Externalities: Calculating the Hidden Costs of Products

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Externalities let you account for the true cost of products by including hidden costs like environmental damage.

Nivi: What’s a mispriced externality? You mentioned it on a previous episode.

Naval: An externality is where there’s an additional cost imposed by whatever product is being produced or consumed, that’s not accounted for in the price of the product. This can happen for many reasons. Sometimes you can fix it by putting the cost back into the price.

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Net Present Value: What Future Income Is Worth Today

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Calculate what future income is worth today by applying a discount to its future value.

Nivi: Let’s talk about net present value (NPV).

Naval: Net present value is when you say, “That stream of payments I’m going to get in the future—what’s it worth today?”

Here’s a common example: You’re joining a startup and getting stock options, and the founder says, “This company is going to be worth $1 billion, and I’m giving you 0.1% of the company; therefore, you’re getting $1 million worth of stock.”

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Consumer Surplus: Getting More Than You Paid For

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A lot of people are willing to pay more than what companies charge.

Naval: Consumer surplus and producer surplus are important concepts. Consumer surplus is the excess value you get from something when you pay less than you were willing to pay.

I get a lot of joy out of my morning Starbucks coffee. Obviously I’ve made some money. So if my coffee cost $20, I would pay it.

But Starbucks doesn’t know that. They can’t price the coffee at $20 just for me, because they’re selling the exact same product to others. So I’m getting a lot of consumer surplus out of the coffee.

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Price Discrimination: Charge Some People More

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You can charge people for extras based on their propensity to pay.

Nivi: Are there any other microeconomic concepts, outside of zero marginal cost of replication and scale economies, that are important to understand?

Naval: Price discrimination is important. It means you can charge people based on their propensity to pay.

Now, you can’t charge people different amounts just because you don’t like them. You have to offer them something extra. But it has to be something rich people care about.

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Compounding Relationships Make Life Easier

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Life gets a lot easier when you know someone’s got your back.

Nivi: Earlier, we talked about compound interest, but we didn’t dig into it much.

Naval: Relationships offer a good example of compound interest. Once you’ve been in a good relationship with somebody for a while—whether it’s business or romantic—life gets a lot easier because you know that person’s got your back. You don’t have to keep questioning.

If I’m doing a deal with someone I’ve worked with for 20 years and there is mutual trust, we don’t have to read the legal contracts. Maybe we don’t even need to create legal contracts; maybe we can do it with a handshake. That kind of trust makes it very easy to do business.

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Turn Short-Term Games Into Long-Term Games

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Improve your leverage in negotiations by turning short-term relationships into long-term ones.

Nivi: Do you want to talk about Pareto optimal?

Naval: Pareto optimal is another concept from game theory, along with Pareto superior.

Pareto superior means something is better in some ways while being equal or better in other ways. It’s not worse in any way. This is an important concept when you’re negotiating. If you can make a solution Pareto superior to where it was before, you will always do that. 

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Schelling Point: Cooperating Without Communicating

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People who can’t communicate can cooperate by anticipating the other person’s actions.

Nivi: Let’s talk about Schelling points.

Naval: The Schelling point is a game theory concept made famous by Thomas Schelling in his book, The Strategy of Conflict, which I recommend.

It’s about multiplayer games where people respond based on what they think the other person’s response will be. He came up with a mathematical formalization to answer: How do you get people who cannot communicate with each other to coordinate?

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Kelly Criterion: Avoid Ruin

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Don’t ruin your reputation or get wiped to zero.

Nivi: Let’s chat about the Kelly criterion. 

Naval: The Kelly criterion is a popularized mathematical formulation of a simple concept. The simple concept is: Don’t risk everything. Stay out of jail. Don’t bet everything on one big gamble. Be careful how much you bet each time, so you don’t lose the whole kitty. 

If you’re a gambler, the Kelly criterion mathematically formulates how much you should wager per hand, even if you have an edge—because even when you have an edge, you can still lose. Let’s say you have 51-to-49 edge. Every gambler knows not to bet the whole kitty on that 51-to-49 edgebecause you could lose everything and won’t get to come back to the average.

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Principal-Agent Problem: Act Like an Owner

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If you think and act like an owner, it’s only a matter of time until you become an owner.

Nivi: We spoke earlier about picking a business model that has leverage from scale economies, network effects and zero marginal cost of replication. There were a few other ideas on the cutting-room floor that I want to go through with you. The first one is the principal-agent problem.

Naval: So mental models are all the rage. Everyone’s trying to become smarter by adopting mental models. I think mental models are interesting, but I don’t think explicitly in terms of mental-model checklists. I know Charlie Munger does, but that’s just not how I think.

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Envy Can Be Useful, or It Can Eat You Alive

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Envy can give you a powerful boost, or it can eat you alive if you let it follow you.

Nivi: Do you want to tell us about jobs you had growing up and the one that kicked off your fanatical obsession with creating wealth?

Naval: This gets a little personal, and I don’t want to humble-brag. There was a thread going around Twitter—Name Five Jobs You’ve Held—and every rich person on there was signaling how they’ve held normal jobs. I don’t want to play that game.

I’ve had menial jobs. There are people who had it worse than me and people who had it better than me.

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