TESIS DOCTORAL Essays on Strategic Location Choices and Pricing Strategies in Oligopolistic Markets Autor: Anett Erdmann Directores: Jesús M. Carro Makoto Watanabe DEPARTAMENTO DE ECONOMÍA Getafe, junio de 2015 TESIS DOCTORAL ESSAYS ON STRATEGIC LOCATION CHOICES AND PRICING STRATEGIES IN OLIGOPOLISTIC MARKETS Autor: Anett Erdmann Director: Jesús M. Carro Codirector: Makoto Watanabe Firma del Tribunal Calificador: Firma Presidente: Vocal: Secretario: Calificación: Getafe, de de Dedicated to the memory of my mother, Eleonore. Declaration I, Anett Erdmann, conrm that the work presented in this thesis is my own. Where information has been derived from other sources, I conrm that this has been indi- cated in the thesis. Anett Erdmann Madrid, June 2015 Abstract The three chapters of this dissertation contribute to the understanding of strategic rm behavior in oligopolistic markets. In particular, I link spatial market features to standard competition analysis, which enables new perspectives to explain market outcomes in geographically dened markets and provide applications to the grocery retail industry. Chapter 1 studies the importance of returns to product dierentiation and distribu- tion economies for a rm’s optimal location choice. Inspired by the empirical work of Holmes (2011), I introduce endogenous distribution costs in the model of Hotelling (1929). The proposed model shows an interesting trade-o between demand and cost considerations when a rm plays a hybrid location strategy. Given the location of local distribution centers and agents’ displacement cost parameters, it is shown that, under certain conditions, the optimal locations of the rms are in the interior of the Hotelling line rather than at the edges of the line. The supply-cost eect which drives this result diminishes with the distance of the distribution center from the market so that the scale of the distribution area also becomes determinant for an optimal loca- tion strategy. Chapter 2 investigates empirically the eect of anticipated price competition and dis- tribution costs in rms’ location choices within an oligopolistic market. I set up a static location-price game of incomplete information in which retailers choose their locations based on (rm-)location-specic characteristics, the expected market power and the expected degree of price competition. In particular, I tie the rms’ strategic location incentives to the population distribution using the concept of captive con- sumers. This approach is in line with theoretical spatial price competition models and does not require price or quantity data. I address the computational diculties of the estimation using mathematical programming with equilibrium constraints. Ap- plied to grocery stores operated by the two main conventional supermarket chains in the US, the model conrms the existence of benets of spatial dierentiation for the rms’ prots and provides evidence that the rms anticipate price competition and distribution costs in their site selections. Chapter 3 studies empirically the volatility of retail price indexes at the store level 6 as a result of changes in the local market structure within an urban market. Us- ing a reduced-form pricing equation, I decompose the potential competition eect in the eect of incumbent retailers and the eect of new grocery store openings. Con- sidering the Spanish supermarket industry, which is strongly regulated, I make use of panel data and use a rst-dierence approach to estimate a distributed-lag model. The results suggest an instantaneous price reaction to entry which is smaller than the long-term competition eect. Possible explanations are constrained price-exibility for incumbent rms in the short run or diculties of the entrant in establishing them- selves as coequal rivals. I nd that this gradual price reaction is especially pronounced for supermarkets positioned in the middle price-segment, and the strongest price re- action has been found for high-price retailers. Contents 1 Hotelling meets Holmes 13 1.1 Introduction . 13 1.2 The linear city with distribution costs . 15 1.2.1 The model . 15 1.2.2 Equilibrium locations . 18 1.2.3 Robustness check: the eect of DCs on variable costs . 26 1.3 An application to the location of supermarkets . 27 1.3.1 Data . 28 1.3.2 Descriptive proximity analysis . 29 1.3.3 Empirical analysis of supply-distance eects . 32 1.4 Discussion: alternative applications of the model . 37 1.5 Conclusion . 39 1.A Appendix: Proofs and algebraic details . 40 1.B Appendix: Detailed explanation of the data . 42 2 The role of captive consumers in retailers’ location choices 44 2.1 Introduction . 44 2.2 Economic intuition . 47 2.3 An econometric spatial location-price game . 50 2.3.1 The model . 50 2.3.2 Maximum likelihood estimation approach . 55 2.4 Data description . 60 2.5 Estimation results . 65 2.6 Discussion . 69 2.6.1 On the role of captive consumers . 69 2.6.2 Comparison to other studies . 70 2.6.3 Limitations and further research . 72 2.7 Conclusion . 72 2.A Appendix: Toy model . 74 CONTENTS 8 2.B Appendix: Detailed calculations of variables . 76 2.B.1 Two rms with one store each . 76 2.B.2 Generalization to multistore rms using uniform pricing . 77 2.C Appendix: Considered Markets . 80 2.D Appendix: Knitro problem specication and outcome . 82 2.E Appendix: Bootstrap distribution . 84 2.F Appendix: Further robustness checks . 86 3 The price reaction of incumbent retailers 87 3.1 Introduction . 87 3.2 The grocery retail industry in Spain . 90 3.3 The data . 93 3.4 Descriptive statistics . 95 3.5 Estimation approach . 98 3.6 Limitations, robustness and further research . 104 3.7 Conclusion . 106 Bibliography 107 List of Tables 1.1 Summary statistics. 30 1.2 Regression results. 35 2.4.1 Descriptive statistics of observed location choice. 64 2.5.2 Estimation Results. 66 2.C.1 Discrete population distribution within the sample markets . 80 2.C.2 Market selection . 80 2.E.3 Bootstrap distribution . 85 2.F.4 Further robustness checks. 86 3.2.1 The grocery retail industry in the City of Madrid . 92 3.4.2 Market entry within the considered time period. 95 3.4.3 Summary statistics. 97 3.4.4 Price changes associated with market entry in period t . 98 3.5.5 FDDL regression on the price of a standard food basket. 102 3.5.6 Summary of estimated competition eects. 102 3.6.7 Competition estimates for dierent reference stores. 105 List of Figures 1.1 The linear city with distribution costs. 17 1.2 Distribution costs. 18 1.3 Best location response. 19 1.4 Market-DC and Non-Market-DC. 24 1.5 Optimal market location and social optimum (for rm A). 25 1.6 Distance distributions. 32 2.2.1 Stylized price setting under spatial dierentiation and xed trade ar- eas. 49 2.3.2 Discrete locations in a polynomial market. 50 2.3.3 Price competition and market power in space. 51 2.4.4 Data visualization for some sample markets. 62 2.A.1 The eect of an increase in captive consumers. 75 2.D.2 Knitro outcome (baseline model). 83 2.E.3 Bootstrap distribution (baseline model). 84 3.4.1 Changes in the market structure. 95 3.4.2 Tracked grocery stores. 96 Acknowledgements This doctoral thesis is the rst part of my journey to becoming a good economist in the eld of applied industrial organization, during which time I have been fortunate enough to meet many great people without whom this dissertation would not have been the same. Firstly, I would like to express my sincere gratitude to my advisors, Jesús Carro and Makoto Watanabe. I am grateful to Jesús for his continuous support over the last four years, including numerous discussions about econometric methodologies as well as guidance in structuring my thoughts, while allowing me the space to develop my own research line; equally, this would not have been possible without Makoto, whom I would like to especially thank for his advice and many instructive discussions about competitive strategies. Besides my advisors, I would like to thank the members of my internal thesis com- mittee, Tobias Kretschmer and Ulrich Wagner, for taking the time to read my work and for their excellent comments and questions, which have improved this thesis sig- nicantly. I would also take this opportunity to express my gratitude to all the members of the Economics Department. In particular, I am grateful to Marc Möller, Natalia Fabra and Matilde Machado for introducing me to a variety of interesting topics in industrial or- ganization, with special thanks to Matilde for her suggestions of several great papers which have formed the beginning of my growing interest in the empirical analysis of strategic rm behaviour, as well as her support since my undergraduate studies as Erasmus student. At this point, I would also like to thank all my fellow students, especially my friends and ocemates, Lovleen Kushwah, Olga Croitorov, Omar Rachedi, Maciej Opuchlik and Yunrong Li, who have been supportive in many ways, and my colleagues Pedro Sant’Anna, Mian Huang, Nikolas Tsakas, Xiajoun Song, Nora Wegner, Sebastian Pan- thoefer and Victor Emilio Troster, for our many discussions about research and the mutual support and fellowship. I do hope we keep in contact! Moreover, I am also grateful to people from outside UC3M, especially Guillermo Caru- ana, Ricardo Flores-Fillol, Luca Lambertini, Alex Perez, Helene Perrone and seminar LIST OF FIGURES 12 participants at the 1st and 2nd CREIP PhD Workshops on Industrial and Public Eco- nomics, the 10th CEPR/JIE School on Applied Industrial Organization, the ISTO/IFO Internal Research Seminar, the XXIX Jornadas de Economía Industrial, the SAEe Con- ference 2014, and the 2014 European Winter Meeting of the Econometric Society for their comments and suggestions.