“A stable competitive market never has more than three significant competitors, the largest of which has no more than four times the market share of the smallest,” BCG founder Bruce Henderson said in 1976.
Assuming the rule holds for connectivity businesses, it is the structure we should eventually see in the global telecom business, which was, until the latter 1980s, not subject to the rules. Formal monopoly businesses--by definition--have no competition.
But if asked to predict the eventual structure of the industry, at least for the tier-one suppliers selling at retail to consumers and businesses, the rule of three and rule of four would have made sense.
In my own work, I have found the rule of four more important than the rule of three, though both rules are related. The reason is that the rule of four essentially provided guidance about questions many had around 1995 when the U.S. fixed telecom market, for example, was being nearly fully deregulated, in terms of telecom competition.
In addition to questions about “who” would enter the market, “what” they would do, “how” they would compete, “when” the market would stabilize and “why” some attack vectors would be tried, many contestants would have wondered about the level of eventual success.
How well would attackers fare? What would be the eventual fate of the incumbents?
Business strategy in competitive markets largely free of regulatory constraints and major entry barriers tend to evolve towards a specific and stable market structure including the “rule of three” and the “rule of four,” Henderson argued.
The rule of three states that a stable market is led by three firms. The rule of four refers to the expected market share in a stable market, where leader market share is twice that of provider number two, and where the number-two supplier has share double that of the number-three provider.
That creates a stable market share structure of 4:2:1. It arguably is stable because there is little incentive for either number one or number two to disrupt the market by attacking to gain share.
The number two supplier--with half the share and revenue of the leader--never has the ability to beat the leader in a long price war. The leader, on the other hand, generally is the most profitable of the top-three firms and risks that level of profitability if it provokes a market share battle that reduces profit margins.
The leader might also trigger antitrust action were it to become significantly bigger.
There are both strategy and tactical implications flowing from the rule of three and rule of four.
If telecom deregulation produced large numbers of new competitors, a contestant shakeout would be nearly inevitable. Surviving firms would need to produce revenue and customer growth rates above market averages, as the number of suppliers shrinks.
The eventual losers would have increasingly large negative cash flows if they try to grow at all. Think about the experience of most competitive local exchange careers in the immediate aftermath of the Telecom Act of 1996 deregulation, the upstart digital subscriber line specialists of the same era, the legacy long distance providers, the bandwidth barons of international capacity, the fate of most independent mobile service providers from the earlier days of the mobile business or most independent cable TV providers.
In all those cases, growth proved too difficult--in large part--because it was too capital intensive for firms that were not making profits. Sustainable profitability would be difficult for any firms aside from the leading and number-two firms.
In competitive markets, share less than 30 percent of the relevant market--or at least half the share of the leader--would prove highly risky and likely unsustainable.
In most deregulating markets, and especially when technology enables new ways to create and deliver products, at different price points and production costs, moats or defensive boundaries separating industries and roles become porous. It no longer is so easy to determine “who are our competitors?”
The change in retail prices matters. Prices tend to fall in deregulating markets, and especially in those segments of the market where demand shifts rapidly. Voice, messaging and bandwidth costs are prime examples.
Though arguably not the case in competitive telecom environments, if prices do not change, competitor willingness to invest at rates higher than the sum of both physical market growth and the inflation rate will shift market share. That arguably has not been the case in the competitive telecom markets, as prices have continually fallen.
Over-investment then becomes a hazard. If everyone is willing to invest at rates higher than revenue growth, then prices and margins will be forced down by overcapacity until firms stop investing.
In a competitive market, the low-cost provider tends to win. But if the low-cost leader holds prices too high, that provider will lose market share until the firm is no longer the market share leader. In markets where the top two providers have nearly the same share, all the other contestants tend to lose share over time.
When the two top providers instead maintain higher prices, they both lose share to the other competitors. Market leaders can protect price at the risk of losing share. Paradoxically, when leaders cut prices, they hasten their dominance by creating the rule of three and rule of four market structures.
The faster the industry growth, the faster consolidation occurs.
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