“We don’t live under a normal world; we live under a power law,” says Peter Thiel in his book Zero to One.
Power law distribution is a concept that is not frequently mentioned in the media, school, government, etc. If you asked a random person about this concept, they would likely give you a blank stare. But it’s power laws that ultimately shape the world across different domains, be it natural disasters, terrorist attacks, book sales, market share held by corporations, size of cities, investment returns, etc.
One of the most well-known power laws is the Pareto Principle, which states that 80% of effects come from 20% of causes. 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 readily be replaced, even for the most trivial of reasons, is naive, foolish, and unethical. Talented, diligent, and motivated employees are crucial for the success of any organization. Doing all that can conceivably be done to limit turnover is vital.
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 individuals. While there is demonstrably some mobility in the system 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 inequality is 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 areas such as the arts, technological innovation, or 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 players in the 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 that can constrain these wealthy and powerful individuals and organizations from dominating the world? And not only in monetary terms, but also in their ability to exert influence in state policy 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 in to bail it out.
Similary, 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 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 state.
To make this work, it would also be necessary to make it illegal to provide any sort of relief to corporations via state channels. 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 from excessive risk taking, while simultaneously shielded from catastrophic downside risk.
The optimal solution is to allow all profits to be privatized and no costs to be socialized. 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 part to their ability to generate economies of scale and their ability to pass on the added compliance costs to consumers by raising the prices of their products.
Large firms also enjoy 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; the layers of regulatory and legal obstacles that accompany in their nascent stage 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.
This is why large firms tacitly approve of highly regulated business envirnonments. A highly regulated market assists them by stifling and bankrupting smaller firms, some of whom may have gone on to eventually supplant them, had the environment been more business friendly.
In addition, complex rules and regulations can easily be circumvented by exploiting loopholes – and it is, of course, the large, established firms that have the resources to avail themselves of the best lawyers.
Large firms 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 can 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 pressure of possibly exiting their class. There should be enough mobility so that individuals have both a reasonable chance at entering the upper class and a reasonable chance of exiting the upper class.
While it seems that we can’t fully 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.