In 1976 the founder of Boston Consulting Group, Bruce Henderson published a strategy memo with a bold claim: “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.”
Despite this provocative statement, Henderson quickly clarified that it was a hypothesis:
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.
Those skeptical of consultants may instantly dismiss something like this. They might find one example that disproves it and say that Henderson was wrong and that no consultant should ever be hired or trusted.
This is a mistake. I think this framework is interesting not only because it does appear to map to some industries (I’ll get to an example in a minute), it also gives us a glimpse into the thought process of Henderson and the consulting industry at the time.
Let’s explore the framework, see how well it maps to some current examples, and have a deeper discussion about the usefulness of frameworks.
The Framework
Henderson made two observations about the nature of industries:
- A ratio of 2 to 1 in market share between any two competitors seems to be the equilibrium point at which it is neither practical nor advantageous for either competitor to increase or decrease share.
- Any competitor with less than one quarter the share of the largest competitor cannot be an effective competitor.
Put more simply, it was the argument that most industries over time become captured by three companies, often in the ratio of 4:2:1.
The biggest critique of his framework is that most companies (even in the 1970s) do not compete in a single industry. To answer this, he clarifies his position by adding the following two qualifications.
- A low share competitor can achieve a leadership position in a given market sector and dominate it cost-wise if there is enough shared experience between that sector and the rest of the market, and he is a leader in the rest of the market, or
- An otherwise prosperous company is willing for some reason to continually add more investment to a marginal minor product. This can be caused by accounting averaging, full line policy, or mismanagement.
The thought behind this rule is fairly straightforward: Cost is a function of market share as a result of the experience curve effect. Two competitors in a market with approximately similar market shares will compete until a competitor gains an advantage, capturing a higher share and gaining volume and cost differential. The benefits from capturing more shares fade out at around the 2:1 ratio.
Is It True? Let’s Test Some Examples
Learning about this framework made me curious. Are there examples of this dynamic in today’s world? As stated earlier, it’s hard to find very specific single industry companies and products and also find their market share information.
Here are a few I put to the test:
Beer in The US – Passes The Test
It’s easy to get information on the beer industry on the beer industry in the US so I thought I’d see how it fared. The three biggest companies control about 70% of the market as follows:
- Anheuser-Busch: 39%
- Molson Coors: 20%
- Constellation: 11%
The ratio between the companies is 3.4 to 1.7 to 1 which means it passes both tests. There are only three significant competitors and the largest has less than four times the market share of the smallest.
Digital Ads Companies – Fits With Exceptions
Based on the following graph, it appears like Google, Facebook, and Amazon control about 64% of the digital ad market and Facebook and Google are quite close for the leader of the industry followed by a long tail of companies that have a small market share.
While it passes the test of the largest competitor not being more than 4 times the smallest competitor, the ratio between the companies is more like 2.8 to 2.4 to 1. Henderson argued that the ratio of 2 to 1 is a likely equilibrium point where it is not worth it for either competitor to increase market share.
It’s hard to know what he’d say about this situation. While one might think Amazon is too small to seriously compete with Facebook and Google, we need to remember Henderson’s exception: “An otherwise prosperous company is willing for some reason to continually add more investment to a marginal minor product.”
This is definitely the case for Amazon. They are known for being willing to lose money for a long time in an industry or on a specific product in order to capture market share over the long term. The Rule of Three and Four might tell us that Amazon is already at an equilibrium point and that it is not worth it to compete or try to become a larger player but it is likely too soon to tell. The digital market industry is still relatively nascent and Amazon has only recently tried to compete in this space.
Bruce Henderson also didn’t foresee how the internet might change competitive dynamics either…
US Laptop Market – Maybe?
The US laptop market has three major competitors but does not follow the 4:2:1 dynamic that Henderson predicts.
The ratio of the top three companies is 1.5 to 1.1 to 1.0. This means it is likely still a very competitive market or that the rule doesn’t hold.
To explore this, I would generate a bunch of hypotheses. Some might include:
- Maybe regulations are limiting M&A activity?
- These companies aren’t really competitors (e.g. people that buy Apple Products might never buy another brand of laptop?)
- Maybe the definition of a laptop also includes other devices?
- Companies are not competing solely on maximizing laptop sales (e.g. Apple can make money on services and software)
This is also the reason these resources can be helpful, which brings us to:
What’s The Point?
You might be asking: who cares? Good question. I often think that consultants and the business world spend too much time over-analyzing data. At its root, I believe that strategy is mostly about increasing the probability of success through analysis. Yet taken too far it can often just be a way to make us think we know more than we do.
The value of frameworks like this is as a mental model to increase the range of ideas you have about how to think about a company’s situation and/or how to solve it.
For example, let’s say you were thinking about entering the beer market. You might quickly look at the market share breakdowns of companies and see that three companies dominate the market and also align with the 4:2:1 breakdown that Henderson predicted. You can then start to ask questions about this:
- Is this because it’s impossible to compete?
- Is this because of laws or regulations?
- Has this industry always been that way?
Boston Beer Company (which makes Sam Adams) has had aspirations to be a big beer company for decades. Right now, however, it only owns about 4% of the total US market share.
If you are a massive company and need to capture more of the market than that you might ask yourself if it is worth it. At minimum, you might use this framework to second guess any overly-optimistic ideas about your ability to move into a new market.
This is really the point of any framework – to help you generate new ways of seeing the world.
I hope this model helps you see one more thing than you did before.
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