The Rule of Three

Surviving and Thriving in Competitive Markets

Jagdish Sheth, Rajendra Sisodia

• Publisher: Free Press
• Year: 2002
• ISBN:
  9780743234306
• Topic: Business
• Subtopic: Business General
• Index: Business

Name any industry and more likely than not you will find that the three strongest, most efficient companies control 70 to 90 percent of the market. Here are just a few examples:

• McDonald's, Burger King, and Wendy's
• General Mills, Kellogg, and Post
• Nike, Adidas, and Reebok
• Bank of America, Chase Manhattan, and Banc One
• American, United, and Delta
• Merck, Johnson & Johnson, and Bristol-Myers Squibb

Based on extensive studies of market forces, the distinguished business school strategists and corporate advisers Jagdish Sheth and Rajendra Sisodia show that natural competitive forces shape the vast majority of companies under "the rule of three." This stunning new concept has powerful strategic implications for businesses large and small alike.
Drawing on years of research covering hundreds of industries both local and global, The Rule of Three documents the evolution of markets into two complementary sectors -- generalists, which cater to a large, mainstream group of customers; and specialists, which satisfy the needs of customers at both the high and low ends of the market. Any company caught in the middle ("the ditch") is likely to be swallowed up or destroyed. Sheth and Sisodia show how most markets resemble a shopping mall with specialty shops anchored by large stores. Drawing wisdom from these markets, The Rule of Three offers counterintuitive insights, with suggested strategies for the "Big 3" players, as well as for mid-sized companies that may want to mount a challenge and for specialists striving to flourish in the shadow of industry giants. The book explains how to recognize signs of market disruptions that can result in serious reversals and upheavals for companies caught unprepared. Such disruptions include new technologies, regulatory shifts, innovations in distribution and packaging, demographic and cultural shifts, and venture capital as well as other forms of investor funding.
Years in the making and sweeping in scope, The Rule of Three provides authoritative, research-based insights into market dynamics that no business manager should be without.

1

Four Mechanisms for

Increasing Efficiency

In 1966, the U.S. Supreme Court refused to allow two supermarkets in Los Angeles to merge. The Vons Grocery Company and Shopping Bag Food Stores, had they been allowed to combine, would have controlled a whopping 7.5 percent of the market. Over 3,800 single-store grocers would still have been doing business in the city. In spite of these statistics, the Court ruled against the merger, citing “the threatening trend toward concentration.”¹

Much has changed in the public's perception of merger activity in the four decades since the Supreme Court's ruling in the Los Angeles supermarket case. Over time, the view that market efficiencies matter and that consumer welfare is actually enhanced by a measure of industry concentration has slowly gained acceptance, although there still are loud complaints from consumer groups that this or that merger will result in higher prices. In truth, markets remain highly competitive even after such concentration, and industries that have experienced consolidation have seen prices remain stable or actually fall. To be sure, profits are generally higher in concentrated industries, but the prices consumers pay may actually decline. This evidence suggests that efficiency gains are a prime driver of greater profitability and market evolution.

For that evolution to be sustainable, markets need both growth and efficiency. Growth comes primarily from understanding and shaping customer demand, whereas efficiency is a function of operations. Through the cyclical pursuit of these objectives, markets become organized and reorganized over time.

Once its basic viability has been established, a start-up industry enjoys high growth but has low efficiency. No matter what criterion is used to measure efficiency—revenue per customer, revenue relative to assets deployed, revenue per employee, for instance—the start-up costs are high. The first shakeout occurs during the industry's initial growth phase to make it more efficient without sacrificing growth. Subsequent attempts to make the industry more efficient come from four key sources or events: the creation of standards, the development of an industry-wide cost structure as well as a shared infrastructure, government intervention, and industry consolidation through shakeouts. These four drivers force the industry as well as the players in it to become more and more efficient in order to stay competitive. As we will see in this chapter, they can occur at any time and in any order, sometimes independently, sometimes closely dependent on each other. Their primary effect, however, is to promote efficiency and fair competition within an industry such that no one company becomes a monopoly.

In subsequent shakeouts, the industry is reorganized for growth, typically through market expansion, including globalization. Driven primarily by investor demands, companies at this stage are concerned with growth of all kinds: revenue growth, cash flow growth, earnings growth, growth in the number of customers and revenue per customer, and growth in market capitalization. To continue to attract investment capital and growth, the industry needs to make productive use of all inputs, including capital, labor, and management talent.

The Creation of Standards

Market inefficiency can hasten the creation of de facto standards. Henry Ford paved the way for one such standard when he devised the highly efficient assembly-line manufacturing process for the Model T. Bill Gates was fortunate indeed when Microsoft received the nod from IBM and others to make the MS-DOS operating system the standard for personal computers. Once that standard was set, even Big Blue, known primarily for its hardware, could not wrest away control with its proprietary OS/2 system.

When standards play a major role and remain largely proprietary, there may not be room for three separate platforms. Typically at most two platforms can survive in the broad market: VHS & Beta for video recorders, VHS-C and 8mm for camcorders, PAL and NTSC for television broadcasts, CDMA and GSM for wireless telephony, PC and Mac for personal computing. Eventually, one platform becomes dominant, if not universal. Thus, 8mm has a big lead over VHS-C, PCs have triumphed over the Mac, and VHS has overwhelmed Beta. The other platform, if it survives, is relegated to a niche market.

The simultaneous existence of two or more standards, as in the case of NTSC and PAL, can be attributed in large part to protectionist ideologies and government regulation. Thanks to a double standard in the worldwide electric industry, tourists must contend with shifting between 110 volts and 220 volts, not to mention remembering to pack a variety of prongs and socket styles; in Europe alone there are some 20 different types of electrical plugs currently in use. To the delight of those tourists, these types of essentially meaningless and highly inefficient differences will start to go away as the electric industry adopts universal standards and the world at large becomes more driven by market economies. The cost of converting to a new single standard, however, is estimated to be $125 billion!²

Already we can see the power of a fully adopted worldwide standard in the World Wide Web. The extraordinarily rapid diffusion of this technology across the globe has resulted in large measure because of that single standard. Emerging industries today are highly cognizant of this fact, and organizations that set industry standards now occupy an influential place in the world economy. The impact of evolving standards is illustrated by the stories of the evolution of the VCR industry and the development in Europe of the Group Special Mobile (GSM) network.

The VCR Industry³

Based in Redwood City, California, the Ampex Corporation invented video tape recorder (VTR) technology in 1956. It sold machines to professionals initially for $75,000, but it was never successful in creating a product for ordinary consumers. However, it was successful in licensing its technology to Sony, which turned it into a competitive advantage.

Sony first introduced videocassette recorders (VCR) to the mass market in 1971, but even its “U-Matic” machines and cassettes were too big and expensive. Accordingly, Sony made modifications and repositioned the machines for industrial users. Next, Sony approached JVC and Matsushita—two of its biggest competitors—about establishing a standard (based on a new Sony technology) that would reduce the size of both machines and cassettes. JVC and Matsushita would accept only the U-Matic format, and JVC refused to cooperate or compromise on technology for smaller machines.

In 1971, JVC established a video home system (VHS) project team and charged it with the mission to develop a viable VCR for consumers, not just one that was technologically possible, but something consumers would prefer. Experimenting with ten different ways of building a home VCR, Sony settled by mid-1974 on the Betamax prototype. It set up a new plant to produce 10,000 units a month, but designed the machine to record for only one hour, reasoning that customers would use it to record television programs for later viewing. Later, when Sony asked Matsushita and JVC to adopt the Beta format, both refused, citing the one-hour recording limit as a major drawback. JVC's VHS format, then in development, would deliver up to three hours. After the Betamax was launched, Hitachi tried unsuccessfully to license Betamax technology from Sony, which basically had decided to go it alone.

Meanwhile, JVC formed an alliance of companies around the VHS standard before it shipped any products. The group included Matsushita, Hitachi, Mitsubishi, Sharp, Sanyo, and Toshiba. The standards war was on, and not even the intervention of Japan's Ministry of International Trade and Industry (MITI) in 1976 could succeed in resolving the dispute.

After JVC's launch in October 1976, Sony recruited Sanyo and Toshiba to join the Beta group. The split between the two formats continued for another ten years. Sony did well at first, in part because of its wide distribution. In 1976 and 1977, its market share was over 50 percent, but the company lost ground quickly. By late 1978, Matsushita with 35.8 percent of the market overtook Sony, whose share had slipped to 27.9 percent. By 1988, VHS had close to 95 percent of world sales. In a show of pragmatism, Sony launched its own line of VHS machines and repositioned Betamax as a high-end system for professionals.

Group Special Mobile (GSM) Network

The development of the Group Special Mobile (GSM) network has been an essential element in the success of European wireless companies such as Finland's Nokia and Sweden's Ericsson. Analog cellular telephone systems grew rapidly in Europe in the 1980s, especially in Scandinavia and the United Kingdom. Because each country developed its own sophisticated systems and networks, the industry was characterized by incompatible equipment and operations. Since mobile phones could operate only within national boundaries, the limited market for each company's equipment meant that economies of scale were poor. It was not unusual to see executives toting multiple phones depending on the country in which they happened to be conducting business at the time. The imminent creation of the European Union (EU) made this highly inefficient situation untenable.⁴

In 1982, Nordic Telecom and Netherlands PPT proposed to the Conference of European Posts and Telegraphs (CEPT) that a new digital cellular standard be developed that would improve efficiency and help the industry cope with the explosion of demand across all of Europe. The CEPT established a body known as Group Special Mobile to develop the system. Members of the European Union were instructed to reserve frequencies in the 900MHz band for GSM to enable easy “roaming” between countries. In 1989, the European Telecommunications Standards Institute (ETSI) offered GSM as an international digital cellular telephony standard.

GSM service commenced in mid-1991. By 1993, there were 36 GSM networks in 22 countries. GSM was successful in gaining acceptance in non-European markets as well, since it was the most mature mobile digital technology. GSM also proved very successful in Asia, with its huge untapped markets that had no analog legacy to overcome.⁵ By 1997, over 200 GSM networks were running in 110 countries, with more than 55 million subscribers. As of January 2001, 392 GSM networks were operational in 162 countries, with dozens more planned. GSM had 457 million subscribers (up from 162 million a year and a half earlier) out of 647 million digital subscribers; another 68 million subscribers continued on analog systems.⁶

The biggest holdout has been the United States, where the government has played no role in selecting a standard, and where a major rival to GSM, CDMA, has won many converts. Overall, the U.S. market is split among three standards: CDMA, GSM, and TDMA (a standard similar to GSM, but incompatible with it). By September 2000, CDMA had 71 million subscribers, whereas TDMA claimed 53.5 million.⁷ Each network operates independently of the others.

While many technology experts argue that CDMA is a superior technology, the advantage appears to be with Europe at this point. Simply put, GSM phones are much more usable worldwide. This wider usage base has allowed Europe to move ahead in phone functionality. Nokia is leading the charge, pioneering Internet access on cell phones. Through infrared technology, phones can transmit data to each other or to a machine; in Finland, this technology can be used to purchase a Coke from a soda machine.⁸ CDMA's acknowledged technological superiority is similar to that enjoyed by Betamax and the Macintosh. As history has taught us, neither was able to prevail.

The battle between CDMA and GSM may well be settled as we move to the next generation of wireless technology: so-called 3G or third-generation wireless systems featuring very high data transmission rates that will allow for two-way video communication. It is expected that most mobile operators will converge on a single worldwide standard for 3G systems.

Industry Cost Structure and Shared Infrastructure

The prevailing cost structure in an industry—those costs primarily related to production, and to some extent to management and marketing—has a deep impact on whether and how soon that industry becomes organized. This impact can be measured in terms of the relative significance of the industry's fixed costs versus its variable costs. As an industry emphasizes automation, incorporates new technology, and tries to mitigate the high or growing cost of human capital, it tends to increase fixed costs and lower variable ones.

Participation in an industry always has certain requisite fixed costs. In all aspects of business—from procurement to operations to marketing—relative market share determines spending efficiency. Thus, when it comes to national advertising and sales, for example, a company that has a 40 percent share of the market is potentially four or more times more efficient than a company with a 10 percent share. These are examples of fixed costs; that is, a company incurs them regardless of how high or low its sales are. Once a company has made the decision to target a particular market, it has to pay the piper no matter how great or small revenues promise to be. As we have observed, those industries in which such fixed costs tend to dominate are more likely to exhibit a prono...