Zeal For Truth

An article in the Dallas Morning News (It shouldn’t take a road trip to shop) a few weeks ago caught my attention. Apparently, poor neighborhoods tend to have fewer grocery stores than expected.

It may not surprise you that grocers open few stores in low-income neighborhoods, but economic theory actually predicts the opposite.

Economic theory predicts that the typical low-income resident spends a lot less on luxuries like vacations, but not very much less on necessities like food. Everyone has to eat. And because there is no good substitute for food, low-income residents spend a higher fraction of their incomes on food than high-income residents do.

Economic theory suggests other reasons why grocery stores should thrive in low-income neighborhoods. Rents are lower, which means stores can save on costs by locating there, and there are few competitors nearby to steal away sales.

It seems that store owners are not behaving as economic theory would predict.

So Dr. Nathan Berg researched how companies decide to locate stores. You can read the full report here: Imitation in Location Choice (warning: previous link includes complicated math equations.) Berg goes into detail and works out the math, but the gist of it is this: there are two ways to decide where to locate a new store.

1. Perform expensive market research and calculate expected profits for each possible location, and pick the most profitable location.
2. See where other businesses are located, and open a store in the same neighborhood.

The second method is a lot cheaper, because you don’t have to pay for market research. You just assume that if a lot of other businesses are in the area, it’s probably a good location. The result is that businesses rarely locate in poor urban neighborhoods. There aren’t any businesses in those neighborhoods, so everybody avoids them because they assume it’s a bad location. When businesses buck the trend and move into these shunned neighborhoods, the results can be unexpeced profits.

Starbucks and Home Depot have earned profits far in excess of what their own demand forecast models predicted by investing in long overlooked, low-income neighborhoods previously regarded as unprofitable.

Potentially profitable neighborhoods being systematically ignored? What does it say about laissez faire capitalism when the market ignores potential profits? Clearly laissez faire capitalism does not result in a perfect marketplace. In the absence of perfect information, the market will never be perfectly efficient.

For example: if businessmen could always perfectly predict their profits, they would not pass up these opportunities. But in the absence of perfect information, businessmen must make decisions based on what they do know. Exhaustive market research is expensive. So decisions are made based on inexpensive heuristics–rules of thumb.

For example, according to one individual involved in location decisions for the German discount supermarket chain Lidl, its location decisions follow a simple rule of thumb: build a store wherever Aldi, Lidls primary competitor, has a location (Scheibene, 2007, personal communication).

So this raises the question: is laissez faire capitalism the best, most efficient way to run an economy? How long must poor urban neighborhoods go without easy access to grocery stores until the free market notices that poor people have to eat too?

I’m not arguing for a command economy. There doesn’t need to be a central authority regulating the location of grocery stores. But maybe there is a place for local governments, at the city and county level, to get involved in attracting grocery stores to poor urban neighborhoods. Keep in mind, this is not charity: these stores will be profitable and will not need to be subsidized. All the local governments need to do is provide the market research–and the success stories from business that have already made the plunge–about the profitability of these long-ignored neighborhoods.