Search results

2 results found.

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…

 

This essay and others are available for syndication.
Contact Us for more information. 

Continue Reading

Jul 13-Jul 17, 2020 

 

a look back at this week’s essays…

 

Pareto Principle, Part I:

The Secret of the 1%

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!

Click here to read more.

 

 

The Pareto Principle, Part II:

A Universal Law That Even Applies to Business 

I don’t remember exactly when I first read about the Pareto Principle, but I’m certain I did not grok it early in my career. It wasn’t until I was running a multimillion-dollar company in which I had secured a profit share… and there’s a good reason for that.

Click here to read more.

 

 

The Pareto Principle, Part III:

Entropy and the Impossibility of Equality 

When I was young, the campaign for equality was about the protection of equal rights under the law.

Today, the call for equality is very different.

Click here to read more.

 

 

what I’m reading 

 

Alchemy: The Surprising Power of Ideas That Don’t Make Sense by Rory Sutherland 

Rory Sutherland understands marketing. But he understands more than that, too. Alchemy is a fast read for marketing professionals, replete with philosophical observations and humor that makes the reading great fun, even for the most seasoned marketing professional.

Check out this online interview with Sutherland here.

A few testimonials:

“This is a breakthrough book. Alchemy is wonderfully applicable to about everything in life. Furthermore, it is funny as hell.” – Nassim Nicholas Taleb, author of The Black Swan

“So many of us are trained to focus on data and the logical, and Alchemy makes a great argument for the irrational. I think everyone could use a reminder that asking dumb questions, reframing old ideas, and, in turn, trying to create a bit of magic, can lead to unexpected solutions for some of our most difficult problems. Alchemy was a reminder of that and then some.” – Inc., “Great Books for Anyone Who Wants to Get Ahead in Life”

“Sutherland, the legendary Vice Chairman of Ogilvy, uses his decades of experience to dissect human spending behavior in an insanely entertaining way. Alchemy combines scientific research with hilarious stories and case studies of campaigns for AmEx, Microsoft, and the like. This is a must-read.” – Entrepreneur, “Best Books of the Year for Entrepreneurs”

“Buy this book. I loved it. It’s full of great insights.” – Matt Ridley, bestselling author of The Rational Optimist and Genome

 

 

recommended links from this week’s blog 

 

* The latest issue of AWAI’s Barefoot Writer – Click here to read the July issue.

 

* Jeff Allen on “Understanding Your Love Language” Here

 

* There are 8 musical terms that every music lover should know. Click here for a good explanation of each one.


* “This Is Where Your Wine Corks Come From” Here

 

* “How to Bleed in the First Line” by James Altucher – Click here to read the entire essay.

 

* Here’s more consumer advice from the FTC.

 

* Fun stuff from the Guggenheim Museum’s Works and Process project…here.

 

 

Q&A 

 

Your Question: 

What do you attribute your success to? Could you narrow it down to just a few main reasons? And based on your experience, what would you say are the main reasons that most people fail to succeed?

One more question: If you could give people like me your best 3 pieces of advice, what would they be?
– RT

 

My Answer: 

Your questions are all interrelated. I’m going to answer them this way:

 

  1. Three things that helped me be successful 

* Want. I grew up as one of eight children, living in a small house across the street from the RR tracks. I wore hand-me-down clothes, drank powdered milk, and worked four hours a day on Saturdays for a weekly allowance of 33 cents. In grammar school, this seemed normal. But in high school, I became acutely aware of and embarrassed by my family’s modest circumstances. This embarrassment fueled a lifelong desire to become more than I was. In short, being a have-not was, for me, a great gift.

 

* Commitment. My desire to be successful was always there, but I never achieved anything extraordinary until I realized that desire alone was not enough. There were plenty of people around me with the desire to succeed. Some of them had more talent. Many of them had more resources. Some were physically more attractive. (Don’t kid yourself – a big advantage!) And some were, although I hated to admit it, smarter. To succeed – to get myself to the front of my imaginary pack – I had to change my behavior. I had to commit to three things: I would work harder than anyone else in my peer group. I would become more knowledgeable than any of them. And I would get more things done – more things that mattered.

 

* Help. I have no doubt whatsoever that my desire and commitment alone would have been enormously helpful in advancing my career. But things began to move so much faster after I humbled myself enough to be mentored by several people that taught me things about work and life that it might have taken me decades to learn on my own. I don’t believe you need many mentors. One is good. Two or three are fantastic. Looking back at my career as I approach my 70thbirthday, it’s easy to see that I had four great ones: my mother, who gave me my contrarian nature; my father, who gave me my ethical values; JSN, my former boss and partner, who taught me how selling works; and BB, my current partner, who taught me (and is still teaching me) that the opposite of every true thing is also true.

 

* Wisdom. I’m not sure if anyone taught me this or if I somehow knew it. But it has been clear to me for as long as I can remember that you can accomplish much more in life if you set, as the purpose of your work, something that is outside of yourself. As an employee in business, that meant working to grow the business I worked for, not to get the business to pay me more. I knew that if I made myself invaluable to my boss, he’d take care of me. Later, in developing partnerships in every sort of project and business, I always had that same idea: Make it work for the other person first and it will come back to you.

 

  1. The three biggest reasons people fail to succeed 

 

* Ignorance. We are all ignorant in the beginning. To become knowledgeable about anything, you must accept the fact that you don’t know and put in the time to know. It takes between 500 and 1000 hours to become competent in any complex skill or career, and 5000 hours to become a master. You have to be committed to constant learning.

 

* Laziness. We are all lazy, naturally lazy. Being lazy is the source of creativity. We want to get what we need or want by working as little as we can. The problem with this is that if you give in to laziness, you will never achieve anything important. You will always be one of the pack. To be super-successful, you have to be willing to work much harder than the average person. You have to work hard for 60 to 80 hours a week.

 

* Arrogance. Many smart, hardworking people make advances but then hit a plateau. This often happens because they make the mistake of thinking that they are special. They believe that they know better than anyone else. They feel that they are “the smartest person in the world.” The smarter and more successful you are, the more  important it is to be humble.

 

  1. My best advice – three recommendations 

* Read The Pledge.

* Then read Automatic Wealth.

* Then read Ready, Fire, Aim.

Hope this helps!

 

 

Have a question for me? Submit it on our Contact Us page.

 

 

For a look back at the stock market, click here

Continue Reading