Simply put, the 80/20 Law states that roughly 80% of the effects are a result of only 20% of the causes. The 80/20 Law (also known as the Pareto Principle), originated in 1906 when economist Vilfredo Pareto observed that 80% of the land in Italy was owned by 20% of its population. Since its inception, people have applied the principle to topics ranging from why people cheat in relationships to sales techniques.
Before going into applications of the 80/20 Law, it’s important to clear up that the the principle is far from an all-encompassing law governing the universe. For example, in terms of internet content, the ratio might be skewed towards 99/1, while a bell-curve distribution is prevalent among other forms of distributions in the world. Instead, the principle focuses on the fact that the majority of outcomes are the results of a minority of the causes.
Now that we’ve gotten that cleared up, let’s take a look at how the 80/20 law is applied to business today.
The majority of your revenues come from a few of your products.
For example, AT&T ran into this problem after becoming the exclusive wireless carrier to offer the iPhone in the United States. Although the iPhone is one of the most popular smartphones today, the array of Android, Windows Phone, and other smartphones on AT&T’s network dwarfs the amount of iPhone users, exemplifying the 80/20 ratio.
Since then, data usage has skyrocketed, growing 8,000% between 2007 and 2010. This single-handedly caused a disproportionate amount of dropped calls and slow data connections around the New York and San Fransisco areas, forcing AT&T to consider tiered data plans to segment its users and free up network space.
According to Mark Siegel, spokesperson for AT&T, “The tiered data plans will meet the needs of the overwhelming majority of consumers. A lot of people think they’re heavy users, but they’re not.” The segmentation of customers makes business sense, as all intermediate economics textbooks will preach the fact that undefined property rights (in this case, unlimited data usage), leads to free riding and overconsumption. Only through clearly defining property rights (setting tiered plans) will consumers pay for their actual usage.
The majority of your business will come from a small proportion of your customer base.
There are several types of consumers in this world. There are the die-hard fanboys who will camp outside of a store at 3 in the morning just to be in line to receive a product on opening day. There are the regulars who will consider you product, but choose among others to make an “informed” decision. Finally, there are the bargain hunters who will only buy from you given a huge discount.
The 80/20 rule stipulates that companies should focus mainly on the 20% who contribute most to revenues , then commit their efforts to swaying the decisions of the other 80%. An example of this is when Apple reduced the price of their iPhone from $599 to $399 two months after the product launched. Realizing that it neglected the early adopters, the small customer base providing a disproportionate amount of revenue with the price drop, Steve Jobs wrote an open letter to them announcing a no-strings-attached $100 rebate to iPhone buyers before the price drop.
This was a great PR move, with the blogosphere offering nods of approval towards Apple’s gesture. An article pertaining to this issue admits that, “taken at face value, it’s a great gesture to the early adopters, without which the iPhone would have tanked at launch.”
The majority of your business will revolve around a small amount of your products.
It’s no secret that moviegoers and television show watchers love new stuff. They love seeing the newest Brad Pitt movies and sitting through a disproportionate amount of commercials to see what happens in the latest episode of Mad Men.
Netflix, a physical and online distributor of movies and television shows, is a company which has tried hard to shift consumer focus from its most popular offerings to its less-watched titles. Since new releases typically cost more to obtain than older titles, profit margins for older titles are much larger. With that said, incentivizing customers to join Netflix for its collection of oldies will yield much higher profits than getting customers who are interested in the small offerings of new releases.
To do so, Netflix employed a state-of-the-art recommendation system. After viewing a title, each consumer’s recommendations list would change to reflect their tastes and interests. In doing so, Netflix began to shift the focus away from its popular titles to more obscure, high-margin ones. As you can see from the graph below, between 2000 and 2005, Netflix had indeed shifted consumer demand to the vast majority of its older content.
This is an example of a company which is focusing on the 80% of content which only contributes 20% of the revenue to increase the returns of such at a low cost.
The 80/20 law has many applications in the world of business. While the idea of a “law” which governs business behavior is daunting, the fact that companies such as Netflix can apply the idea in a contrarian fashion affirms the cliche that one must know the rules before they can break them.