Saturday, May 7, 2011

Why Does This Happen? Small Business Clustering in Indonesia

Tire vendors as far as the eye can see! Scenes like the one to the left are common here in Indonesia; when you come here you'll likely encounter agglomerations of merchants offering the same good or service. This include rubber stamp makers, license plate makers, sunglasses salesmen, florists, furniture makers, and others. At first glance it might doubt the logic of 15 nearly identical keymakers setting up shop next to one another; surely there can't be enough demand on a daily basis to support them all. And why would someone set up shop right next to 14 other guys doing the same thing? Doesn't it make sense to start your business someplace else to draw customers from a different location rather than join in the apparently vicious competition? Well, like most things in life, there's more here than meets the eye, and a basic understanding of some simple geographic principles helps us make sense of it all.

Historically there are a lot of examples of like professions being grouped into certain districts. Sometimes this has more to do with regulation than anything else. For instance, in the royal cities of Java professions such as gamelan manufacturers were all located on a particular street. Other places, like New York City's Garment District, gradually became centers because different types of businesses in the same industry (weavers and tailors, for instance) clustered together to minimize transport and other costs. But neither of these explanations seems to help with the keymakers and tire sellers. But there are other possible explanations!

One possibility was predicted by economist Harold Hotelling in 1929 (Hotelling’s Model). Hotelling asks us to imagine a beach filled with thousands of people (which shouldn’t be too hard in Hawaii). An enterprising businessman decides to open an ice cream stand somewhere on the beach. Where do you think his stand is most likely located? If you answered “it the middle”, you’re correct. Now, due to the success of our ice-cream vendor, someone else gets the bright idea to open another ice cream shop to compete. Where do you think our new competitor is most likely to set up shop? Take a look at the diagram below and think for a minute.

According to Hotelling (and according to our common sense), the new vendor will build his stall right next to the existing stall! The reason for this is because he/she can grab half the market from the first competitor (we're assuming, of course, that the buyers only think about how far they have to walk). If an additional competitor were to set up shop, he/she also would tend towards the center (see the diagram below). This might be one way to explain the concentration of tire vendors, key makers, etc. But I suspect that there are other factors at work here. To shed some light on this curious phenomenon, I set out on an adventure of discovery.

My first stop was a long line of 10-15 keymaker’s stalls on Jalan Demangan. Here there wasn’t really any difference between the various products and there didn’t seem to be much pressure to attract customers. After buying a key (rp 5000) to break the ice, I talked with the keymaker.

“Why are there so many keymakers here?” I asked.

“Because this is the key place”, he answered.

“Yeah but why is this the key place?” I prodded.

“Because all the keymakers are here”, he responded.

After this round of circular logic was completed we got down to business. There isn’t a whole lot of cooperation between the keymakers, but apparently there is some. He said he sells around 20 keys a day, which, at 5000 rupiah per key, is somewhere around $13, enough to pay for life’s necessities. He told me all the keymakers are pretty much the same and that he mainly gets customers through repeat business or word of mouth.

Another explanation is that the various vendors are related somehow. It might be that a parent sets his children up in the same business. So next stop was the fruit stand where I do my buah shopping. Although there are several stalls in a row, they are all owned by people from the same family, and so there is a good bit of cooperation here. I saw a variation on this theme on “tire alley”. Some are relations. Others come from villages far away. The way this works is that a “pioneer” opens up a shop, has success, and sends word back to the village, and is soon followed by others who set up their own shops. There are also a couple of different dynamics at work amongst the 20-30 vendors here. The tire salesmen cooperate with one another as well; they even have an association responsible for keeping the area clean and resolving disputes. There was also a high degree of differentiation in terms of products offered as well as equipment used.

The flower vendors told me they had traditionally all been grouped together, but they came to their current location after being displaced from their original spot downtown, which the government turned into a parking area. They were given their new area as compensation. Here again there seemed to be some cooperation as well as family connections among vendors. The furniture guys cooperate the most (based on my short interviews). This is because they are all from the same area in Bantul, a district outside the city limits. I asked them the same question I asked the others: “What if a hotel managers comes and wants to buy 100 cabinets (keys, flower arrangements, etc)….Do you share the work with your neighbors or do you do it all yourself?” Though all the others responded that they would probably fill the order themselves, the furniture guys said they would share the order.

Keith's Rule...

Another reason for clustering is that groups of small businesses together seem, to the rest of the economic “system”, as one large business. This might help them draw customers from further away. Thus their range increases but their profitability threshold remains low (1). Think about how car dealers tend to cluster together. Customers know that they can see a lot of cars without having to go all over town. To illustrate this, I invented a little model. If we imagine the world as a flat isotropic plane (2) with an even distribution of population we can represent the market area as a circle. As we know, the area of a circle is the radius of the circle times the square of Pi. Now for the purposes of my model I've substituted the business threshold for the area. That way I can solve for the radius of the circle, which gives me my hypothetical range. Each additional shop increases the threshold, but it also increases the range. In the table below you can see how it works. The marginal range is simply the additional market radius required to support an additional vendor.

Number of Shops
Marginal Range

This is a pretty interesting result. As you can see from the table above, as the number of shops gets bigger, the marginal range gets smaller. That means that the market radius required to support each new shop actually decreases! Eventually this will tend asymptotically towards 0, which means that you can keep adding shops forever without hurting the market (3)! Of course, the real world doesn't work this you get further away from the center of the city the population density decreases, and we can't really assume that the market doesn't get saturated at some point. But this does show us that business clustering isn't necessarily a bad thing.

Anyway, back to the story. When I talked to the sunglasses vendor he told me that there isn't much cooperation between the different vendors, but they all cluster together for the reason I just explained. Thus there's a symbiotic relationship even if there is no cooperation.

This also presents the opportunity to think about the nature of competition. All the key makers were the same; they have pretty much a standard service and inventory that they offer, and there isn't any difference between them. This would be similar (4) to what economic geographers refer to as “perfect competition”. In perfect competition there is no product differentiation. This means that the good or service sold by one vendor is no different from those sold by all the other vendors. In addition, there are no barriers to entry in the market place (anyone can start a business) and there is easy entry and exit from the market. The tire guys at first glance looked like perfect competition as well, but when I started talking to them I realized that there are a lot of differences between them, and they try to find niches by offering different products. There is also significant variability in the tools they use; some have state of the art equipment while others use older equipment. This is closer to monopolistic competition. Look for a future post describing these concepts in deeper detail.

Anyway, I had a great time biking around town talking to folks. They were universally friendly and more than willing to talk. I also wanted to know if the success of the business depends on the location in the line of stalls, but I forgot to ask. But all in all, this was a pretty neat opportunity to apply some theories and ideas from economic geography.

(1) Threshold and range are terms from Walter Christaller’s Central Place Theory. Threshold refers to the minimum market population or income required to support a particular distance. Range is the maximum distance customers are willing to travel to buy something. Can you think of some types of businesses that have short ranges? What about long ranges? What kind of business has a low threshold? A high threshold? Are there any obvious connections between these two concepts? (Diagram courtesy of Dr. Jean-Paul Rodrique, Department of Geography, Hofstra University).

(2) An isotropic plane is pretty much just a flat surface with no variations. Isotropic planes are one of the favorite tricks of geographers in making simple models. Remember that models are merely representations of reality, and they vary in detail. This is a very simple model, much like Von Thunen's market rent model.

(3) My calculus is really rusty, but I think a way to represent this is the following (I hope this is right because it took me 20 minutes to figure out how to use the equation tool in Word:

(4) Instances of perfect competition are rare. A closer example here might be the becaks I described in a previous post. Can you think of an example of perfect competition in Hawai’i? What about examples of monopolistic competition or oligarchy?


Mahalo Nui Loa to Dr. Matt McGranaghan, Department of Geography, University of Hawai'i, and Dr. Gary Fuller, Professor Emeritus, Department of Geography, University of Hawai'i.


  1. Is the business clustering only possible in areas like this where rent is cheap(assumption), or does it exist in every market?

  2. I'm not sure how much the cheap rent has to do with it. There are instances of business clustering in places like NYC, where you find the garment district and lots of jewelers in the same place. I would imagine the rent it pretty high there.