In this article, we'll examine the Rule of Three and Four's working processes and how it can be an effective strategy tool when put to good use. With this tool, company leaders and decision-makers can adequately determine the status of their company in their industry and map out the resulting strategy.
What is it?
The Rule of Three and Four stipulates that a stable, competitive industry will accommodate no more than three significant competitors (called generalists). According to the rule, the largest generalist typically commands at most four times the market share of the smallest generalist. This rule of thumb was first introduced in 1976 by Bruce Henderson (the founder of BCG, who popularized business strategy), based on his review of various industries.
As Bruce Henderson suggested: "a stable competitive market never has more than three significant competitors; the largest has no more than four times the market share of the smallest."
The following conditions govern the Rule of Three and Four:
The market reaches equilibrium when there's a market share ratio of 2 to 1 between any two competitors. At this point, it is difficult for the smaller competitor to win a significant share, and it is costly for the bigger competitor to win more shares (as the smaller competitor will fight tooth and nail). Hence, the competitors tend not to increase or decrease their share.
Competitors who can only manage to pull less than a quarter of the largest competitors' shares cannot be effective. They, therefore, cannot move the market and will be somewhat at the mercy of the large players.
These conditions imply that the equilibrium state in any competitive industry is the 4:2:1 ratio for the three generalists, i.e., 50% market share for the largest generalist, 25% market share for the second generalist, 12.5% market share for the smallest generalist, and the rest of the players (non-generalists) share the remaining 12.5% market share.
You can use this rule of thumb to assess your company's standing in its industry. Following that, your findings can form the basis of your next strategy decision.
For instance, if your company is among the three generalists, you may focus your efforts on consolidating your company's market position.
If the ratio 4:2:1 is not yet achieved, you can confidently try to grow your company's market share.
If, on the other hand, your company falls outside the top three, you may contemplate whether attempting to move to another industry rather than staying in the current industry is your best move.
When do we use it?
The Rule of Three and Four is especially relevant when companies' decision-makers need to make projections regarding their company's growth potential in various industries. In addition, it is handy for predicting the future of stable, competitive industries (including the market behaviors of certain competitors in those industries). Beyond this, the Rule of Three and Four is used when:
You need to gain a better understanding of the industry environment.
You need to determine the long-term viability of your company's position in the industry.
Depending on your company's position (based on its market share), you want to know what business strategy to adopt.
What business question is it helping us to answer?
Based on the above, the Rule of Three and Four helps us answer questions such as:
What do I need to know about my company's industry environment?
What is my company's position on the market share index? Is the long-term viability of the company guaranteed based on its position?
Is the Rule of Three and Four applicable to this industry? If yes, should I look to focus on/exit/enter the industry?
What business strategy should I adopt if the 4:2:1 ratio has not yet been reached?
How do we use it?
To use the Rule of Three and Four, you start by researching your company's industry environment for a more thorough understanding of its workings. This knowledge makes all the difference. To begin with, you can determine if the rule applies to the industry.
If the rule applies to your company's industry, you'll want to determine your company's position in the industry based on its market share. If your company falls among the three largest in the industry, that assures its long-term viability.
Your next step then depends on the findings of the previous step. Based on this rule, companies that fall outside the top three typically become cash traps. As a result, decision-makers in such companies must figure out whether to aggressively pursue change or exit the industry entirely. Similarly, companies in the top three can decide to either defend their positions or seek to gain more ground.
Practical Example
This rule is observed across various industries. Consider the household appliances industry, there are three major players, i.e., Whirlpool, Electrolux, and GE.
Imagine that Whirlpool is trying to grow its market share and want to use this tool. It, then, must first survey the industry to understand whether the industry is competitive (hence the rule of three and four applies). If yes, Whirlpool must determine its position in the industry by examining its market share in relation to Electrolux and GE. Is there any scope of gaining more share? If yes, then Whirlpool can tailor its strategy.
Companies with the top spot have comparative advantages; they can control the market for as long as they hold this advantage. On the flip side, companies outside the top three competitors must decide if it's more feasible to trigger a shift in the competitive landscape or exit the industry.
Advantages
The Rule of Three and Four offers the following advantages:
This tool is simple for the company's decision-makers to apply. Moreover, it doesn't require much data – mainly market share and the nature of the top competitors in the industry.
This tool is applicable across a wide range of industries (such as electronics, food, automobiles, banking, and retail).
It helps companies garner valuable insights as to the viability of their businesses.
With the insights derived from this tool, businesses can decide on effective strategies to drive growth and profitability.
Disadvantages
This tool also has a few drawbacks, such as:
It is just a rule of thumb – not a natural law without exception.
The Rule of Three and Four only applies to stable, competitive industries. It doesn't apply to non-competitive industries (e.g., monopoly, oligopoly, and duopoly).
Also, this rule does not apply in markets that are not still evolving rapidly (and hence unstable).
It may not be effective in newly emerging markets because it takes many years for any industry to reach equilibrium.
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