A.15 – Market Area Analysis

Author: Dr. Jean-Paul Rodrigue

Concepts and methods in the analysis of market areas such as market size and level of competition.

1. Market Size and Shape

Each economic activity has a location, but the various demands (raw materials, labor, parts, services, etc.) and flows each location generates also have a spatial dimension called a market area.

A market area is a surface over which a demand or supply offered at a specific location is expressed. For a factory, it includes the areas where its products are shipped; for a retail store, it is the tributary area from which it draws its customers.

Transportation is particularly important in market area analysis because it impacts the location of economic activities as well as their accessibility. The size of a market area is a function of its threshold and range:

  • Market threshold. Minimum demand necessary to support an economic activity such as a service. Since each demand has a distinct location, a threshold has a direct spatial dimension. The size of a market has a direct relationship with its threshold.
  • Market range. The maximum distance each unit of demand is willing to travel to reach a service or the maximum distance a product can be shipped to a customer. The range is a function of transport costs, time, or convenience in view of intervening opportunities. To be profitable, a market must have a range higher than its threshold.

In the case of a single market area, its shape in an isotropic plain is a simple concentric circle having the market range as the radius. Since the purpose of commercial activities is to service all the available demand, when possible, and the range of many activities is limited, more than one location is required to service an area. For such a purpose, a hexagonal-shaped structure of market areas represents the optimal market shape under a condition of isotropy. This shape can be modified by non-isotropic conditions, mainly related to variations in density and accessibility.

Market Threshold and Range
Market Size and Threshold
Market Profitability
The Optimal Shape of a Market Area
Non-Isotropic Conditions and the Shape of Market Areas

2. Economic Definition of a Market Area

A market depends on the relationships between supply and demand. It acts as a price-fixing mechanism for goods and services. Demand is the quantity of a good or service that consumers are willing to buy at a given price. It is high if the price of a commodity is low in relation to its usefulness, while in the opposite situation – a high price – demand is low. Outside market price, demand can generally be influenced by the following factors:

  • Utility. While goods and services that are necessities (such as food) do not see much fluctuation in demand, the demand for items deemed of lesser utility (even frivolous) would vary according to income and economic cycles. There are important differences between discretionary and non-discretionary spending.
  • Income level. Income, especially disposable income, is directly proportional to consumption. A population with a high-income level has much more purchasing power than a population with a low income.
  • Inflation. Involves an increase in the money supply in relation to the availability of assets, commodities, goods, and services. Although it directly influences prices, inflation is outside the supply-demand relationship and decreases the purchasing power, if wages do not increase accordingly.
  • Taxation. Sale and value-added taxes can have an inhibiting effect on the sales of goods and services as they add to the production costs and claim a share of consumers’ income.
  • Savings. The quantity of capital available in savings can provide the potential to acquire consumption goods. Also, people may restrain from consuming if saving is a priority, namely in periods of economic hardship. The wide availability of credit in a fiat currency system has considerably skewed the relationships between savings and consumption as it promotes current consumption levels at the expense of future consumption.
Supply, Demand and Equilibrium Price
Delimitation and Variations in Market Areas

Supply is the number of goods or services that firms or individuals are able to produce, taking into account of a selling price. Outside price, supply can generally be influenced by the following factors:

  • Profits. Even if the sales of a product are limited, if profits are high, an activity providing goods or services may be satisfied with this situation. This is particularly the case for luxury goods. If profits are low, an activity can cease, thus lowering the supply.
  • Competition. Competition is one of the most important mechanisms for establishing prices. Where competition is absent (an oligopoly), or where there is too much (over-competition), prices artificially influence supply and demand.

According to the market principle, supply and demand are determined by the price, which is an equilibrium between both. It is often called the equilibrium price or market price. This price is a compromise between the desire of firms to sell their goods and services at the highest price possible and the desire of consumers to buy goods and services at the lowest possible price.

For many economists, the market is a point where goods and services are exchanged and do not have a specific location since it is simply an abstraction of the relationships between supply and demand. It is important to underline that since most of the time consumers must move in order to acquire a good or receive a service. The producer must also ship a commodity to a location where the consumer can buy it; a store or a residence (in the case of online shopping). The concept of distance must thus be considered concomitantly with the concept of the market. In those conditions, the real price includes the market price plus the transport price from the market to the location of final consumption.

3. Competition over Market Areas

Competition involves similar activities trying to attract customers from a similar pool. Although the core foundation of competition for a comparable good or service is the price, there are several spatial strategies that impact the price element. The two most common are:

  • Market coverage. Activities offering the same service will occupy locations in view of offering goods or services to the whole area. This aspect is well explained by the central place theory and applies for sectors where spatial market saturation is a growth strategy (convenience stores, fast food, coffee shops, etc.). The range of each location is a function of customer density, income distribution, transport costs, and the location of other competitors.
  • Range expansion. Existing locations try to expand their ranges in order to attract more customers. Economies of scale resulting in larger retail activities are a trend in that direction, namely the emergence of shopping malls. Taken individually, each store would have a limited range. However, as a group, they tend to attract additional customers from wider ranges. First, a complementarity of goods or services is offered. A customer would thus find it convenient to be able to buy clothes, shoes, and personal care products at the same location. Second, a diversity of similar goods or services is offered (more choice) even if they compete with one another. Third, other related amenities are provided, such as safety, food, indoor walking space, entertainment, and parking space.

Developing operational market area models has been the object of numerous approaches. Initial work undertaken in the first half of the 20th century focused on simple market competition (Hotelling’s law), which was the foundation of market area analysis by considering factors such as retail location and distance decay. Later, factors such as market size were taken into consideration (Reilly’s law), permitting to build complex market area representations. Since market areas are often non-monopolistic and subject to customer preferences, this factor was included with market areas becoming ranges of probabilities that customers will attend specific locations (Huff’s law). Although market areas are particularly relevant for retail analysis, the methodology also applies to time-dependent activities, such as freight distribution, since distribution centers are located to service specific national or regional markets.

Conventional Distance Decay Curves for Retail Activities
Hotelling’s Principle of Market Competition
Reillys’ Law
Huff’s Law
Optimal Location and Throughput by Number of Freight Distribution Centers

The emergence of e-commerce has substantially modified competition over market areas through a substitution from a retail distance decay function to parcel distribution capabilities. Market accessibility remains fundamental, but how this market is serviced changes. When customers travel to a store, proximity to population clusters is fundamental. Market areas are structured by the combination of mobility options available, such as walking, public transit, and the automobile. When parcels are delivered, proximity to distribution capabilities becomes the most important factor. Passenger mobility ceases to be a relevant factor, while freight mobility becomes the main impedance factor related to delivery time.

4. Geographic Information Systems and Market Areas Analysis

Geographic Information Systems (GIS) have become fundamental tools for evaluating market areas, especially in retailing. With basic data, such as a list of customers and their addresses (or ZIP codes), it is relatively simple to evaluate market areas with reasonable accuracy. This task would have been much more complex beforehand. With GIS, market area analysis left the realm of abstraction to become a practical tool used by retailers and service providers in complex real-world situations. In the spatial representation of a GIS, the market area is a polygon that can be measured and used to perform operations such as intersection (zones of spatial competition) or union (area serviced). Among the major methods a GIS can be used to evaluate market areas are:

  • Concentric circles. The simplest method since it assumes an isotropic effect of distance in all directions. The radius represents the maximum distance a customer is willing to travel. It is useful to have a rough overview of the situation when limited information is available.
  • Share by polygon. When data is available at the zonal level, such as the ZIP code, the market area can be expressed as a market share for each zone.
  • Star map. Composed of straight lines between each customer and location. It thus requires information and the location of each customer. It indicates the extent and the shape of the market area and is particularly relevant for distribution systems where relationships between distribution centers and their customers are shown.
  • Spatial smoothing. A trend surface based on the location of actual customers. The higher the density of customers (the importance of each customer can be weighted), the higher the membership to a market area.
  • Transport distance. Particularly useful for retailing or any activity that depends upon consumer accessibility or timed deliveries. A measure of transport distance, often driving time in minutes, is calculated on-road segments radiating from the facility location. Under such circumstances, the market area is a direct function of the efficiency, connectivity, and accessibility of the local transport systems.
  • Manual polygon. Based on the local knowledge, common sense, and judgment. It may implicitly consider other methods.
GIS Methods to Estimate Market Areas

Related Topics

Bibliography

  • Holmes, T.J. (2006) “The Diffusion of Wal-Mart and Economies of Density”, University of Minnesota, Department of Economics.
  • Hotelling, H. (1929) “Stability in Competition”, The Economic Journal, Vol. 39, No. 153, pp. 41-57.
  • Huff, D.L. (1973) “The Delineation of a National System of Planning Regions on the Basis of Urban Spheres of Influence”, Regional Studies, Vol. 7, No. 3, pp. 323–329.
  • Isard, W. (1956) Location and Space-Economy: a general theory relating to industrial location, market areas, land use, trade, and urban structure, Cambridge: MIT Press.
  • Marshall, J.U. (1989) The structure of urban systems, Toronto: University of Toronto Press.