Location Choice for a Small Business – Recognizing Market Structures and Their Implications for Firm Behavior

George Orlov (Cornell University) and Douglas McKee (Cornell University)
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Summary

Students will discuss the location choice of a small business and how this choice determines the market structures in which the business would have to operate. Students will discuss how a profit-maximizing firm would behave in each of the three locations and what would be the resulting outcome in terms of revenue and profits. The exercise aims at helping students recognize different market structures and connect simplified "real world" descriptions to theoretical models.

Context for Use

● The activity is appropriate for both Principles and Intermediate microeconomics.
● Students should have studied perfect competition, monopoly, and oligopoly prior to working on this exercise.
● This activity should be suitable for discussion in any class size.
● The activity will likely take around 20 to 25 minutes.

Overview

In this activity students will discuss the optimal placement of a small business. The goal of the activity is for students to recognize what type of a market each of the described locations represents. While students are often very capable of solving a profit optimization problem if they are explicitly told that Firm A is, a monopolist or a firm that participates in a perfectly competitive market, they balk at the task when faced with a description of the market without an explicit statement as to which type of a market structure they are dealing with. The exercise is designed to help them practice connecting simplified "real world" descriptions and theoretical models.

Students will discuss how a profit-maximizing firm would behave in each of the three locations and what would be the resulting outcome in terms of revenue and profits. This also helps emphasize that businesses with the same cost structure could behave very differently based on their environments.

Expected Student Learning Outcomes

In this exercise students will practice recognizing market structures based on (simplified) descriptions of "real-world" environments. Furthermore, they will solidify their understanding of the optimal behavior of the firm in each of the market structures.

On the "big picture" scale, this relates to the goal of students recognizing real-world situations where the models they learn are (and are not) appropriate. Students should be able to apply their new tool set to simple real-world questions and use it to argue for (or against) particular policies.

Information Given to Students

A small business investor wants to open a 24-hour convenience store which will carry essentials (toiletries, water, basic foodstuffs, etc.). The investor can choose to open the store in a downtown location, a midtown location, or a suburban location.
Downtown consists exclusively of hotels and corporate office buildings. Midtown has one large retailer (e.g., Safeway, Wegmans, or Wal-Mart) which is open from 6:00 am and until 10:00 pm. There are many apartment buildings. The suburb has many 24-hour convenience stores and residential housing.

Considering the investor will lease the property for the convenience store, which of the three locations would be the best option for the investor? Be explicit and careful about your assumptions.

You can ignore such aspects as the socio-economic status of the consumers in the chosen area. Furthermore, assume that crime rates do not play a part in the investors decision in this case.

A. Downtown
B. Midtown
C. Suburbs


Student Handout for "Location Choice for a Small Business – Recognizing Market Structures and Their Implications for Firm Behavior" (Microsoft Word 2007 (.docx) 16kB Sep16 19)

Teaching Notes and Tips

What prefatory remarks should set up the application exercise? – The statement "You can ignore such aspects as the socio-economic status of the consumers in the chosen area. Furthermore, assume that crime rates do not play a part in the investors decision in this case." Can be removed from the setup if you would like your students to think of how these factors might affect demand and the profitability of the business.

Does facilitating the teamwork require any special action? – No, beyond the usual circulation and making sure that the groups are actively discussing the problem at hand.

● The focus of the exercise should be on the firm's profits. In the Downtown the firm acts as a monopolist, being able to set higher prices. Its demand will be formed by the office workers and visitors to the town, residing in hotels. The firm will have non-zero profits. In the Suburbs the store will function as a part of a perfectly competitive market or, possibly, a monopolistically competitive market (the exercise is slated towards the former option though). In either case (Perfect Comp. or Monopolistic Comp.), economic profits will be zero. Midtown presents the interesting discussion point. It is an oligopolistic market, but one with a large entrant already in place. Residents of apartment buildings would provide a substantial demand, probably higher than the demand in Downtown, but there are two caveats. First, the market has to be shared with a larger store. Second, the larger store being the incumbent in a Stachelberg sense, will dictate the market quantity and prices (via quantity). Even though the convenience store gets to be a monopolist from 10:00 pm to 6:00 am, in a more-or-less realistic environment the store, likely, would not be able to vary prices based on the time of day (to be technical, this limitation by menu costs). Another point to consider is the potential differential in the two stores' cost structures. While it is not explicitly stated, students might arrive at an argument that the big grocery store is likely to have lower marginal costs than a small 24-hour convenience store. In this stylized environment, being an entrant with higher marginal costs will negatively affect the convenience store's profitability. Profits would therefore decrease going from option A to B to C.

● If the instructor wishes to engage in discussions of crime levels and socio-economic status, it would be suggested that the SES in both Downtown and the Suburbs will likely be higher than in the Midtown area. (Relevant) Crime rates would decrease going from Downtown to the Suburbs. In discussion of crime it is worthwhile to think of expected profits ("Suppose that with probability p the store is subject to a robbery/burglary resulting in a loss of revenue") and insurance costs which add to the semi-variable costs of operating the business.

● The main concepts for this exercise are: market power (price-setting behavior), monopoly, oligopoly, perfect competition, (monopolistic competition), revenue, marginal costs. Optional concepts include (but are not limited to): expected profits, insurance, income-based demand shifts (talking about SES).

What kinds of follow-up questions are recommended for facilitating the debriefing conversation among team reporters? In particular, how might the instructor get teams to evaluate which answer is the best, provide the analytical support for the team answers, identify what information would enable an economist to decide between alternative answers? - Have the students think through the amount of economic profit that the investor would be able to receive in each of the locations. Specifically, it is worthwhile to think about the demand side and how much control over the price of the goods would the store have in each location.

What points should be emphasized in the instructor's summary remarks to conclude the exercise? - It would be worthwhile to bring up that location decisions are very complex and have many dimensions to them. Depending on the course, this could segue into discussing strategic location choice with multiple firms, such as in the Hotelling model

Assessment

Consider setting up a question where an entity acts as an oligopolist or a monopolist and contrast it with cases where there are lots of firms (with differentiated or non-differentiated products, in case you do not cover monopolistic competition). Do not explicitly identify the market structures, but have the students figure out what they are.

References and Resources

N/A