Guest Post: The Pareto Economy

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Submitted by Charles Hugh Smith from Of Two Minds

The Pareto Economy

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.

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Wed, 02/20/2013 - 22:56 | 3262051 MeelionDollerBogus
MeelionDollerBogus's picture

At least 80% of the fuckers on this planet are so bereft of intellect or life experience or any kind of logical ability they'll gladly demand slavery upon themselves & insist it's better if their neighbors (that's us) enjoy it too.

So ya, they pretty much are the problem. The elite bank robbers of the world only get away with it because the larger populace doesn't use numbers, masses of riots, to attack, jail & execute the fuckers.

Sun, 02/17/2013 - 20:25 | 3252004 Monedas
Monedas's picture

20% of dog kibbles is protein .... 80% is filler and stool builder !

Sun, 02/17/2013 - 20:27 | 3252006 Who is John Galt
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20% of the posters on this site account for 80% of the moronic posts.

Mon, 02/18/2013 - 03:38 | 3252492 mkhs
mkhs's picture

No, 80% account for the moronic posts; 20% have some value.

Sun, 02/17/2013 - 20:28 | 3252007 Whatta
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so would it be 80% of GS calls cause 20% losses or vice-versa?

Mon, 02/18/2013 - 00:24 | 3252348 RopeADope
RopeADope's picture

20% of global fraud is derived from 80% of GS revenues.

Sun, 02/17/2013 - 20:28 | 3252009 Silversinner
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having 80% of the sex with 20% of the girls.

having 20% of the sex with 80% fat and ugly girls.

damn booze.

Sun, 02/17/2013 - 20:31 | 3252011 Monedas
Monedas's picture

80% of the posters account for 20% of the humour !

Sun, 02/17/2013 - 20:31 | 3252012 Whatta
Whatta's picture

Icahn's 20% stake in HLF causes Ackman 80% losses?

Sun, 02/17/2013 - 20:35 | 3252016 Smegley Wanxalot
Smegley Wanxalot's picture

80% of the STDs I have came from 20% of da ho's I banged.

Sun, 02/17/2013 - 20:41 | 3252022 smacker
smacker's picture

80% of political elites are a complete waste of space. The other 20% do something useful, for themselves.

Sun, 02/17/2013 - 20:47 | 3252029 Monedas
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Western economies are 20% Capitalist .... 80% Socialist !

Sun, 02/17/2013 - 21:13 | 3252072 smacker
smacker's picture

Exactly so. But we're not supposed to notice, 80% of the time.

Sun, 02/17/2013 - 20:50 | 3252034 Monedas
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20% of the Khmer Rouge killed 80% of Cambodia's literates !

Sun, 02/17/2013 - 20:51 | 3252038 Monedas
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80% of your Lasagne is horsemeat .... 20% is beef !

Sun, 02/17/2013 - 20:58 | 3252048 Snoopy the Economist
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The 80/20 rule is truly powerful. It may sound sad but I try to live my life by the 80/20 rule - everything I do I follow this rule and by addressing 20% of teh biggest issues I find that many of the smaller '80%' issues fix themselves. Ahh the life of an engineer.

Sun, 02/17/2013 - 21:07 | 3252063 Monedas
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If you measure your dick .... starting from your asshole .... 20% is taint .... 80% is dick !

Sun, 02/17/2013 - 21:08 | 3252066 User 3461
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Sun, 02/17/2013 - 21:56 | 3252139 jballz
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20% of zerohedge posts account for 80% of my shitty mood.

Sun, 02/17/2013 - 22:50 | 3252164 socalbeach
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From Wikipedia,

"It is a common rule of thumb in business; e.g., "80% of your sales come from 20% of your clients". Mathematically, where something is shared among a sufficiently large set of participants, there must be a number k between 50 and 100 such that "k% is taken by (100 - k)% of the participants". The number k may vary from 50 ... to nearly 100 ... There is nothing special about the number 80% mathematically, but many real systems have k somewhere around this region of intermediate imbalance in distribution."

Sun, 02/17/2013 - 22:30 | 3252170 smartstrike
smartstrike's picture

If 20% earn 80% of the profits, how is the economy supposed to work? The Pareto principle would suggest that the economy isn't working for 80%?

Sun, 02/17/2013 - 22:37 | 3252181 Smegley Wanxalot
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80% of the time I waste online is wasted on 20% of the porn sites I visit.

Sun, 02/17/2013 - 22:44 | 3252189 lead salad
lead salad's picture

80% of owebama is ass, 20% is hole.

Sun, 02/17/2013 - 22:58 | 3252200 Pareto
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I thought the Pareto rule (principle) was simply this: Given any endowment between two or more individuals, Pareto efficiency occurs when there is an opportunity for an exchange such that at least one person is made better off and no one person is made worse off.  It wasn't until neoclassical economists got a hold of this and developed authoritarian government redistribution measures such as the Kaldor/Hicks coercive kind, where a redistribution is said to be Pareto efficient if as a result of government action, the winners could compensate the losers and still leave something left over regardless of whether compensation is actually paid.

Frank Michelman (1967) evaluates the Pareto criterion and the "just compensation" principle in the context of regulatory takings and the takings clause to the 5th Amendment (...nor shall private property be taken for public use without just compensation - Takings Clause, 5th Amendment, US Constitution).  The utilitarian welfare maximization principle (or the Kaldor/Hicks efficiency) uses the Pareto criterion as a crutch, in my opinion, insofar as I doubt Vilfredo ever had the social welfare maximization principle in mind.  Michelman, didn't think so either.

He emphasized, among other things, that demoralization costs are not, nor have ever beem factored into the Pareto principle when applied to social welfare maximization redistribution schemes conjured by government.  Michelman's demoralization costs constitute, "the total value of (1) the dollar value necessary to offset disutilities which acrue to losers and their sympathizers specifically from the realization that no compensation is offered, and (2) the present capitalized dollar value of llost future production (reflecting either impaired incentives, or, social unrest) caused by demoralization of uncompensated losers, their sympathizers, and other observers disturbed by the thought that they themselves may be subjetced to similar treatment on some other occasion" (p. 1214).

Never heard of the 80-20 rule in the context of Pareto efficiency.

Sun, 02/17/2013 - 23:42 | 3252274 faustian bargain
faustian bargain's picture

"Never heard of the 80-20 rule in the context of Pareto efficiency."

Er, what? Never heard of it?

Mon, 02/18/2013 - 00:25 | 3252350 Pareto
Pareto's picture

Its true.  I hardly understand this to be his greatest contribution, but, evidently it is.  In economics, the 80-20 principle was never the focus of Pareto's work.  Welfare economics focused strictly on the maximization principle.  Admitedly, I know little about the 80-20 rule.

Mon, 02/18/2013 - 00:46 | 3252370 Monedas
Monedas's picture

Please try to stay on topic .... 20% of single guys .... get 80% of the available ass !

Sun, 02/17/2013 - 23:45 | 3252280 adr
adr's picture

Manufacturing and overhead usually takes up around 20% of the MSRP of a decent quality product. For a time 40% profit went to the manufacturing distributor and 40% went to the retail store. Equal distribution of profit. This then went to keystone pricing, 50% margin to the retailer, 30% to distributor. Next came the push to 60% retail margin. The mega retailers are now starting to push for 80% margin. Once that line is crossed it becomes impossible to produce any quality product and make a profit as a manufacturing distributor. If cost is 20% and you must sell at 80% margin, there is no profit. So the manfacturing distributor is destroyed.

In fact the line has been crossed already, only outsourcing and reducing quality have allowed profit to be generated out of the ever shrinking margin of a manufacturing distributor.

Big retail has started to go direct to overseas manufacturers and purchase the rights to brand names. Dick's Sporting Goods purchasing the rights for Reebok and Adidas Baseball. The name is worth 10%, manufacturing and overhead add 20%. This leaves Dick's with 70% margin. To get to 80% they reduce quality 10%. This leaves 10% for name and 10% for the actual product. $10 retail produced for $1.

Same goes for JC Penney. The already reduced quality by 10%, but sales did not follow. In order to increase sales, they cut retail prices. They eliminated the brand and brought out JC Penney brand clothes saving the 10% brand fee. We'll see if it works. Sure you now pay $18 instead of $20, but it still only cost $2 to make the shirt. Some people think the label with a brand is worth the extra $2.

It really is all bullshit. Wall Street makes sure of that.

Mon, 02/18/2013 - 01:10 | 3252386 HeavydutyMexica...
HeavydutyMexicanOfTheNorthernKingdom's picture

80% enter through the wide door, 20% enter through the narrow door.

Mon, 02/18/2013 - 07:16 | 3252569 mellons
mellons's picture

Disappointing to read such nonsense in zh

A ratio is meaningless if it can be applied arbitrarily to any relationship without any factual basis.

Wed, 02/20/2013 - 22:48 | 3262028 MeelionDollerBogus
MeelionDollerBogus's picture

the ratio IS the factual basis, just like with Fibonacci. One set of data is a set of facts, another set of facts contains the mathematical relationships that exist in the data. None of it is conjecture, opinion or deniable.

If you want to show it's inapplicable in certain cases then pick a case and make your case. Where it's held as applicable people have picked a case & made a case (successfully defended).

Mon, 02/18/2013 - 08:15 | 3252581 Cloud9.5
Cloud9.5's picture

So 20% are the critical mass needed for a change?

Mon, 02/18/2013 - 08:39 | 3252600 kralizec
kralizec's picture

I keep reading about doom, when do I get to see it?  Frankly, I am surprised we made it this far. . .

Mon, 02/18/2013 - 09:09 | 3252616 TrumpXVI
TrumpXVI's picture

I believe I've got another example.  

With women, 20% of their behavior is the product of their individual personality, and 80% of their behavior is due simply to the fact that they are women!

Mon, 02/18/2013 - 13:56 | 3253476 whoknoz
whoknoz's picture

20% of your stuff represents 80% of your net worth...so go clean out your closets!

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