Pareto Principle, Part I: The Secret of the 1%

“Give me the fruitful error anytime, full of seeds, bursting with its own corrections.” – Vilfredo Pareto

It may be the most important idea in economics – but it also applies to science, to sports, and to human behavior. It explains not only why things are the way they are, but also why, no matter how you try, it’s almost impossible to change them.

Welcome to a series of essays on the Pareto Principle!

As you can surmise from that introduction, I have a lot to say on this subject. And lest you think it’s going to be episode after episode of longueur, I promise to focus on ideas you haven’t heard before.

Today, I’m going to tell you how the Pareto Principle relates to economics generally and wealth inequality specifically. I’m going to show you why every modern economy in the world is subject to it. And I’m going to present a new principle derived from it – the Masterson Mandate – that explains the phenomenon of “the 1%.”

In Part II of this series, I’m going to talk about how it applies not just to economics but to virtually every aspect of life. I’ll explain, in particular, how helpful it was for me to understand its business implications.

In Part III ,I’m going to try to connect the Pareto Principle to the second law of thermodynamics. I’m going to argue that it is a layman’s explanation of how entropy works – and how every form of human achievement is a sort of futile attempt to defy the universal and inevitable drift towards chaos.

How’s that sound?

A bit of history… 

Just before the turn of the last century, an Italian economist named Vilfredo Pareto published an essay in which he observed that 80% of the land in Italy (the primary form of wealth back then) was owned by 20% of the population. This ratio, he asserted, was not unique to Italy. It was roughly the same for all the European countries.

And it was true not only of wealth but of income. In researching English tax records, for example, he found that there was a similar (though not quite as severe) imbalance: About 30% of the population made about 70% of the national income.

Looking at other economic factors, Pareto found the range of ratios: 70/30, 80/20, and 90/10, with the average being about 80/20. He pointed this out in his first essay, published in a French economic review, and in several later publications.

It is hard to imagine that he was the first to make this observation, but he gained worldwide fame for it, and his name has been associated with the phenomenon ever since.

When you consider the diversity of cultural and economic conditions in Europe during Pareto’s time, you wouldn’t expect wealth and income to be distributed so similarly. It was surprising when he wrote about it, and it’s still true today. According to a 1992 United Nations Development Program report, 20% of the world’s population controls 82.7% of the world’s wealth.

What’s happening here?

How is it possible that for more than 100 years economists have seen this grossly uneven distribution of wealth in every industrialized economy?

There have been several hypotheses, but the one that has the most support is something that academics call the “Accumulative Advantage.”

It goes like this: In any random population, some percentage of that population has an economic advantage. It might be inherited wealth. It might be family connections. It can be luck – being in the right place at the right time. Most commonly, though, it is education.

Of those that have such an advantage, a percentage of them put it to work. Even if the advantage is relatively small – say, having a master’s degree rather than a bachelor’s degree – it is enough to move those that have it forward.

By continuously applying that advantage over time, the advancements become larger. Eventually, they become exponentially larger. After a generation, the difference can be enormous.

A new look at a very old problem 

It’s hard to find an economic topic that has been hotter in the past 10 years than “wealth and income inequality.” Everyone seems to agree that it is a grave problem that in some places, such as the US, is getting worse.

In these discussions of economic inequality, however, the Pareto Principle is rarely invoked. Instead, the discussion focuses on the concern that so much of the wealth is owned or controlled by a mere 1% of the population.

It’s a legitimate concern. The top 1% own a vast amount of wealth compared to the 99%, and the gap between them is getting larger.

But when we look at wealth inequality through the perspective of the 1% versus the 99%, we are making a serious mistake. The fact is, the widening wealth gap is not just between the 1% and the 99%. It’s between the 20% and the 80%. In other words, the wealth gap is a Pareto problem – the same problem we’ve had for at least 130+ years, and quite possibly forever.

How to explain? 

Let’s assume for the moment that the 80/20 ratio is a universal economic law – that, no matter what you do, economies will reconstitute themselves to put 80% of the wealth in the hands of 20% of the population.

If that is the natural order of things, what is the percentage of wealth that the 1% would “naturally” own?

This seems, at first, to be an easy bit of arithmetic. One percent is 5% of 20%. So if the 20% own 80% of the wealth in any given economy, the 1% should own 5% of that 80% – or 4%.

Right?

Maybe. But what if the Pareto Principle worked within the 20%? What if the top 20% of the 20% owned 80% of what the 20% own?

In that case, we would look first at the 4%, not the 1%, because 4% is 20% of 20%. So the calculation would be that the top 4% of the general population should own 80% of the 80% or 64% of the national wealth.

Do you follow?

I’ll do it again…

Let’s call this new theory – that the Pareto Principle is regressive – the “Masterson Mandate.” The Masterson Mandate suggests that 20% of the 20% (or 4%) should own 64% of the wealth of the general economy.

Twenty percent of 20% is 4%. If 80% of the world’s wealth is owned by 20% of the population, then 20% of that 20% – or 4% – should own 80% of the 80%, which is 64%.

Okay. One more time: 20% of 4% is 0.8%, and 20% of 64% is about 12.8%.

Now to the 1%… 

What is 1% compared to 4%? It’s 25%. That’s not 20% – but since the Pareto Principle is not an exact ratio, we are going to accept the 25% as consistent.

We said that the Masterson Mandate would suggest that 4% of the population would own 64% of the wealth of the larger economy. It would also suggest that 25% of the 4% (or 1%) would own about (a bit more than) 80% of that 64%. Eighty percent of 64% is about 50%.

Holy cow!

The Masterson Mandate suggests that the natural state of things is that the top 1% of any economy should own 50% of the economy’s wealth.

In the US, the top 1% owns 40%. Does that mean they haven’t yet acquired their “natural” share? Does it mean that the wealth gap should continue to increase?

Alas, I cannot answer these questions right now. I only this moment came up with the Masterson Mandate. It will require further study.

More coming…

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