusion is relevant to transportation costs of distribution in addition to the type of assembly. In particular, if the distribution costs are assumed to be f.o.b., this inclusion to the principal-agent framework may enable the analysis to specify more accurate plant location from both standpoints of cost and revenue perspectives. Although these aspects are beyond the scope of this analysis, it is worth exploring further possibilities of extension.
Acknowledgements This paper was completed under the funded projects of Ncleo Ciencia Regional y Polticas Pblicas (Iniciativa Cientco Milenio de MIDEPLAN) and Comisin Nacional de Investigacin Cientca y Tecnolgica (CONICYT) in Chile. The author wishes to thank anonymous referees for their helpful comments and suggestions on an earlier version of the paper. A preliminary version of this paper was presented at the 30th Annual Meeting of the Canadian Regional Science Association in May 2008 at Quebec, Canada.

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