“We don’t live under a normal world; we live under a power law,” says Peter Thiel in his book Zero to One.
Many people are familiar with the normal distribution, otherwise called the “bell curve,” where a distribution of values cluster around the mean.
Power law distribution is a concept that is not frequently mentioned in the media, school, government, etc. If you asked a random person about either of these two concepts, they would likely give you a blank stare. But it is power laws that shape a significant part of the world in various domains, be it natural disasters, terrorist attacks, book sales, market share held by corporations, investment returns, etc.
The Pareto Principle (a type of power law) states that 80% of effects come from 20% of causes – this is one of the most well-known power laws. Another is Price’s law, which states that the square root of the number of people in a domain do 50% of the work. These models have proven to be useful in a variety of applications in their ability to identify and provide solutions to problems relating to inequality.
When we apply power laws to the business world we find relatively few firms control the majority of the market. Some well-known examples include Alphabet, Facebook, Amazon, Microsoft, and Apple. These firms not only dominate in their respective industries (with some making the case that they should be prosecuted for violating anti-trust laws), but are responsible for a large chunk of the returns in the stock market.
Emperical studies, such as this one, have reached the same conclusion: most of the gains in the stock market will come from relatively few stocks.
If you are running a company, it is incumbent on you to ensure everything is done to maximize revenue. Power laws have definite applications in the process of hiring, training, and retaining employees: 50% of sales will be generated by the square root of the number of people in the a firm (as as example, if a particular company employs a hundred workers, ten will be responsible for 50% of the sales generated). Therefore, if you are running a company, it’s critical for you to do everything possible to attract the most competent and efficient workers and retain them for as long as possible. Proper incentives are key so that your competition doesn’t snatch them up.
The notion that employees are fungible and can be readily replaced for even the most trivial of reasons, is naive, foolish, and unethical. Talented, diligent, industrious, and motivated employees are crucial for the success of any organization; doing all that can conceivably be done to limit turnover is pivotal.
The disparity in wealth is perhaps the most salient example of power laws at work, and also, unsurprisingly, the most emotionally-laden.
The vast majority of wealth on the planet accrues to relatively few people. While there is demonstrably some mobility in society for people to move in an out of the affluent class, a major portion of the world’s wealth has always been concentrated in the pockets of a handful of individuals.
The poverty and humans rights nonprofit organization Oxfam, released a report in 2016 showing that 62 individuals had a net worth equal to 3.6 billion people. In addition, since the turn of the century, the poorest half of the world’s population has received a paltry 1% of the total increase in global wealth, while half of that increase was enjoyed by the top 1%.
The Sinister Effects of Power Laws
One of the conclusions we can draw from the effects of power laws is that vast inequality seems inevitable and as a society very few of us will make a huge impact on the world, be it positive or negative.
While power laws can be beneficial in domains such as the arts, technological innovation, or great scientific discoveries, the situation becomes more problematic when focusing on issues such as firm size and the distribution of wealth. The truth about power laws in the domains of wealth and power is particularly sobering because we know that acute disparities in these areas can precipitate great civil unrest and economic degradation.
Technology and free trade, both lauded as crucial for increasing the standard of living for people, have exacerbated the return on capital – but most of the wealth generated has flowed to few individuals.
As automation and artificial intelligence becomes more common-place, a maniacal commitment to optimization will pervade the business world; increasingly fewer people and materials will be required to create products and perform services.
If proponents of open borders and global economic consolidation are able to push back against the recent wave of nationalistic reactionary forces, we can expect the movement of capital and labour to intensify, allowing it to settle to where it is needed the most. The result will be a further reduction in input costs and a dramatic increase in profits for monopolistic firms.
Some of these firms, such as Google and Facebook, have proven to not only dominate their industries, but have successfully embedded themselves as powerful institutions in the dynamic cultural and political landscape. These firms have had a tremendous influence in what we read, think, and listen to. Their recent commitment to combat so-called “fake news” and “hate speech” is something to ponder over. Punishing people who hold certain political, social, and even scientific views is becoming more common.
Is there anything to constrain these wealthy and powerful individuals from dominating the world – not only in monetary terms but also their ability to exert influence in government and irrevocably transform our culture?
What happens when a major firm or institution collapses? The effects could be devastating when contemplating how power law distributions work.
In 1998, the hedge fund Long-Term Capital Management held positions in the bond market that were so enormous and heavily leveraged that when Russia defaulted on its debt and debased its currency, the Federal Reserve had to rush into bail it out. During the 2008 housing crisis in the United States certain firms were deemed “Too big to fail” and received substantial bailouts.
Can We Create a More Equal World?
A possible approach could be to ensure that firms do not become too large. This could be accomplished theoretically by putting guarantees in place specifying that corporations must adhere to these three conditions:
- Obey all existing laws.
- Fully internalize all costs.
- Receive no state benefits
While rule #1 is self-explanatory, rules #2 and #3 would be instituted to make it clear to corporations that they will not be bailed out in case of bankruptcy. In addition, they would not receive any subsidies, tax breaks, grants, loans, and other incentives from the government.
To make this work it would also be necessary to make it illegal to provide any sort of relief to corporations via the government. Corporate lobbying and political donations would have to be banned and legislation drafted to curtail the “revolving door” practice between government officials and corporate executives.
The more government privileges a corporation is conferred, and the more it is immunized from it’s mistakes, the larger it can grow, due to the fact that it enjoys unlimited upside benefits from excessive risk taking while simultaneously shielded from catastrophic downside risk. The optimal solution is, therefore, to allow all profits to be privatized and no costs to be socialized (meaning taxpayers must pay for the damages corporations inflict on individuals and property). If a group of individuals decide to form a corporation they need to understand that they will be held fully accountable for their transgressions and not be bailed out using taxpayer money.
A different approach could be to simply enact stricter regulations. While this argument does have some merit when it comes to high risk industries (nuclear power plants come to mind), more onerous regulations do not necessarily keep corporate abuse at bay.
As the complexity of the regulations grows, the amount of money and effort expanded to employ various legal and compliance departments also grows. In order to successfully traverse the regulatory landscape more and more funds will have to be diverted from economically beneficial activities to ensure the firm is in full compliance with the law. Large firms can more easily absorb these costs, due in large part to economies of scale and their ability to pass on the added compliance costs to consumers by raising the prices of their products. Monopolistic firms will usually not be hurt, as they have the privilege of unwavering loyalty from consumers, who are, begrudgingly, willing to pay higher prices due to the importance they place on familiarity, trust, and convenience (known as switching costs).
The firms that end up suffering are the startups and those in the growth phase – the layers of regulatory and legal obstacles that accompany them during these nascent stages will prove to be financially crippling. Many will shut down, others won’t even start, and the rest will be bought out by the monopolists, should they deem them a threat.
Increasing regulations doesn’t help solve the problem. In fact, large firms tacitly approve of them. A highly regulated market assists them by stifling and bankrupting the smaller firms, some of whom may have eventually supplanted them if the regulatory environment was more business friendly. In addition, complex rules and regulations naturally present the possibility that they can be evaded by exploiting loopholes – and it is, of course, the large, established firms that have the resources to avail themselves of the best lawyers. They can also “bribe” politicians with donations to draft legislation in their favour (a form of government failure known as regulatory capture). Once these politicians leave the public sector, firms sometimes hire them as compliance advisors, a practice known as the revolving door. The amount of money these politicians are offered is, unsurprisingly, substantial.
“The more corrupt the state, the more numerous the laws.”
The best way to combat the concentration of wealth and power is to foster the development of a legal, economic, and social system that has sufficient churn, that is, the system routinely subjects individuals and firms to the pressures of possibly exiting their class. There should be enough mobility so that individuals have both a reasonable shot at entering the upper classes as well as a reasonable shot at exiting the upper classes, should they currently reside there.
While it seems that we can’t prevent power laws from concentrating wealth and power in few hands, we can at least let nature take its course by ensuring that individuals always have “skin in the game,” that is, they fully internalize the risks they are taking and ultimately bear the consequences should they fail (which can include bankruptcy, loss of reputation, loss of power and influence, even death). Those who are at the top should always be on guard that they can easily fall from grace and end up in the gutter. If we create and maintain a system that protects them from this risk, the amount of power and wealth they possess may eventually prove to be the undoing of the current social order; a violent reset may take place – because the great mass of people, hopeless and helpless, eventually lose their patience and tolerance.