Many markets in third-world countries have small stores selling exactly the same goods located side-by-side. In the Mid-East you can go to the gold souk, or the carpet souk. In the Far East you will see an entire street of hat shops, or bamboo-pole shops. My favorite street in Hanoi is full of shops that only sell gaffer-tape and scotch-tape. What is the economic mechanism that drives this clustering? Surely the pressure would be to price your goods lower than the next guy, thus driving down prices overall, to all of the shop-owners disbenefit?
Souks and bazaars are in appearance competitive market places. The close proximity of shops selling virtually identical goods should drive price down. So, why do shops locate close to each other instead of locations where they would have less competition?
An important reason is that central market places will attract many consumers. If stores were located in various areas of a town, it can take time for consumers to locate a shop that offers the specific goods they are looking for and to locate the shops that offer that good at the best price. In addition, consumers would have to go through multiple locations to purchase all the different goods they want. For consumers, going to a single market place saves on the costs of searching for products and discovering prices. Thus, shops located in central market places will see more traffic but the tradeoff is that they will face greater competition from similar shops nearby.
Are prices competitive in souks and bazaars? That is difficult to say because in many of these market places shops do not post prices. To learn about prices, a consumer must ask the merchant, who may give a different answer to different consumers. Finding the lowest price requires consumers to shop around and negotiate. Although shops face stiff competition from other nearby shops, they may be able to make profit from some consumers with little knowledge of prices and who are not willing to negotiate. This is especially true of tourists who are not familiar with the price of products and local customs.