The Pareto Law: vital few vs trivial many

Submitted by Charles Hugh Smith from Of Two Minds

The Pareto distribution suggests that costs could be cut by 80% across the entire economy.

Economist Vilfredo Pareto's (1848 - 1923) data-driven discovery that 80% of the land in Italy was owned by 20% of the population led to the Pareto principle, known as the 80/20 rule. Research has turned up an astonishing range of natural and social examples of the 80/20 rule: fixing 20% of software bugs eliminates 80% of the tech support calls, 20% of the customers are responsible for 80% of the complaints, and so on.

The Pareto distribution is not a Newtonian law of precise prediction, it is a power law probability distribution: it projects probabilities and ranges, not exact numbers. For example, the top 25% of U.S. wage earners pay 87% of the Federal income taxes. The point is not precision but the basic distribution.

The 80/20 rule can be further reduced (80% of 80 is 64 and 20% of 20 is 4) to a 64/4 rule: the 4% "vital few" have outsized influence on the "trivial many" 64%. We can see the rough outlines of this distribution in income and taxes: The top 1% of taxpayers reported almost 17% of all taxable income and paid 37% of all income taxes; the top 5% reported 32% of all income and paid 59% of the taxes, and the top 10% earned 43% of the income and paid 70% of the taxes.

As I have often noted, most recently in The Fiscal Cliff's Structural Endgame (December 28, 2012), and Why the Middle Class Is Doomed (April 17, 2012), roughly 70% of all financial wealth is held by the top 5%. That is remarkably close to the 4%/64% distribution we would expect.

Can 4% of Homeowners Sink the Entire Market? (February 21, 2007) Answer: yes, 4% of mortgages defaulting collapsed the global housing bubble.

The Pareto distribution has another application: cost-benefit analyses. Though it is more difficult to substantiate than ownership of assets or taxation, we can estimate that accomplishing 20% of the standard diet/fitness recommendations yields 80% of the health benefits.

A small, simple house that costs 20% of the average U.S. new home reaps 80% of the benefits: privacy, ownership, a warm place to sleep, etc. (Having built a plywood cabin by hand in 1978 that is still doing duty, I would go further and say a dwelling that cost 4% of the average home construction cost provides 64% of the benefits, as long as minimal electricity and indoor plumbing are included.)

This distribution of costs and benefits has profound macro-economic consequences. The U.S. "healthcare" i.e. sickcare system costs twice as much per person as competing nations' healthcare and still leaves tens of millions of people uninsured or underinsured. Though those profiting from sickcare will of course deny it, we can project that spending 20% of the current wasteful cartel/crony-capitalist system's budget would accrue 80% of the beneficial healthcare.

We can go on to project that 20% of the defense budget accrues 80% of the actual national defense provided by the U.S. military (as opposed to cartel/crony-capitalist weapons procurement and Imperial over-reach).

The applications of the Pareto distribution are endless and extremely thought-provoking. 80% of the potholes could be filled with 20% of the city street-repair budget. 20% of the food harvested could provide a nutritionally adequate diet for 80% of the people. (if you doubt this, recall that we waste an estimated 40% of our food and food products output, and it takes 3 to 15 pounds of harvested fish to grow one pound of farmed fish.)

What if 20% of the time spent in meetings produce 80% of the work/decisions?

Does anyone seriously doubt that spending 20% of the conventional cost (\$120,000) for a four-year college degree would yield 80% of the quantifiable education gained?

If one car is shared by five people, 20% of the cost of vehicle ownership yields 80% of the benefits of ownership.

You see the point: roughly 80% of the U.S. economy is waste, friction, skim, fraud, profiteering and diminishing-returns inefficiency. Any system that spends 80% of its surplus on diminishing returns is doomed to insolvency.

This terrifies the conventional economics cargo cult because it suggests the market/state cannot provide jobs to 95% of the working-age populace.

Within the high cost-basis Status Quo, this is true. Few can afford to hire workers to perform marginal-return work, and few people can afford the absurd costs of education, healthcare and housing.

The solution is to radically lower the cost of living (education, healthcare, housing, governance/government) and reinvigorate the forgotten foundation of human life, the community.

I discuss this further in my most recent book, Why Things Are Falling Apart and What We Can Do About It.