Pareto, The 80/20 Principle and Winner-Take-All Effects

If you've ever worked in consulting, accountancy, law, or (God forbid) investment banking, you know that life at the office consists primarily of meetings, email, writing memos, with the occasional bout of actual work mixed in.

Scientists have come a long way in decoding the mysteries of the universe. One mystery they have yet to crack though, is how these monolithic companies don't just implode and wither away. More often than not, it seems they're held together by nothing more than duct tape, pixie dust, and bureaucracy.

In total, about 80% of an employee’s time is taken up by non-work-related activities. After all, where would the world be if we didn't attend that 3PM marketing strategy meeting? And so about 20% of an employee's time generates the majority of value for the company. Talk about lopsided returns.

However, these imbalances exist everywhere. A small amount of effort accounts for the majority of results and a small number of cities is where the majority of people live, just like a small number of customers usually accounts for the majority of complains.

To cover all that and much more, we should probably start with a 19th-century Italian economist who had a disproportionate interest in peas.

The Few Things That Really Matter

Vilfredo Pareto was tending his garden back in the late 19th century when he suddenly realized that a small number of the peas he sowed accounted for the majority of the harvest by the end of the season. Twenty percent of the peas resulted in 80 percent of the harvest, to be exact.

At the time, Pareto was studying the wealth distribution in Italy. And to his great surprise, he noticed the exact same distribution! A little over 20 percent of the people in Italy collectively owned 80 percent of the land. Just like the pea pods in his garden, it seemed that a minority accounted for the majority of the resources.

Over the course of his career, this distribution would pop up again and again. Researchers in the 20th century would continue to find similar occurrences, which led them to the Pareto Principle:

A small number of things accounts for the majority of the results.

More critically, it was often the exact same 20 percent that accounted for roughly 80 percent of the results. Since then, the Pareto Principle has become more commonly known as the 80/20 Rule.

If the 80/20 Rule states that 20% of your inputs produce 80% of the outcomes, what happens if you drill down further and take it to its natural conclusion?

In his 2013 book ‘The 80/20 Principle’, Perry Marshall did just that. Looking at businesses, where 20% of the customers usually account for 80% of the revenue, he came to the following conclusion:

“…20 percent of the 20 percent of customers are ultra-valuable… Four percent of (your) customers may account, or could account, for 64 percent of (your) profits”.
(Emphasis mine)

Let that sink in for a second. It's possible that 4 percent of your customer base accounts for roughly 64 percent of your revenue.

Let's take this one step further, shall we?

What if you were to take 20 percent of that 4 percent of customers? You'd end up with ~0.8 percent in total. Using the same math, that ~0.8 percent of customers would account for a little over 50 percent of all your revenue.

We could take this even further and figure out what the 20 percent is of that, so on and so forth. However, this is where the math becomes finicky and examples hard to come by. But it perfectly illustrates the point:

The majority of the results are driven by a minority of causes.

It's Good To Be A Winner

What the 80/20 Rule very clearly demonstrates is that — above all — it's good to be a winner and to focus on the inputs that account for a disproportionate part of the outcomes. By making sure that you actively target that 20 percent, you guarantee you're doing the work that matters most.

The Pareto Principle is an example of a so-called power law. Whether you realize it or not, these power laws surround us and influence an enormous part of our modern lives.

Just like with the 80/20 Rule, it's often a small group that accounts for the majority of outcomes. Whether that is the number of records an artist sells, the distribution of wealth amongst billionaires or the performance of the stock market.

The most common power law is what is often called the winner-takes-all effect. This occurs when a small number of players gain the vast majority of resources in a particular domain. This could be market share in a particular market or the number of sales within a given category.

We all understand power laws to a certain extent. Only one person can win a race. But what makes winner-takes-all effects different is that the gap between the winner(s) and the rest of the field is very large, and usually expanding at that.

Take Facebook for example. Over the past 15 years, it's grown from a Harvard-exclusive version of MySpace into the world's biggest social network. And not it's even close, either. One in every three people on this planet have a Facebook account and over 65 percent of all social media traffic goes directly to Facebook. Twitter comes in at second place with a paltry 14 percent.

Social media is inherently a winner-takes-all market, which inevitably leads to one major player dominating the industry.

Here's why: You sign up to a social media service in order to connect with people you know or find interesting. The more people are on there, the more appealing it becomes for you to sign up. Therefore, any new entrants to the social media market would need compete with the fact that your friends already have a Facebook account. Who's wants to be the first person to sign up to a social media service?

This is what is called a network effect, where the entirety of Facebook (or some other service) becomes more valuable as it gets more users, since that in and of itself is what then draws other users to sign-up. And this is also what makes it more difficult for the competition. In the end, the biggest will continue to grow bigger (since that's where the people are) and the rest will slowly die off.

Winner-takes-all effects surround us. Just consider that 99.99 percent of the computers on Earth either run Windows or MacOS, with almost 80 percent of that being Windows. Winner-takes-all effects pop up here because there are:

High Barriers To Entry

Building an Operating System is expensive as hell. It's not something you quickly throw together over the course of a weekend and immediately start to market. There are thousands of people at Apple and Microsoft whose sole job it is to update and build their respective OS’. As time goes on, it takes more and more resources to be able to compete, owing to the number of hours spent on it. Therefore, with each passing year, the likelihood of a new OS dethroning Apple or Microsoft becomes slimmer and slimmer.

High Switching-Costs

Consumers hate change. If you've ever witnessed YouTube changing it's site-layout and the inevitable backlash, you know that people really don't like change. Even if it might benefit them. There are huge barriers for people switching between different Operating Systems. Everything is different. The way you use your mouse, the way files are structured. And that's not to mention that a lot of the software you have is often incompatible with a competing OS. So, once someone has gotten used to a particular OS, it will take a lot for them to switch, leading to a few dominant players remaining dominant.

Accumulated Advantages

Small advantages compound. In most winner-takes-all markets, being slightly better than your competition allows you to continue to get better. Back in the 1980s, there were dozens of different Operating Systems, all competing for a slice of the pie. What ended up happening was that a handful of competitors were just slightly better than the rest and had higher sales numbers to show for it. These earnings could then be reinvested into making the OS even better, increasing the gap between them and the competition. The small advantages compound and slowly but surely become big, insurmountable ‘moats’. This process of small wins leading to bigger wins is what's known as “Accumulated Advantages.”

As it turns out, these three points are the easiest way to identify markets and industries where winner-takes-all effects reign.

Winner-Take-All Effects & The Internet

With the advent of the Internet and the increasing digitization of our society, winner-takes-all effects have become more common. For many entrepreneurs, it's even what will attract them to a particular industry or business idea. As Peter Thiel puts it: “Competition is for losers. If you want to create and capture lasting value, look to build a monopoly”. And in the 21st century, the best way to build a monopoly is to make use of winner-takes-all effects.

Here's why digital products are positioned so perfectly to take advantage of them:

  • Digital products and services, be they social media sites or Amazon's market place, have very high fixed costs and yet low-to-zero marginal costs. Amazon spends a fortune to build, maintain, and host their website. However, it costs them next-to-nothing on a per-user basis. What's more, economies of scale allow business to have more efficient processes and infrastructure, spreading the cost over millions of customers.
  • As we've already discussed, network effects ensure that people will congregate where other people already are. This is why Facebook blew up and continues to be the dominant player. But it's also evident in the rise of popular games like Fortnite, the adoption of Instagram, and the popularity of WhatsApp outside of the USA.
  • Thanks to the internet, distribution has become essentially free. It doesn't take any resources whatsoever to copy a piece of software. And with the rise of high-speed internet, you can literally buy an application and have it downloaded on your hard drive within a couple of seconds. No need for delivery trucks, packaging or other physical labor. As a result, products can be sold at lower prices, resulting in business who are still bound to physical distribution to lose out.

As Pareto put it, a small number of things is responsible for the majority of the output. Be it pea pods, your activities at work, or the revenue your customers bring in. This is why it's so important to focus on the couple of things that really matter, to the exclusion of everything else.

The people and businesses that focus on the few areas that truly matter will consistently maintain an edge over their competition. This will then compound and snowball into greater and greater accumulated advantages. Given a long enough timeframe, this will allow them to rise to the top, capturing a larger market share with every passing month and year. Eventually, winner-takes-all effects will kick in.

And, as we've established, it's good to be a winner.

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