How Do Markets Get to Stable Rule of Three, Rule of Four Shape?

“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. 

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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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Still, few mobile markets have the stable 4:2:1 market structure. Until recently, many observers would have argued that the U.S. mobile market was a structural duopoly. It is possible that will change in the wake of the T-Mobile merger with Sprint.

Stable, Competitive Markets Have a 4:2:1 Structure

Bruce Henderson, founder of the Boston Consulting Group is credited with a couple of foundational ideas about business, including the notion of the experience curve, which explains how the cost of products decreases with volume.

“Costs characteristically decline by 20 percent to 30 percent in real terms each time accumulated experience doubles," Henderson posited in 1968.

Among the ideas some may deem most important relates to market structure under conditions of competition.

"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,” Henderson argued.

Sometimes known as “the rule of three,”  he argued that stable and competitive industries will have no more than three significant competitors, with market share ratios around 4:2:1.

There are important implications. We may decry “bigness.” We may prefer that a plethora of firms exist. But the rule of three suggests a robustly competitive market will, over time, assume a stable form where three firms dominate, with market shares have a specific structure.

To wit, the leader will have market share double that of company number two, while company number two has twice the market share of the third firm. Empirical studies tend to confirm the pattern.

In most markets, argue Bain consultants, two firms have 80 percent of the profit. In other words, market share also often is a proxy for profitability. “On average, 80 percent of the economic profit pool was concentrated in the hands of just one or two players in each market,” say Bain and Company consultants. In other words, it really matters if a firm is number three in any market.

That virtually perfectly corresponds to a market share pattern of 4:2:1, as the number-three provider tends to have less than 10 percent share, in that pattern.  

One sees this pattern in some telecom markets. Looking at market share and return on invested capital for the three largest telecom providers in Thailand, China, and Indonesia since 2015, you can see that financial return and market share tend to be directly related.

The real-world structure does not precisely match the rule of three prediction, of course, with Thailand having the almost-perfect correspondence between predicted results and actual results.

In many other markets, two observations are apt: where the 4:2:1 pattern does not exist, markets either are not competitive, or not stable, or both. And though we might be tempted to think such patterns exist mostly for capital-intensive industries, the pattern seems to hold in most industries.  

Source: Reperio Capital

My rule of thumb incorporating the “rule of three” is that the leader has twice the share of number two, which in turn has twice the share of provider number three. In Thailand, China and Indonesia, the general pattern holds.

In Thailand the pattern holds well. The leader has 53 percent share, number two has 31 percent and number three has 17 percent share.

Applying the rule of three in consumer telecom markets is complicated, however, since the “markets” include segments such as video entertainment, internet access, voice and mobility where specific players have distinct market share profiles.

The broad conclusion is that telecom markets are not yet stable.  

Myanmar to Test "Rule of Three"

That mobile and fixed network communications industries structurally are oligopolies might irritate many, but has proven to be an enduring foundation of communications industry dynamics globally, since the great wave of privatizations and competition began in the 1980s.

Some might argue that stable oligopolies are possible somewhere between two and four providers, with many arguing three strong contestants is the optimal sustainable outcome. That four or more providers exist in many markets is considered by many a “problem” in that regard, generally called the rule of three.

Most big markets eventually take a rather stable shape where a few firms at the top are difficult to dislodge.

Some call that the rule of three or four. Others think telecom markets could be stable, long term, with just three leading providers. The reasons are very simple.

In most cases, an industry structure becomes stable when three firms dominate a market, and when the market share pattern reaches a ratio of approximately 4:2:1.

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, according to the rule of three.

In other words, the market share of each contestant is half that of the next-largest provider, according to Bruce Henderson, founder of the Boston Consulting Group (BCG).

Those ratios also have been seen in a wide variety of industries tracked by the Marketing Science Institute and Profit Impact of Market Strategies (PIMS) database.

Myanmar aims to test the thesis.

Myanmar has formally invited proposals from local public companies to create a fourth mobile operator, in partnership with a foreign company. Myanmar also is planning to auction off additional spectrum.

The Rule of Three applies wherever competitive market forces are allowed to determine market structure with only minor regulatory and technological impediments. But there are some circumstances where market structure does not take that stable “rule of three” shape.

Regulatory policies hinder market consolidation or allow for the existence of “natural” monopolies.

Also, in some cases, major barriers to trade and foreign ownership of assets can have the same effect.

We shall see what happens, long term, in Myanmar. In other instances, four has proven to create an  unstable market. But instability can last for long periods of time, so the outcome cannot be predicted, yet.

In July 2015, Telenor had grown its subscribers to more than 10 million, while Ooredoo reported  3.3 million at the end of April, 2015.

Myanmar also is allocate more sub-1-GHz spectrum in the 700 MHz, 850 MHz, and 900 MHz bands.

As you would guess, as mobile adoption--especially of smartphones--grows, new demand will be created for subsea bandwidth to Myanmar.

As of the end of the first quarter of this year, mobile penetration in Myanmar stood at 25 percent,  up from less than 19 percent at the end of 2014.  

In a significant development, half of people buying a mobile phone buy a data plan, while 70 percent of all the phones sold are smartphones.

Myanmar  has about 30 Gbps of international bandwidth, with Telenor and Ooredo adding another 10 Gbps, and another order of magnitude to come over several years.

There are currently 3,000 mobile towers, but the country needs 15,000 to 20,000, and 25,000 km more transport facilities.

What AI Market Structure Will Emerge?

In what sorts of markets does rapid market share growth really matter for the long term? In what markets is it possible to shift share positions once markets are mature? When should firms focus on specialties and niches? When is an aggressive growth strategy called for, and when is it ill advised?  

When and why should leaders shift to profitability rather than growth, in growth markets? When will business leaders reach the limits of their growth strategies and have to consider becoming asset sellers?

The "Rule of Three" is a concept in business strategy originally introduced by the Boston Consulting Group that might inform business leader decisions of these types. 

The rule suggests that in mature, competitive markets where there are barriers to entry; economies of scale or are capital intensive, three companies tend to dominate, with the largest player holding 40-50 percent of the market, the second-largest holding 20-30 percent, and the third-largest holding 10-20 percent market share.

The concept is useful for strategists and market researchers as it suggests reasonable strategy possibilities, such as whether it makes sense to undertake disruptive actions to gain share, and if so, what rational possibilities for gains could occur. 

The other corollary is that profitability also tends, in such markets, to correspond to market share. 

So the rule suggests the importance, in capital intensive industries, of taking advantage of barriers to entry; economies of scale and industry segment leadership, especially when young industries are emerging. 

Hence the importance of rapid growth and share gains in software, some types of hardware, connectivity services, commercial aircraft manufacturing, search or cloud computing,  for example. 

Such Rule of Three markets generally are not susceptible to disruptive attacks, once the pattern is set. If one assumes market share is roughly correlated with profitability, then the market leader will have twice the profitability of provider number two, which in turn will have twice the profitability of provider number three. 

A 40-20-10 pattern could hold, with the balance held by numerous other specialty firms. That advantage in profitability contributes to all other efforts to maintain market leadership on the part of the leader, and also limits the possible range of actions by providers two and three to compete. 

Pricing attacks might generally fail for the simple reason that the market leader can simply match any price reductions attempted by the smaller providers. A firm with 10-percent margins could easily see zero margin, which is not sustainable. And a firm with a 20-percent margin that is sliced in half could not easily sustain such outcomes for too long, much less a permanent halving of profit margin. 

That also tends to be true of attempting value attacks (bundling, for example), which often can be matched by the market leader. 

The Rule of Three does not apply to fragmented industries, though. Consider the U.S. fast food market, where brand matters; product segments are diverse; barriers to entry are quite low and economies of scale might not be decisive. 

Brand	Share
McDonald's	43.80%
Starbucks	9.60%
Chick-fil-A	8.60%
Taco Bell	6.60%
Wendy's	5.70%
Burger King	5.40%
Dunkin'	3.70%
Subway	3.40%
Domino's	3.20%
Chipotle	2.80%
Sonic Drive-In	2.40%
Pizza Hut	2.30%
KFC	2.10%
Panda Express	1.50%
Arby's	1.40%

And though lots of markets--consumer and business--are concentrated, many are not. Concentrated industries are more likely to resemble the Rule of Three pattern, while fragmented industries tend not to show the pattern. The exceptions are that some segments of fragmented industries might well show a quasi-Rule of Three pattern.  

Athletic footwear might provide one example of a Rule of Three pattern, even within a larger industry category (fashion and apparel) that might be fragmented. 

Market Type	Industry	Market Characteristics	Example Companies
Concentrated	Consumer
	Soft Drinks	Dominated by a few large companies.	Coca-Cola, PepsiCo
	Smartphones	High market share held by a few players.	Apple, Samsung
	Athletic Footwear	Leading brands control most of the market.	Nike, Adidas
	Credit Cards	Few major issuers dominate the market.	Visa, Mastercard
	Fast Food	A small number of chains dominate.	McDonald's, Starbucks, Chick-fil-A
Concentrated	Business
	Commercial Aircraft	Duopoly structure in many regions.	Boeing, Airbus
	Operating Systems (PC)	Few companies dominate the market.	Microsoft, Apple
	Cloud Computing	Concentrated among a few major players.	Amazon AWS, Microsoft Azure, Google Cloud
	Professional Services (Big 4)	Dominated by a few global firms.	Deloitte, PwC, EY, KPMG
	Search Engines	One company holds a massive market share.	Google
Fragmented	Consumer
	Restaurants	Highly localized, many small competitors.	Local and regional chains
	Fashion and Apparel	Wide range of brands, trends, and niches.	Zara, H&M, many independent brands
	Home Improvement	Multiple large and small players.	Home Depot, Lowe's, Ace Hardware
	Organic Food	Numerous small and regional producers.	Whole Foods, Trader Joe's, local farms
	Craft Beer	Many small, independent breweries.	Local craft breweries
Fragmented	Business
	Marketing Agencies	Numerous small firms, specialized services.	Local and regional agencies
	Construction	Many small to medium-sized firms.	Local contractors, regional builders
	Logistics	Highly fragmented with many local operators.	Local trucking and shipping companies
	Real Estate	Numerous small firms, localized markets.	Local agencies and independent agents
	Consulting	Many small and specialized firms.	Local consultants, boutique firms

The U.S. home broadband market provides another example. Looking at all providers, the Rule of Three does not seem to hold. But within the category, looking only at legacy telcos, the pattern does seem to hold. AT&T has 15- to 18-percent share; Verizon seven to 10; Lumen two to four. 

The caveat is that AT&T, Verizon and Lumen do not actually compete head to head in most markets. In fact, market share corresponds to homes within the respective provider service territories. In contrast, where AT&T, Verizon and T-Mobile compete head to head across virtually all markets, shares are roughly equal. 

So even if mobile service is highly capital intensive, mature, with high barriers to entry, there seem to be offsetting factors, even when brand preference might be relatively stable. At some level, the regulatory context might prevent any of the providers from amassing too much more share. And most observers would likely agree that offers are highly competitive. 

ISP	Share
Comcast (Xfinity)	27-30%
Charter Communications (Spectrum)	23-26%
AT&T	15-18%
Verizon (Fios)	7-10%
Cox Communications	6-8%
Altice USA (Optimum, Suddenlink)	4-5%
CenturyLink (Lumen Technologies)	2-4%
Frontier Communications	1-2%
Mediacom	1-2%
Windstream	1-2%

Likewise, the Rule of Three seems to apply in the U.S. cloud computing “as a service” industry. Some will point to Microsoft’s share as deviating from the expected pattern. But real world markets often do not perfectly match what theory tells us to expect. 

Also, Microsoft’s revenue in the “intelligent cloud” segment historically has included productivity software, for example. But Microsoft has gradually been realigning revenue reporting to better reflect performance of the “cloud computing as a service” activities that compete head to head with Amazon Web Services and Google Cloud. 

The point is that Microsoft cloud computing revenue has for some time not been an easy “like to like” comparison with AWS or Google Cloud “computing as a service” revenues, as Microsoft once included other revenues, such as game platforms, within intelligent cloud.

Company	Market Share
Amazon Web Services	32.00%
Microsoft Azure	22.00%
Google Cloud Platform	10.00%
IBM Cloud	6.00%
Oracle Cloud	4.00%
Salesforce	3.00%
Alibaba Cloud	2.00%
Other Providers	21.00%

On the other hand, Microsoft, in removing productivity software subscription revenue from intelligent cloud, has added advertising revenues to the intelligent cloud category. 

The upshot is that there should be a temporary resetting of Azure market share, in a downward direction. 

The Rule of Three might be relevant early in a concentrated industry’s emergence as well as once the market share pattern is established, as it suggests disruption will be highly unlikely. 

The rule will be less useful--or break down--under some circumstances, such as when a major technology disruption threatens the legacy business model; when governments decide to regulate or deregulate an established industry; when some innovation enables non-traditional suppliers to enter a market or when consumer preferences change significantly. 

Economic downturns, new business models, supply or distribution chain disruptions or cultural or societal shifts could, in principle, be disruptive to established industries. Auto manufacturing might provide an example, as consumer shifts in preference for higher-mileage vehicles; sport utility vehicles rather than sedans; trucks rather than passenger vehicles; or hybrid and electric vehicle demand occur. 

As the artificial intelligence market grows, business leader strategies might well turn on expectations about whether the Rule of Three actually applies, as if so, where in the business.