The Pareto Principle

Pictured above is Vilfredo Pareto. Vilfredo discovered an economic principle which as since been named after him. The Principle is also known as the 80/20 rule.

Chris Anderson explains the concept in his book, the The Long Tail.

“In the summer of 1897 an Italian polymath named Vilfredo Pareto busied himself in his university office in Switzerland, studying patterns of wealth and income in nineteenth-century England. It was the age of Marx, and the question of wealth distribution was in the air. Pareto found that the spread of wealth was indeed unequal in England—most of it went to a minority of the people. When he calculated the exact ratios, he found that about 20 percent of the population owned 80 percent of the wealth. More important, when he compared that with other countries and regions, he found that the ratio remained the same.

What Pareto had discovered is that there is a predictable mathematical relationship in the patterns of wealth and populations, something he called the Law of the Vital Few. It seemed constant over time, and across countries. Pareto was a brilliant economist, but he was a poor explainer, so not many understood the importance of his insight. He went on to write obscure sociological tracts about elites, which unfortunately were taken up at the end of his life by Mussolini’s fascists. But the theory of unequal distribution took on a life of its own, and Pareto’s observation is now known as the 80/20 Rule.

In 1949, George Zipf, a Harvard linguist, found a similar principle at work in words. He observed that while a few words are used very often, many or most are used rarely. Although that’s not surprising, what Zipf also observed was that that relationship was entirely predictable, and indeed was the same as Pareto’s wealth curve. The frequency with which a word was used was proportional to 1 divided by the word’s frequency rank among all words. This means that the second item occurs approximately 1⁄2 as often as the first, and the third item 1⁄3 as often as the first, and so on. This is now called Zipf’s Law.

The same is true, Zipf found, for a host of other phenomena, from population statistics to industrial processes. He analyzed Philadelphia marriage licenses within one twenty-block area and showed that 70 percent of the marriages were between people who lived no more than 30 percent of that distance apart.

Since then, other researchers have extended the rule to everything from atoms in a plasma to the size of cities. At the heart of these observations is the ubiquity of powerlaw distributions, the 1/x shape that Pareto first saw in his wealth curves.”

In The Tipping Point, Malcom Gladwell describes some of the scenarios in which the Pareto Prinicple has been applied.

“Economists often talk about the 80/20 Principle, which is the idea that in any situation roughly 80 percent of the “work” will be done by 20 percent of the participants. In most societies, 20 percent of criminals commit 80 percent of crimes. Twenty percent of motorists cause 80 percent of all accidents. Twenty percent of beer drinkers drink 80 percent of all beer.”

Chris Anderson continues to explain typical misunderstandings of the concept:

“The best known manifestation of Pareto/Zipf distributions is the 80/20 Rule, which is often used to explain that 20 percent of products account for 80 percent of revenues, or 20 percent of our time accounts for 80 percent of our productivity, or any number of other comparisons that all share this characteristic of a minority having disproportionate impact.

The 80/20 Rule is chronically misunderstood, for three reasons. First, it’s almost never exactly 80/20. Most of the large-inventory markets I’ve studied are 80/10 or even less (no more than 10 percent of products account for 80 percent of sales).

If you’re troubled by the fact that 80/10 doesn’t add up to 100, you’ve discovered the second confusing thing about the Rule. The 80 and the 20 are percentages of different things, and thus don’t need to equal 100. One is a percentage of products, the other a percentage of sales. Worse, there’s no standard convention on how to express the relationship between the two, or which variable to hold constant. Saying a market has an 80/10 shape (10 percent of products account for 80 percent of sales) can be the same as saying it’s 95/20 (20 percent of products account for 95 percent of sales).

Finally, the Rule is misunderstood because people use it to describe different phenomena. The classic definition is about products and revenues, but the Rule can just as equally be applied to products and profits.”

Hey. I’m Alex Murrell. I'm a Planner at Epoch Design in Bristol where I help deliver highly creative, innovative and effective pack, instore and online communications for some of the world’s biggest FMCG brands. Want to know more? You can find me on Twitter or LinkedIn.

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