The Power-Law Distribution of Market Capitalization

by Walter Johnson

Money makes money. Having it opens doors and opportunities that the poor do not have. Around the turn of the century, Italian economist Vilfredo Pareto discovered that in most areas of life, a small percentage of causes is responsible for most of the effects. This is true in economics as well as in social life. For Pareto, economics, intelligence, politics and even biology all follow the same rule: A minority creates a disproportionate share of everything. In other words, if there is something of value you want, rest assured that a tiny minority of minds created it.

Pareto Distribution

A "power law" distribution is any regular correlation of variables in which the larger variable increases at an exponential rate. A simple concept of "power law" is found in the "Pareto distribution," commonly used to understand market capitalization. In this case, the Pareto distribution says that 80 percent of all wealth is caused by 20 percent of firms. It is exponential, because those with money have the means and ability to continue to see it grow. Therefore, the globe's income gap is normally an 80/20 split: Twenty percent of the population controls 80 percent of the wealth.

Power-Law

The power law relation to market capitalization is fairly simple to grasp. Eighty percent of the total capitalization of the stock market is done by 20 percent of the firms, as a general rule. More specifically, as the American stock market lists roughly 6,000 specific firms, about half of the value represented by stock prices is generated by about 100 firms. The top 1,000 firms are responsible for about 95 percent of all market capitalization.

80-20

Pareto's distribution is one of the most common forms of the "power law." The sociology is clear. Money begets money exponentially. People with money know much more about the stock market than do people without money. They know many successful investors and places to invest their cash. This is true of national income distributions, global income distributions and stock market capitalization. Therefore, the 80-20 rule is as much a sociological law as an economic one. Making lots of money is tough. But once you make your fortune, making it bigger becomes easier, because that money opens doors.

Emerging Markets

Indian economist and former professor Debasis Bagchi writes that the power-law distribution of the Indian stock market becomes more pronounced the more the market becomes capitalized. That is, the higher the level of total market capitalization, the more it perfectly represents the 80-20 rule. India's income distribution is basically identical with the level of market capitalization: 20 percent control 80 percent of the wealth. The only issue is when markets fail. Bagchi writes that if a country like India is going through an economic crisis, the market capitalization falls away from the Pareto rule. This strongly suggests that the sociological explanation of the 80-20 rule is true: Money opens doors. When there is little money to be made, the wealthy get out of the market, and as a result its capitalization no longer reflects the Parteo distribution.

About the Author

Walter Johnson has more than 20 years experience as a professional writer. After serving in the United Stated Marine Corps for several years, he received his doctorate in history from the University of Nebraska. Focused on economic topics, Johnson reads Russian and has published in journals such as “The Salisbury Review,” "The Constantian" and “The Social Justice Review."

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