The Pareto distribution, named after the Italian civil engineer, economist, and sociologist Vilfredo Pareto, is a power-law probability distribution that is used in description of social, scientific, geophysical, actuarial, and many other types of observable phenomena. Originally applied to describing the distribution of wealth in a society, fitting the trend that a large portion of wealth is held by a small fraction of the population, the Pareto distribution has colloquially become known and referred to as the Pareto principle, or "80-20 rule", and is sometimes called the "Matthew principle". This rule states that, for example, 80% of the wealth of a society is held by 20% of its population. However, the Pareto distribution only produces this result for a particular power value, (α = log45 ≈ 1.16). While is variable, empirical observation has found the 80-20 distribution to fit a wide range of cases, including natural phenomena and human activities.
Probability density function
Pareto Type I probability density functions for various with . As the distribution approaches where is the Dirac delta function.
Cumulative distribution function
Pareto Type I cumulative distribution functions for various with .
where xm is the (necessarily positive) minimum possible value of X, and α is a positive parameter. The Pareto Type I distribution is characterized by a scale parameter xm and a shape parameter α, which is known as the tail index. When this distribution is used to model the distribution of wealth, then the parameter α is called the Pareto index.
Cumulative distribution functionEdit
From the definition, the cumulative distribution function of a Pareto random variable with parameters α and xm is
Probability density functionEdit
When plotted on linear axes, the distribution assumes the familiar J-shaped curve which approaches each of the orthogonal axes asymptotically. All segments of the curve are self-similar (subject to appropriate scaling factors). When plotted in a log-log plot, the distribution is represented by a straight line.
Moments and characteristic functionEdit
- (If α ≤ 2, the variance does not exist.)
- The raw moments are
- The moment generating function is only defined for non-positive values t ≤ 0 as
- The characteristic function is given by
- where Γ(a, x) is the incomplete gamma function.
The conditional probability distribution of a Pareto-distributed random variable, given the event that it is greater than or equal to a particular number exceeding , is a Pareto distribution with the same Pareto index but with minimum instead of .
A characterization theoremEdit
Suppose are independent identically distributed random variables whose probability distribution is supported on the interval for some . Suppose that for all , the two random variables and are independent. Then the common distribution is a Pareto distribution.
Generalized Pareto distributionsEdit
There is a hierarchy  of Pareto distributions known as Pareto Type I, II, III, IV, and Feller–Pareto distributions. Pareto Type IV contains Pareto Type I–III as special cases. The Feller–Pareto distribution generalizes Pareto Type IV.
Pareto types I–IVEdit
The Pareto distribution hierarchy is summarized in the next table comparing the survival functions (complementary CDF).
In this section, the symbol xm, used before to indicate the minimum value of x, is replaced by σ.
The shape parameter α is the tail index, μ is location, σ is scale, γ is an inequality parameter. Some special cases of Pareto Type (IV) are
The finiteness of the mean, and the existence and the finiteness of the variance depend on the tail index α (inequality index γ). In particular, fractional δ-moments are finite for some δ > 0, as shown in the table below, where δ is not necessarily an integer.
where B( ) is the beta function. If
then W has a Feller–Pareto distribution FP(μ, σ, γ, γ1, γ2).
and we write W ~ FP(μ, σ, γ, δ1, δ2). Special cases of the Feller–Pareto distribution are
Pareto originally used this distribution to describe the allocation of wealth among individuals since it seemed to show rather well the way that a larger portion of the wealth of any society is owned by a smaller percentage of the people in that society. He also used it to describe distribution of income. This idea is sometimes expressed more simply as the Pareto principle or the "80-20 rule" which says that 20% of the population controls 80% of the wealth. However, the 80-20 rule corresponds to a particular value of α, and in fact, Pareto's data on British income taxes in his Cours d'économie politique indicates that about 30% of the population had about 70% of the income. The probability density function (PDF) graph at the beginning of this article shows that the "probability" or fraction of the population that owns a small amount of wealth per person is rather high, and then decreases steadily as wealth increases. (Note that the Pareto distribution is not realistic for wealth for the lower end. In fact, net worth may even be negative.) This distribution is not limited to describing wealth or income, but to many situations in which an equilibrium is found in the distribution of the "small" to the "large". The following examples are sometimes seen as approximately Pareto-distributed:
- The sizes of human settlements (few cities, many hamlets/villages)
- File size distribution of Internet traffic which uses the TCP protocol (many smaller files, few larger ones)
- Hard disk drive error rates
- Clusters of Bose–Einstein condensate near absolute zero
- The values of oil reserves in oil fields (a few large fields, many small fields)
- The length distribution in jobs assigned supercomputers (a few large ones, many small ones)
- The standardized price returns on individual stocks 
- Sizes of sand particles 
- Severity of large casualty losses for certain lines of business such as general liability, commercial auto, and workers compensation.
- In hydrology the Pareto distribution is applied to extreme events such as annually maximum one-day rainfalls and river discharges. The blue picture illustrates an example of fitting the Pareto distribution to ranked annually maximum one-day rainfalls showing also the 90% confidence belt based on the binomial distribution. The rainfall data are represented by plotting positions as part of the cumulative frequency analysis.
Relation to other distributionsEdit
Relation to the exponential distributionEdit
The Pareto distribution is related to the exponential distribution as follows. If X is Pareto-distributed with minimum xm and index α, then
is exponentially distributed with rate parameter α. Equivalently, if Y is exponentially distributed with rate α, then
is Pareto-distributed with minimum xm and index α.
This can be shown using the standard change-of-variable techniques:
The last expression is the cumulative distribution function of an exponential distribution with rate α.
Relation to the log-normal distributionEdit
The Pareto distribution and log-normal distribution are alternative distributions for describing the same types of quantities. One of the connections between the two is that they are both the distributions of the exponential of random variables distributed according to other common distributions, respectively the exponential distribution and normal distribution.
Relation to the generalized Pareto distributionEdit
The Pareto distribution is a special case of the generalized Pareto distribution, which is a family of distributions of similar form, but containing an extra parameter in such a way that the support of the distribution is either bounded below (at a variable point), or bounded both above and below (where both are variable), with the Lomax distribution as a special case. This family also contains both the unshifted and shifted exponential distributions.
The Pareto distribution with scale and shape is equivalent to the generalized Pareto distribution with location , scale and shape . Vice versa one can get the Pareto distribution from the GPD by and .
Relation to Zipf's LawEdit
Relation to the "Pareto principle"Edit
The "80-20 law", according to which 20% of all people receive 80% of all income, and 20% of the most affluent 20% receive 80% of that 80%, and so on, holds precisely when the Pareto index is α = log4(5) = log(5)/log(4), approximately 1.161. This result can be derived from the Lorenz curve formula given below. Moreover, the following have been shown to be mathematically equivalent:
- Income is distributed according to a Pareto distribution with index α > 1.
- There is some number 0 ≤ p ≤ 1/2 such that 100p % of all people receive 100(1 − p)% of all income, and similarly for every real (not necessarily integer) n > 0, 100pn % of all people receive 100(1 − p)n percentage of all income.
This does not apply only to income, but also to wealth, or to anything else that can be modeled by this distribution.
This excludes Pareto distributions in which 0 < α ≤ 1, which, as noted above, have infinite expected value, and so cannot reasonably model income distribution.
Relation to Price's LawEdit
Price's square root law is sometimes offered as a property of or as similar to the Pareto distribution. However, the law only holds in the case that . Note that in this case, the total and expected amount of wealth are not defined, and the rule only applies asymptotically to random samples. The extended Pareto Principle mentioned above is a far more general rule.
Lorenz curve and Gini coefficientEdit
The Lorenz curve is often used to characterize income and wealth distributions. For any distribution, the Lorenz curve L(F) is written in terms of the PDF f or the CDF F as
where x(F) is the inverse of the CDF. For the Pareto distribution,
and the Lorenz curve is calculated to be
For the denominator is infinite, yielding L=0. Examples of the Lorenz curve for a number of Pareto distributions are shown in the graph on the right.
According to Oxfam (2016) the richest 62 people have as much wealth as the poorest half of the world's population. We can estimate the Pareto index that would apply to this situation. Letting ε equal we have:
The solution is that α equals about 1.15, and about 9% of the wealth is owned by each of the two groups. But actually the poorest 69% of the world adult population owns only about 3% of the wealth.
The Gini coefficient is a measure of the deviation of the Lorenz curve from the equidistribution line which is a line connecting [0, 0] and [1, 1], which is shown in black (α = ∞) in the Lorenz plot on the right. Specifically, the Gini coefficient is twice the area between the Lorenz curve and the equidistribution line. The Gini coefficient for the Pareto distribution is then calculated (for ) to be
(see Aaberge 2005).
Therefore, the logarithmic likelihood function is
It can be seen that is monotonically increasing with xm, that is, the greater the value of xm, the greater the value of the likelihood function. Hence, since x ≥ xm, we conclude that
To find the estimator for α, we compute the corresponding partial derivative and determine where it is zero:
Thus the maximum likelihood estimator for α is:
The expected statistical error is:
Malik (1970) gives the exact joint distribution of . In particular, and are independent and is Pareto with scale parameter xm and shape parameter nα, whereas has an inverse-gamma distribution with shape and scale parameters n − 1 and nα, respectively.
The characteristic curved 'long tail' distribution when plotted on a linear scale, masks the underlying simplicity of the function when plotted on a log-log graph, which then takes the form of a straight line with negative gradient: It follows from the formula for the probability density function that for x ≥ xm,
Since α is positive, the gradient −(α + 1) is negative.
Random sample generationEdit
is Pareto-distributed. If U is uniformly distributed on [0, 1), it can be exchanged with (1 − U).
Bounded Pareto distributionEdit
|Variance||(this is the second raw moment, not the variance)|
(this is the kth raw moment, not the skewness)
The bounded (or truncated) Pareto distribution has three parameters: α, L and H. As in the standard Pareto distribution α determines the shape. L denotes the minimal value, and H denotes the maximal value.
The probability density function is
where L ≤ x ≤ H, and α > 0.
Generating bounded Pareto random variablesEdit
is a bounded Pareto-distributed.
Symmetric Pareto distributionEdit
It has a similar shape to a Pareto distribution for x > xm and is mirror symmetric about the vertical axis.
Multivariate Pareto distributionEdit
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