The Pareto Principle posits that 80% of results come from 20% of causes. While this is a generalization that certainly does not apply in many cases, marked asymmetries between causes and effects have many important business implications, from how strategy is designed to how resources are allocated. For entrepreneurs and companies, a key challenge as well as opportunity is to recognize the tendency of many systems toward asymmetry and use that tendency to strategic benefit. After discussing the fundamental assumptions of the Pareto Principle, this Article illustrates how this economic concept can be used to help drive business strategy.
The Pareto Principle
The economic doctrine that came to be called the Pareto Principle was developed by the Italian economist Vilfredo Pareto in the late 19th century. Pareto developed an economic model to describe the economic phenomenon he observed whereby 80% of the land in Italy was owned by 20% of the population.
After it was observed that this relationship was not only limited to land in Italy, the Pareto Principle was extended to many other fields, including business and science. In the 1940s, the business consultant Dr. Joseph Juran applied the Pareto Principle to business processes, dividing them into the “vital few” and the “trivial many.”
Some real-world examples of the Pareto Principle include situations where:
- 80% of sales come from 20% of a company’s customers
- 80% of investment capital comes from 20% of a company’s investors
- 80% of wealth is owned by 20% of the people
- 80% of software crashes are caused by 20% of software bugs; and
- 80% of project outcomes are generated by 20% of project efforts.
From a business perspective, the significance of the Pareto Principle is that a large amount of a business’s time should be focused on the 20% of causes that have the greatest impact.
Pareto Principle Dynamics
The Pareto Principle is not only relevant as a statement of the end-state of a particular system but also as a reflection of dynamics that tend to make that end-state more likely. A key issue to consider from a strategic perspective is therefore the dynamics that occur to make Pareto distributions or other targeted end-states more likely.
Initial condition variance. Small differences in initial conditions can lead to wide differences in outcomes. Two boats may start sailing next to each other, but if their trajectories are even slightly different over time they will be separated by a very large distance. These differences can be dramatically magnified if the boats’ trajectories take them through different sailing environments.
Power law relationships. Many interconnected variables in systems are defined by power law relationships, where the result of one variable is defined by a non-linear function of another variable. For example, a very small number of earthquakes cause the vast amount of earthquake-related damage. A small number of books or authors may comprise the vast majority of book sales. Power law relationships tend to become less exponential over time, which has the effect of stabilizing the systems that are defined by those relationships.
Complex interactions. No system can function for long in conditions of chaos. Because of this, there is a great deal of pressure in all systems to coalesce around patterns and the functionality of these patterns tends to increase the likelihood that those patterns will increasingly be adopted and institutionalized. In many systems, even distributions can significantly increase functionality challenges.
Network effects. Many systems are defined by networks, which can be comprised of people or processes. These networks tend to lead to asymmetrical relationships between network participants.
Pareto Principle Dynamics in the Business Context
Pareto Principle dynamics are often observable in business.
One area where it can be observed is in asset accumulation, because the concentration of a resource tends to make the increased concentration of that resource more likely. For example, land is a valuable asset that can be used as collateral to acquire additional land. The more collateral you have, the easier it tends to be to acquire additional land. As this provides a competitive advantage over people without land, over time there is a good chance that land ownership distributions will become increasingly asymmetrical.
A second example of Pareto Principle dynamics in business is market share. Companies with significant market share often have numerous types of resources that they can use to further increase their market share, such as:
- access to capital
- access to human resources
- name recognition; and
- extensive market information.
The reverse is often true with smaller companies. Their limited resources make them more susceptible to different types of shocks, and this increases their exposure to scenarios which can cause them to further lose market share. Larger competitors, due to their greater resources, often have the ability to take this market share.
A third example of Pareto Principle dynamics is the uneven distribution of perceptions and its impact on actions. If we consider, for example, an investment in a particular sector or a particular geographic area, it is unlikely that all investors will make the same type of risk and return analysis. This is because risk is inherently subjective, and the particular circumstances and strategy of a company may make a certain type of investment appear riskier to one investor than another. These differences in perceptions create imbalances in investment decisions that, over time, can lead to marked capital allocation asymmetries.
Pareto Principle Adjustments
Despite the strength of Pareto Principle, there are several reasons why it should be adjusted in the business context.
System Complexity Differences. Different types of systems or environments have different levels of complexity, and this impacts cause-and-effect relationships. As a general matter, businesses operate within an environment that is considerably more complex and dynamic than, for example, a closed system with relatively few causes and effects. A country’s economy, for example, is far more complex and dynamic than a machine with few moving parts.
In business, a company’s competitive position is a mix of many factors, including strategic direction, employee satisfaction, the strength of its systems and market conditions. Regardless of a company’s market share, each of these factors can change in unexpected ways and how these factors change can undermine a company’s market position.
The fact that business conditions are the result of many complex factors increases the probability that cause-and-effect relationships will also shift.
Strengths Can Become Weaknesses. The Pareto Principle assumes that disproportionate power of certain causes tends to perpetuate itself. However, in business, the very factors that can lead to an asymmetrical impact or concentration of results can in turn set in motion forces that ultimate reverse those results. For example, a company may need to spend a great deal of resources to maintain its competitive position and in adverse economic times these expenditure requirements can become a significant liability that can increase the company’s competitive vulnerability.
Business Environments Are Highly Exposed to Disruptive Forces. Unlike simpler types of systems, a key element of many business environments is that they are highly exposed to potentially disruptive events. These events can include:
- sudden market shifts
- regulatory changes
- the emergence of new competitors; and
- technology.
These forces can dramatically alter the relationship between market causes and effects: 20% of an effort that produced 80% of revenues under one set of market conditions may not produce 80% of those revenues in another; laws that level the business playing field may cause market positions to be more evenly distributed.
Application of the Pareto Principle to Strategy
There are several ways that the Pareto Principle and Pareto Principle dynamics can be used to improve business strategy.
Use of Resources. The very first lesson of the Pareto Principle applicable to strategy is that businesses should strive to avoid focusing large amounts of resources on activities that will only provide a small amount of benefits. While this is often done in the name of diversification, Pareto Principle dynamics directly question whether the net value creation benefits of diversification are greater than those of a more concentrated strategy. A single product or market strategy may lead to a stronger market position than a multi-product or market strategy.
One implication of the Pareto Principle is that is calls into question the economic benefits of diversification.
Long-Term Focus. A second implication of the Pareto Principle is that asymmetry becomes increasingly likely over time. The longer you continue with a certain activity, the greater the likelihood that you will be able to take advantage of dynamics, such as the network effect, which follows power law principles. If an entrepreneur follows a “fail fast” strategy, they may simply absent themselves from the very dynamics that ultimately lead to success. “Win slow” may be more reflective of the actual pathway of many successful enterprises.
The Importance of Metrics. Putting strategic emphasis on what is working well requires companies to understand what in fact is working well. While this sounds easy enough, in complex business environments it may not be so easy to tell exactly what causes are producing the majority of the results. For example, in the case of the sale of a product, are people buying it because: (i) the product is good; (ii) the price is good; (iii) the service is good; or (iv) marketing is good? Factors that might seem to be responsible for success may not actually be responsible for success. This is related to understanding what product a business is actually selling.
Addressing this issue requires focusing on clear and actionable metrics. These metrics should establish criteria for success and performance should be tested against those criteria. A key part of this process should be reaching out to customers to seek information regarding their purchasing decisions motivations, so the company understands what its success drivers really are. Once a company understands this, it can increase its focus on those drivers to try to further build its competitive advantage.
Organizational Communication. Companies are comprised of different departments that may have different roles, objectives and agendas. These differences, and the at times counterproductive organizational gridlock it can produce, can cause companies to inefficiently allocate resources. Successfully focusing on what is working well requires companies to not only understand what they are doing right but also continuously communicating that to employees so it becomes a shared rallying point for future action.
Building strong inter-company communication channels is a way for companies to create a culture of focus around what they are doing right.
Institutional focus is a result of communication at all organization levels. On many occasions, firm employees with customer-facing roles may be in a very good position to solicit and convey feedback to other corporate teams. This can help break down barriers between “front of the house” and “back of the house” departments and reduce the risk of the formation of strategic or operational silos that impede Pareto Principle dynamics that help optimize company performance.
Conclusion
While the 80/20 relationship between causes and effects is not applicable in many cases, the Pareto Principle does usefully highlight the reality that many systems, including the systems that define business activities, tend toward asymmetrical states. If businesses focus on the dynamics that cause asymmetries, it can help them build strategy in a way that makes benefiting from these dynamics more likely.
Thanks to Hugo Aitken for the photo for this article, which is available on Unsplash.