Nothing explains the “Winner Take All” nature of an economic transition like the Pareto principle.
Vilfredo Federico Damaso Pareto (1849-1923) was a man of many… names, for one thing… but also of many talents.
Trained as an engineer, he once managed the largest ironworks in Italy. But in his 40s Pareto began to study economics. In 1893 he became chairman of the Department of Political Economy at the University of Lausanne in Switzerland.
Pareto was also a philosopher, political theorist, and sociologist who wrote the first book on what we would call “behavioral economics,” The Mind and Society.
And, for all I know, he made a killer pesto genovese, the specialty of his family’s home town, Genoa.
However, what made Pareto famous is something he simply noticed, early in his career, while working as a civil engineer for the Italian railroad. Going over maps and deeds of right-of-way, Pareto realized that about 80% of land in Italy was owned by about 20% of Italian families.
He did historical and international research and discovered that this 80/20 pattern of land ownership was prevalent around the world and through the ages.
Global and historical income distribution also followed the 80/20 approximation – 1/5 of people make 4/5s of the money.
But what’s more surprising is that the 80/20 rule of thumb applies to many other phenomena. Farmers find that 20% of peapods produce 80% of the peas, 20% of the seed corn grows into 80% of the ears, and 20% of a cow’s weight turns into 80% of the prime beef cuts.
It’s a general rule – 20% of causes result in 80% of effects. The rule applies to scientific experiments, computer programming, sports training, occupational health and safety, etc.
It certainly applies to business – 20% of the customers provide 80% of the revenue, 20% of the employees do 80% of the work, and 20% of the senior executives make 80% of the pay.
This 80/20 rough computation is known as the Pareto principle and the results of an 80/20 calculation are a Paretian distribution.
The Pareto principle is not, however, a law. It doesn’t have to rule your life. Maybe you’ve got 20% of the cats in the neighborhood and they’re having 80% of the kittens. You can fix that.
And sometimes the Pareto principle is just a bad idea.
I once had the pleasure of being the M.C. at a convention of beer distributers. (And, yes, it was as much fun as it sounds.)
Beer distributors are wonderful people. They get more wonderful as the evening goes along. They are very generous in urging you to sample their wares.
Another thing about beer distributors is that they tend to be family businesses – often owned by the same family since Prohibition ended, with four, five, even six generations in the business.
On the last evening, our keynote speaker was managerial genius Jack Welch, who’d just stepped down after 20 years as CEO of General Electric where he’d raised the value of the company by 4000%.
Welch likes an “all Q&A” format. I called on members of the audience. The beer distributors had great questions. Jack had great answers. Everything was going well… until we came to Welch’s application of the Pareto principle to employees.
Jack told the beer distributors that they should do annual performance reviews on their entire workforce and analyze that workforce on a 20/70/10 basis. Jack said that 20% of their workforce will be good, 70% of their workforce will be average, and 10% of their workforce will be bad. He said, “Every year you should reward the top 20%, retrain the middle 70%, and fire the bottom 10%.”
The room went quiet. It took me a moment to realize what was wrong. Then I said, “Jack, what if the bottom 10% of your workforce is your brother-in-law?”
The beer distributors broke up. Jack started to laugh too. Everything got back on track and we had a fabulous night.
Of course, The Transition that we’re undergoing in our economy doesn’t have much to do with your brother-in-law. Except to show that the Pareto principle is not a cause for universal despair.
The digital transformation of our economy will mean a reapportionment of rewards – no doubt in a Paretian distribution.
This doesn’t mean that you have an 80% chance of being a loser in The Transition. But it does mean that you have to re-think 80% of what you’re doing as a businessperson and investor.
The Pareto principle is actually a message of opportunity.
Gather 10 people into a room. (Myself, I’d pick a barroom – but room of your choice.) You are much better at something than eight of them. Even if you’re just better at drinking… Marry into one of the beer distributor families.
But, statistically, the likelihood is high that you have some skill or technical ability that eight people don’t. Now use it.
Failing that, make yourself better informed than 80% of people. That isn’t hard.
Recently National Geographic and The Council on Foreign Relations conducted a poll of 1,203 young adults with college educations – 66% estimated the U.S. population to be between 750 million and 2 billion, 75% said English was the most common native language in the world, 75% couldn’t find Israel on a map, and 70% didn’t know which branch of government has the Constitutional power to declare war.
And your brother-in-law? Maybe he makes a killer pesto genovese.