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.
The conditions which create this rule are:
Characteristically, this should eventually lead to a market share ranking of each competitor one half that of the next larger competitor with the smallest no less than one quarter the largest. Mathematically, it is impossible to meet both conditions with more than three competitors.
The Rule of Three and Four is a hypothesis. It is not subject to rigorous proof. It does seem to match well observable facts in fields as diverse as steam turbines, automobiles, baby food, soft drinks and airplanes. If even approximately true, the implications are important.
The underlying logic is straightforward. Cost is a function of market share as a result of the experience curve effect.
If two competitors have nearly equal shares, the one who increases relative share gains both volume and cost differential. The potential gain is high compared to the cost. For the leader, the opportunity diminishes as the share difference widens. A price reduction costs more and the potential gain is less. The 2 to 1 limit is approximate, but it seems to fit.
Yet when any two competitors actively compete, the most probable casualty is likely to be the weakest competitor in the arena. That, logically and typically, is the low share competitor.
The limiting share ratio of 4 to 1 is also approximate but seems to fit. If it is exceeded, then the probable cost differential produces very large profits for the leader at breakeven prices for the low share competitor. That differential, predicted by the experience curve, is enough to discourage further reinvestment and efforts to compete by the low share competitor unless the leader is willing to lose share by holding a price umbrella.
There are two exceptions to this result:
Whatever the reason, it appears that the Rule of Three and Four is a good prediction of the results of effective competition.
There are strategy implications:
There are tactical implications which are equally important:
The market leader controls the initiative. If he prices to hold share, there is no way to displace him unless he runs out of the money required to maintain his capacity share. However, many market leaders unwittingly sell off market share to maintain short term operating profit.
A challenger who expects to displace an entrenched leader must do it indirectly by capturing independent sectors, or be prepared to invest far more than the leader will need to invest to defend himself.
There are public policy implications:
A rigorous application of the Rule of Three and Four would require identification of discrete homogeneous market sectors in which all competitors are congruent in their competition. More typically, competitors' areas of competition overlap but are not identical. The barriers between sectors are sometimes surmountable, particularly if there are joint cost elements with scale effects. Yet it is a commonly observable fact that most companies have only two or three significant competitors on any product which is producing a net positive cash flow. Other competitors are unimportant factors.
The Rule of Three and Four is not easy to apply. It depends on an accurate definition of relevant market. It requires many years to reach equilibrium unless the leader chooses to hold his share during the high growth phase of product life. However, the rule appears to be inexorable.
If the Rule of Three and Four is inexorable, then common sense says: if you cannot be a leader in a product market sector, cash out as soon as practical. Take your writeoff. Take your tax loss. Take your cash value. Reinvest in products and markets where you can be a successful leader. Concentrate.