Vilfredo Pareto was many things—a civil engineer, an economist, and a sociologist—but one thing he is most known for is his fascination with the problems of power and wealth. Who has it, how they get it, and the disparities between societies. In his mid-to-late life, Pareto discovered an astonishing pattern: the Pareto distribution. He observed that wealth follows a power law probability distribution rather than a linear or triangular flow from the lower class to the elite. Pareto noticed that 80% of Italy's wealth belonged to just 20% of the population. The similar pattern was observed when the study was extended to various nations and historical periods. This observation would later be popularised as the "80/20 rule," the idea that around 80% of consequences or outcomes come from only 20% of causes. [I will use 80/20, Pareto Principle and Power Law interchangeably].
The power law might not seem intuitive, but anecdotal and empirical evidence are everywhere. It is the idea of compounding interest, seemingly trivial in isolation and in its infancy, yet feeling unfair or miraculous when you see it in action. It is, as Peter Thiel calls it in Zero to One, "the law of the universe". It defines our surroundings so completely that we usually don’t even see it."
"The greatest shortcoming of the human race is our inability to understand the exponential function."
- Albert Allen Bartlett -
It is natural to expect things to follow a normal distribution, where majority of outcomes fall around the average and the rest fanning out on either extreme. Besides, that seems a bit fair, stable, predictable, and even appealing. However, many real-life circumstances, particularly consequential events, do not follow that neat pattern. The power law, on the other hand, offers a more accurate image. In practice, the power law is also difficult to eliminate. Even in places like China, where you would consider strictest and most driven to level wealth inequality, the Gini index (measure of income distribution—wealth inequality) is higher than the UK, Germany, or France. Surprisingly, most developing and emergent nations have more wealth inequality than developed countries.
And once you open your eyes to it, it’s hard to unsee Pareto principle anywhere you look—from the most trifling pastimes to apocalyptic occurrences.
Applications
Personal and professional:
Even at a simplified individual level, the Pareto principle is ubiquitous. Of the 80,000 people we can meet in our lifetime, most we'll never even remember and very few will have an unbalanced influence on how we think, what we do, or where we end up. Some of them you'll only encounter once or twice. However, one word they say, one thing they do, or the next person they introduce you to will have inconceivable impact cascading throughout your life. For some, it’s true with school or work. The few classes we took, an event we attended, an essay we wrote, the recommendation we got from that teacher, or any of those incidental events that later became the turning point. They seem unconnected in the moment, but when you look back, you realise it was power law—one small thing compounding into the next in silence until it almost becomes the only thing.
Startups:
It’s widely cited that about 90% of startups fail. Well, whatever the number is, the idea is the same. Of the millions of startups started, a handful reach the levels of Amazon, Tesla, Apple, or Google. And those that do have a far-reaching impact on the world. For example, the top 10 tech companies (0.02% of total listed companies globally) have a combined market capitalisation (‘total value’) of about $10 trillion, or 9% of the global market capitalisation. But even on an individual startup basis, many founders apply the Pareto Principle in making those early key choices on which lever to pull to get a certain conversion, which referral to nurture, and which leads to focus on for that 80% sales.
Venture Capital (VC):
VC performance follows the power law distribution even closer. In a fund of dozens of companies, a few radically outperform the rest. Examples are everywhere, with extremes like Peter Thie’s ~2000x ($1.1 billion) return on Facebook (more than all the other investments in that fund combined). It’s also reported that only about 10 of Y Combinator’s 2000+ startups drive about 75% of the total value, the majority of which are based in Silicon Valley. Across the VC ecosystem, a small percentage of firms capture most of the industry's returns. But even the mighty winners like Sequoia, Kleiner Perkins, New Enterprise Associates, and Andreessen Horowitz are no exception to this skewed power law distribution of returns within their portfolios. You would even argue that they are the kings because they understand the power law and look at every investment through that lens.
Wider business and economy:
Although businesses make decisions all the time, few produce the greatest impact overall. The most effective CEOs and executives understand the power law. They look for those few decisions and actions that produce disproportionate upsides with little resources. In the overall market, you see the same disparity. About 30% of sectors account for over 60% of total market capitalisation. The top few companies dominate the market, and almost the entire ecosystem of top giant companies is concentrated in less than 10 countries—with the majority in the US. Extending to the wider global economy, around 5 countries account for 51% of global GDP, the top 10 for 66%, and the top 25 for 84% (that’s 13% of countries controlling 84% of the global economy!). Global household wealth (net asset, or the difference between household assets and liabilities) is even worse. Only 1% of countries—China and the US—account for half of global household wealth.
You can talk about the richest individuals, the wealthiest families, minimum wages, the most popular artists/songs, most followed social media accounts. The same pattern pops out. Not the average, even, or bell curve. The skewed. The unpredictable. The power law.
Why should I care?
If I look around, I don’t see much reason to disagree with Peter Thiel when he says, "We don’t live in a normal world; we live under a power law." This is not an argument about whether that is fair; if that is a question, I would prefer a world that is even fairer than a normal distribution. But knowing about the undeniable existence of the power law is not a bad idea. It gives perspective on many things and can be used to identify and pursue your 20% opportunities which have the potential to give you a 4-fold impact in whichever area of your life. Hopefully you can also use it to increase your awareness of and appreciate those few people who make your life disproportionately happier, easier, and better.
Interesting read. I found it surprising that you were surprised by the level of wealth inequality in developing countries versus developed countries.