Must Watch & Must Read- Walmart & The Economics of Density

Economics of Density can be a solid competitive advantage for geographically impacted businesses like retail stores, restaurants and other local businesses. The core idea behind Economics of Density is that economies of scale in supply chain, marketing & management support are best achieved in tight geographic circles. Its easier said than done because its very hard for businesses to stay focused and expand in a disciplined way. 

Take a look at a really great video about Walmart’s expansion strategy. Notice how they expand in concentric circles.

Thomas Holmes, a professor of economics at the University of Minnesota, talks about the Economics of Densityhere

Key excerpt of the interview:

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fedgazette: Let’s begin with a description of the economics of density. How should readers understand the term, especially in light of your work on Wal-Mart?

Holmes: Briefly, Wal-Mart has an incentive to keep its stores close to each other so it can economize on shipping. For example, to make this simple, just think about a delivery truck: If Wal-Mart stores are relatively close together, one truck can make numerous shipments; however, if the stores are spread out, you wouldn’t have that benefit. So, I think that the main thing Wal-Mart is getting by having a dense network of stores is to facilitate the logistics of deliveries.

There are other benefits, too. Opening new stores near existing stores makes it easier to transfer experienced managers and other personnel to the new stores. The company routinely emphasizes the importance of instilling in its workers the “Wal-Mart culture.” It would be hard to do this from scratch, opening up a new store 500 miles from any existing stores.

fedgazette: This idea leads to another term at the core of your paper, “diffusion path,” which I understand to be a description, in this case, of a store’s location choices. Please describe Wal-Mart’s diffusion path.

Holmes: This is an important point. Wal-Mart started with its first store near Bentonville, Ark., in 1962. The diffusion of store openings radiating out from this point was very gradual. And this diffusion didn’t just occur in one direction, but spread out in all directions, with the same measured deliberation. Imagine a slowly blooming flower, or a pebble dropped in a pond, with the waves moving across the water in slow motion. It is very helpful to view a movie [WMV file] of the entire year-by-year diffusion path.

fedgazette: You observe in your paper that Wal-Mart chooses lower-quality sites over more optimal ones. This seems counterintuitive: Why would Wal-Mart engage in such a strategy?

Holmes: Lower-quality is a funny term, and we have to be careful about how we’re using those words. If Wal-Mart looks at the whole United States, there are naturally going to be some places that look more attractive than others. We have to take into account that all potential locations are not born equal. Now, if we would rank those sites, what would be the chance that all of the best ones would be in Arkansas or in Missouri, which is where Wal-Mart initially put all its stores? Not very likely.

For the sake of this discussion, let’s say that Wal-Mart’s most desirable location, or “sweet spot,” when it was starting its business was a town the size of 20,000. One strategy Wal-Mart could have pursued would have been to go around the country opening stores in its sweet spot locations and then later go back and “fill in” less desirable locations. With this alternate strategy, the first store in Minnesota would have opened a lot sooner than it actually did, as there certainly are locations in Minnesota right in Wal-Mart’s sweet spot. But with this strategy, stores would initially have been much more spread out. Wal-Mart would have lost the gains from having a dense network of stores.

Instead, Wal-Mart waited to get to the plum locations until it could build out its store network to reach them. It never gave up on density.

fedgazette: And when you see what it’s done, with the benefit of hindsight, it seems like the right thing to do, almost the obvious thing to do. But that would suggest that other retailers would have also recognized the benefits of density and should have engaged in the same behavior. Did Wal-Mart invent, if you will, this retailing idea?

Holmes: It is useful to contrast Wal-Mart with Kmart, as both opened their first stores in 1962. Wal-Mart, from the very beginning, was different from Kmart. Wal-Mart built up its store network gradually from the center out; Kmart (and Target, for that matter) began by scattering stores all over the country. Early on, Wal-Mart focused on logistics, with things like daily deliveries from its distribution centers, early adoption of advanced communication technology and so forth. Kmart did not do these things. A customer going into these two stores might not be able to see much ofa difference between the two stores. But underneath, in the way that merchandise was getting on the shelves, these stores were very different.

But to get to your question: I don’t think that Wal-Mart’s logistics strategy was appreciated at the time. Its model, now being replicated by others, was a new model.

fedgazette: It would seem that Wal-Mart was confident enough in its retailing product that it wasn’t concerned about being late into a particular market; that is, it stuck to its density strategy without leapfrogging to a new sweet spot, even if that sweet spot may have been threatened by a competitor. Is that an accurate assessment?

Holmes: That’s almost the way it seems. It knew it had a good product and strategy and perhaps didn’t worry too much about other players. But I think it’s a bit of an open question about how much Wal-Mart may have been partially preempted in some markets. For example, it may have been a little late getting into Minnesota and the Ninth District more generally, as Target has filled in the area, leaving less room for Wal-Mart. The median person in our district is 6.3 miles to a Wal-Mart, the largest distance across all districts, with the exception of the New York district. Contrast this with the Dallas district, where the median person is only three miles to a Wal-Mart.Of course, the median distance of 6.3 miles here still represents a significant amount ofpenetration on Wal-Mart’s part.

It may have been that by waiting to get to Minnesota until it was able to build up its network to reach it, Wal-Mart gave Target time to preemptively build up its network here. The key thing to note, however, is that if Wal-Mart had done something different—if it had jumped ahead to Minnesota before it had built out its network—it wouldn’t have been Wal-Mart. It would have been undercutting the strategy that made it successful in the first place.

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