Hotelling's law

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Not to be confused with Hotelling's rule.

Hotelling's law is an observation in economics that in many markets it is rational for producers to make their products as similar as possible. This is also referred to as the principle of minimum differentiation as well as Hotelling's "linear city model". The observation was made by Harold Hotelling (1895-1973) in an article 'Stability in Competition' in Economic Journal in 1929.

The opposing phenomenon is product differentiation, which is usually considered to be a business advantage if executed properly.

1 Example
2 Application
3 See also
4 References

[edit] Example

Suppose that there are two competing shops located along the length of a street running north and south. Each shop owner wants to locate his shop such that he maximises his own market share by drawing the largest number of customers. (In this example, the shop itself is the 'product' considered.) Customers are spread equally along the street. Suppose, finally, that each customer will always choose the nearest shop.

For a single shop, the optimal location is precisely halfway along the length of the street. The shop owner is indifferent about the location of the shop since it will draw all customers to it, by default. From the point of view of a social welfare function that tries to minimize the sum of square distances that people need to walk, the optimal point is halfway along the length of the street.

Hotelling's law predicts that a street with two shops will also find both shops right next to each other at the same halfway point. Each shop will serve half the market; one will draw customers from the north, the other all customers from the south.

Obviously, it would be more socially beneficial if the shops separated themselves and moved to one quarter of the way along the street from each end - each would still draw half of the customers (the northern or southern half) and the customers would enjoy a shorter travel distance. However, neither shop would be willing to do this independently, as it would then allow the other shop to relocate and capture more than half the market.

This phenomenon is present in many markets, particularly in those considered to be primarily commodities, and results in less variety for the consumer.

[edit] Application

Businesses in fact follow both product differentiation and Hotelling's law, as contrary as they may seem. Take for example JetBlue. The new startup airline markets itself as a revolutionary type of airline – cheaper airfare, nicer plane, better locations. As JetBlue tries to differentiate its product from its competitors, it also adopts similar flight schedules and similar service.

An extension of the principle into other environments of rational choice such as election "markets" can explain the common complaint that, for instance, the presidential candidates of the two American political parties are "practically the same". Once each candidate is confirmed during primaries, they are usually established within their own partisan camps. The remaining undecided electorate resides in the middle of the political spectrum, and there is a tendency for the candidates to "rush for the middle" in order to appeal to this crucial bloc. Like the paradigmatic example, the assumption is that people will choose the least distant option, (in this case, the distance is ideological) and that the most votes can be had by being directly in the center.