Ratios are all the rage these days. We particularly hear a lot about the 1% and their growing share of the world's wealth. But there are many others. Only this week, in her Financial Times column, Rana Foroohar quoted research from the McKinsey Global Institute showing that 10% of companies account for 80% of profits and the top quintile earns 90%. As she points out, these top companies are not the traditional capital-intensive industrial giants of the past, but the intellectual property-rich tech superstars of Silicon Valley - the likes of Apple, Google and Amazon.
However, the ratio that arguably beats all others is 80:20, also widely known as the Pareto Principle, after the Italian economist who discovered it in 1897. Pareto (in further evidence that there is little new under the sun) was looking at patterns of wealth and income in the nineteenth-century. Unsurprisingly perhaps, he found that most income and wealth went to a minority of people. More significant, he also discovered 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 the group enjoyed. Moreover, Pareto found that the same pattern of imbalance was there whenever he looked at data referring to different time periods or different countries. As is often the case with originators, Pareto did not develop and publicize his findings as well as he might have, and it fell to others to see the potential in an idea that has become something of a rule of thumb for business - especially the notion that 80% of sales typically come from 20% of customers.
Although the principle was developed to good effect in the years after the Second World War by such pioneers as Harvard professor George K. Zipf and the engineer Joseph Juran, who became known as the father of the quality revolution, much of the credit for its wide application goes to management consultant and author Richard Koch, who published The 80/20 Principle in 1997. While explaining the history of the notion, Koch also gave it new impetus by showing how it could become a useful way of looking at all sorts of business problems. For the 20th-anniversary edition of a book that has sold millions of copies around the world and become a business classic, he has added new chapters that bring it right up to date. Indeed, he points out that he believes the technology industry developments that so fascinate Foroohar and other commentators help explain the mystery of how the 80/20 principle works. "When I wrote the first two editions of this book, I had no idea why the principle worked so well," he writes. "I quote the economist Josef Steindl - 'For a very long time, the Pareto law has lumbered the economic scene like an erratic block on the landscape: an empirical law that nobody can explain.' But now I'm excited, because I think I know the explanation, and it also explains why 80/20 is becoming even more prevalent, affecting our lives in mysterious and perplexing ways."
Koch's explanation is what he calls "the burgeoning power of networks." While accepting that the number and influence of networks have been growing for a long time, he suggests that since the later years of the 20th century the increase has become faster and more dramatic. Because networks also behave in an 80/20 way, so the principle becomes more prevalent. Obviously, the arrival of the internet and the rise of companies whose very purpose is to connect people, such as Facebook and Twitter, have only exaggerated the trend.
Much has been written about the New Economy over the past couple of decades and a lot of it has been found to have been misguided, particularly the notion that new-economy businesses do not need to make money in the same ways as traditional ones (as the dotcom bust proved). But Koch seems to have put his finger on one of the things that marks out the real winners in this new era. He asserts that nearly all the web or app-based organizations that have appeared in recent years - such as Apple, Google, eBay, Uber, Amazon, Netflix and Airbnb - are "either networks or have networks nestling within their ecosystems."
The significance of this, Koch adds, is that such organizations do not require direction from the top in order to grow, as is the case with traditional businesses. Their growth comes not from the top, nor the bottom, but from outside the organization. "It is the network itself that grows, as a result of actions by the network members themselves - if the network is owned by a business, the 'members' are also 'customers' or potential customers," he writes. "The network grows because of its own internal dynamics and because it is in the interests of the network members that it should grow."
This last point seems crucial - and helps to explain why it is proving so difficult for regulators to control the new commercial giants. Much as users might - when they pause to think about it - complain about the power of the companies they have in a short period of time become almost totally dependent upon the network. In the past, people knew when they were being sold to - for the simple reason that the big auto companies and the rest hired expensive advertising firms to target them. There was a clear "them" and "us". Now, people are encouraged to feel part of a community where new products are more subtly offered as "upgrades" and "enhancements" that draw us in all the more. The fact that many of these businesses have funky or cute names only adds to the soft impression. But consumers and those who should be protecting them should not be fooled. The internet might in theory provide open access to everybody, but in reality it is dominated by a few - in a perfect example of the Pareto principle.
Koch writes that Wikipedia lists more than 200 search engines. "Yet four of them worldwide - Google, Baidu, Bing and Yahoo - take 96% of the market. So 2% of search engines hog 96% of search engine enquiries and therefore advertising - a 96/2 relationship," he adds. Google - hardly surprisingly - alone has 66% of the search market, a figure that rises to 94% for mobile search. Meanwhile, in Chinese e-commerce, the Alibaba site takes 75% of all transactions, says Koch. Thanks to the global connectedness offered by the internet, it is increasingly possible for a single company to dominate markets not just in one country but around the world much more easily than was the case in the past.
Indeed, as Koch points out, networks "are not just increasing the incidence of the principle and making it pretty much ubiquitous, but also increasing the extremity of the principle." In other words, 80/20 is becoming 90/10, 95/5 or even 99/1. Koch has a few "hints" for individuals looking to thrive in this world - chiefly, spot an opportunity in a potential superstar organization - without really dealing with the consequences of this fast-developing trend. But we should be grateful that, thanks to Koch and those whose ideas he has built upon, we have a better notion of what is going on. We just need some leaders who can do something about it.
