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Pareto’s Law, Inequality, and Why the Customer Isn’t Always Right.

The year is 1896, somewhere in western Europe an Italian economist by the name of Vilfriedo Pareto is tending to his garden, and notices a pattern. Pareto’s peas follow an unequal distribution, with a small portion of the plants producing the most peas, while the rest produce very few. This small observation of a seemingly meaningless pattern would lead to Pareto’s name-sake discovery and become one of the most popular theories in modern economics. Though he is a life-long academic with published papers in Mathematics, Engineering and political science, it is in his 50th year that he will publish his masterpiece – simply titled “Cours d’économie politique” or “Course of Political Economy.”

Pareto’s Law

Pareto’s paper, inspired by the distribution of his peas, looks into the distribution of land ownership in Italy, and finds that approximately 80% of the land is owned by 20% of the people. Pareto’s peas also followed this 80/20 split, and he began to see it everywhere. Pareto’s discovery boils down to a simple idea: 80% of the results come from 20% of the actions, or more accurately, 80% of the effect comes from 20% of the causes. Though this law may be explained in some part by Capitalism and the structure of modern society, it does indeed  appear a lot in the natural world, leading Pareto to believe that this is not only a law driven by man, but an underlying principle of the universe itself. We can observe Pareto’s law in many situations such as:

People spend 80% of their time with 20% of their friends.

Businesses earn 80% of their profits from 20% of their customers.

Microsoft reports that 80% of errors are caused by 20% of reported bugs.

20% of the population uses 80% of healthcare.

This “snapshot” of economic principle seems like it may just be an observation, and not something that would cause a change in behaviour. Pareto, however, saw beyond this and realized that his 80/20 principle has profound implications for efficient resource allocation. He knew that by tending to his 20% of peas more carefully, he would increase his crop more, and with less effort, than if he were to put the time and effort into tending more to his 80% which are not producing well. He applied this principle to production, as will be explained below using the classic “Butter vs Guns” example.

The above graph is to do with production of goods in an economy. For simplicity sake we have said that the economy only products 2 goods – Guns and Butter. Point B shows a position where all productive capacity is utilized, but a lot of guns are being produced, and very little butter is being produced. As we do not know the relative demand for these goods, we can not say whether this is a bad or good thing, we can however say that it is efficient as all productive capacity is utilized. Likewise, we can say that points D and point C are also both efficient for the same reason. Point A shows a point where more guns than C are being produced, and more Butter than A is being produced – the point is still inefficient though, as at point D more of both are being produced. In essence, the economy can not be internally made more efficient by moving along the blue line, though it can become more efficient by moving from a point within the blue line to a point on the blue line. A shift in productive capacity (more goods can be produced with the same amount of input) would result in the blue line expanding outwards, this is a key goal of any economy. Keep this in mind as we move onto the next section.

OK – maybe I am terrible at explaining things, but if the last part confused you, feel free to skip this next section – things are about to get confusing.

Above we have what is called an Edgeworth box, an idea actually developed before Pareto’s law, but in the context of mathematics, and not economics. Firstly look at our blue-lined graph in the previous section. As discussed earlier, the idea is to expand the blue line outward, while remaining at an efficient point on the blue line. In the above Edgeworth Box the black lines represent the productive capacity of economy A, and the red lines represent the productive capacity of economy B. The idea here is we are trying to redistribute the initial endowment of resources (point q) to a point where no-one can be made better off without making the other party worse off – or as I like to think about it, we are looking for win-wins, or at least win-indifferent. The natural solution for this occurs where the two lines are tangent, as neither party has a trade-incentive where they could be made better off. Make sense? Maybe not really but I will pretend like it did.

Why the customer isn’t always right.

 

In Pareto’s eyes, there was two basic principles behind this – efficiency and allocation. In a business setting, it is always a task to motivate employees to reach their productive capacity (and thus operate on the blue line as seen in graph 1). This is normally seen as the “obvious” way to increase business productivity, and thus customer and client satisfaction. I would propose that this traditional idea of business is flawed, and perhaps effective allocation of effort is just as important as maximizing output. By a business refocusing from “busy work” that is in the inefficient 80% of activities, I would encourage the profit making 20% to be area in which 80% of the effort is assigned. Maybe it’s unnecessary paper work, worthless procedures, company tradition, or just those low-profit customers who take up all your time but likely you need to re-think your time allocation. Think of Pareto, his peas, and his crazy italian beard next time you tell that customer to take a hike and stop wasting your time. You’ll feel better for it knowing there is less on your plate, and you have made your activities more Pareto Efficient.

 

Thanks for reading!