Pareto Principle

In the next few posts, I’ll be posting about other fundamentals that I have missed so that we could move on to better stuff (i.e. stuff that not everyone knows) by the time I reach the 100 post mark.

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The Pareto Principle (also known by many names e.g. Law of the Vital Few, 80/20 Principle, etc.) is a widely observed phenomenon wherein 80% of the effects come from only 20% of the causes.

Richard Koch’s book The 80/20 Principle provides a brief explanation how this principle was discovered:

The pattern underlying the 80/20 Principle was discovered in 1897, about 100 years ago, by Italian economist Vilfredo Pareto (1848-1923).

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So what did Vilfredo Pareto discover? He happened to be looking at patterns of wealth and income in ninteenth-century England. He found that most income and wealth went to a minority of the people in his samples. Perhaps there was nothing very surprising in this. But he also discovered two other facts that he thought highly significant. One was that there was a consistent mathematical relationship between the proportion of people (as a percentage of the total relevant population) and the amount of income or wealth that this group enjoyed. To simplify, if 20 percent of the population enjoyed 80 percent of the wealth, then you could reliably predict that 10 percent would have, say, 65 percent of the wealth, and 5 percent would have 50 percent. The key point is not the percentages, but the fact that the distribution of wealth across the population was predictably unbalanced.

Pareto’s other finding, one that really excited him, was that this pattern of imbalance was repeated consistently whenever he looked at data referring to different time periods or different countries. Whether he looked at England in earlier times, or whatever data were available from other countries in his own time or earlier, he found the same pattern repeating itself, over and over again, with mathematical precision.

The concept did not gain popularity because, as explained by the book, Pareto “was very bad at explaining it”. It was only popularized decades later when other researchers rediscovered Pareto’s work and expanded it beyond economics.

The importance of the Pareto Principle is summarized in the book a few pages later:

The reason that the 80/20 Principle is so valuable is that it is counter-intuitive. We tend to expect that all causes will have roughly the same significance. That all customers are equally valuable. That every bit of business, every product, and every dollar of sales revenue is as good as any other. That all employees in a particular category have roughly equivalent value. That each day or week or year we spend has the same significance. That all our friends have roughly equal value to us. That all inquiries or phone calls should be treated in the same way. That one university is as good as another. That all problems have a large number of causes, so that it is not worth isolating a few key causes. That all opportunities are of roughly equal value, so that we treat them all equally.

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I’ve personally taken advantage of this principle many times even before I knew there was such a principle. One fine example is in my college days: I got through UP with flying colors even though I spend over 10 hours a day in an internet cafe or an org tambayan by focusing the things that would result in greater returns. I didn’t do stereotypical study habits like studying every night because it’s just a waste of effort; I know I’m likely to forget those things.

Instead, I did do my best to understand the lesson as it is taught by the teacher in class, even if it means sacrificing taking down notes. This way, I would have a firm grasp of the lessons with just minimal effort, allowing me to spend the rest of the day as I please.