Hotelling meets Holmes : the importance of returns to product differentiation and distribution economies for the firm's optimal location choice

Inspired by the empirical work of Holmes (2011), which suggests the economic importance of distribution costs in the firm's optimal location decision, this paper introduces endogenous distribution costs in the model of Hotelling (1929). The proposed model shows an interesting trade-off between demand and cost considerations when a firm 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 location of the firms are in the interior of the Hotelling line rather than at the edges of the line. The supply cost effect which drives this result diminishes with the distance of the distribution center from the market so that the scale of the distribution area becomes also determinant for an optimal location strategy. The theoretical results are complemented with an empirical analysis for distribution intensive grocery retailers using location data for the two main conventional supermarket chains in the U.S. The data suggest that the firms consider distribution costs when differentiating from the competitor