Local Competition, Product Substitutability, and Prices: An Empirical Test

In markets where spatial competition is important, theory predicts increases in producer density (the number of producers per unit area in the local market) should lead to lower average prices. When producers are heterogeneous, this link exists for two reasons. First, the greater product substitutability in denser markets makes it more difficult for high-cost producers to profitably operate because customers can more easily switch to lower-cost producers. This leads to a greater selection of lower-cost producers in dense markets, as the cost distribution is truncated from above. Holding markups constant, this would imply lower prices in such markets. However, the second effect implies that optimal markets should fall in demand density. The greater substitution possibilities in dense markets make firms\92 residual demand curves more elastic. The combination of greater selection of low-cost producers and smaller markups imply that average (and maximum) prices should be lower in dense markets. I test and find support for these implications using data from U.S. ready-mixed concrete plants. Markets with (arguably exogenous) high demand density levels have lower average and maximum prices. I also show that these findings do not simply result from lower factor prices in dense markets, but rather because dense-market producers are low-cost because they are more efficient