You Better Understand The Difference Between Contracts and Power

If you want to incite a war give one of your kids an Otter pop but not the other. You’d think I shot Franz Ferdinand in my kitchen. The inevitable refrain “it’s not fair!” is coming faster than you cut the plastic off the top of the frozen treat. We try to maintain a rough sense of fairness around here. You can earn a treat but your brother will deserve at least a chance to earn his own. The whole equality-of-opportunity not equality-of-outcome thing.

It sounds good, but it is one of those fake realities we build around our children to keep the peace.

The first-grader notices the dissonance. He thinks we are hypocrites when we later tell him the world is not fair so he should ignore what other kids have or get to do. I don’t blame him. His thinking isn’t gray enough to appreciate the difference between a local and global variable or the notion of scale dependence (ie it’s reasonable to be a capitalist who practices socialism in your own home).  Why teach a child that life isn’t fair when they are so young?

The earlier you can rid yourself of the “Just World Delusion”, the better. You can’t control whether you are born on third base or in a gutter. You can be destined for diabetes or densely packed with fast-twitch muscle fiber. Nothing has been fair since you were a zygote. Once you internalize this, your empathy reflex starts to fire faster. Your victim-blaming impulse shrinks away. But there’s a flipside. You must pair this compassion with the toughness that an unjust world requires. A compassionate person without toughness is a doormat and a sucker. And worse of all, ineffective.

There’s a good chance that if you are reading this you are compassionate. This is a list of friends after all. So if I can offer an angle to boost your toughness in this unjust world, I have a better chance of helping, so here’s some tips:

1. Heed the words of negotiation guru Chester Karrass: It’s not what you deserve, it’s what you negotiate.

  • Beyond what reasonable people agree are inalienable rights, the word “deserve” holds no meaning to me. I won’t go into it here, but one of the biggest arguments I can remember having with a loved one was over this word. It makes me cringe.

2. Do not mistake a contract for power.

  • A non-compete’s bite doesn’t necessarily come from its letter. It comes from the threat of litigation. A deep-pocketed organization can outlast you in court whether or not the contract can be legally upheld.
  • NFL stars are known to “holdout” of their contracts. The keyword is “stars”. The underlying power dynamic may be more predictive of the outcome than the writing of the contract.
  • If you include a “do not exceed” clause in a deal with a contractor, do you actually get peace of mind? When you enter a renovation, you have little power. A “do not exceed” clause may simply incentivize the contractor to ditch your project if it risks cost overruns. And if you shop for a new contractor for an unfinished job, you are asking for a broomstick without lube.
  • To understand power, you must consider what is scarce. You may have a great product to sell, but nothing is more scarce than screen real estate on top of an Amazon search. Amazon has aggregated all the eyeballs in the western world which is a more scarce feat than Duracell creating a great battery. At the end of the day, there’s still Energizer. The power dynamic is so stark that Amazon actually competes with its sellers by white-labeling commodity products like batteries. This is not new. Costco and Walgreens know the value of their scarce shelf space and sell their own generics.
  • Another example of power is what is known as “owning the relationship”. In the investing world, mutual funds are losing AUM to index funds which passively mimic the SP500. One of the reasons for this trend is that investors are becoming justifiably very fee conscious. Faced with a stingier client, financial advisors are selling their clients’ mutual funds and buying index funds which have almost no fee. The clients now only pay the advisor fee, say 1%, versus the advisor fee plus mutual fund fee. The advisors have been able to defend their own businesses by disintermediating mutual fund managers. So why did the mutual fund managers lose to the financial advisor in this battle? The advisor owns the relationship with you, the client. In the process of giving you a customized plan, they take you to lunch or hold your hand on a phone call. Mutual funds’ performance has not justified their use over passive index funds, but more crucially, the advisors no longer had an incentive to push them since selling them didn’t offer the fat loads or commissions they did a generation ago. If you find this specific dynamic interesting, check this interview.

3. Law of Rent: land rent is equal to the economic advantage of using a site in its most productive way

  • In other words, if you lease space to sell your amazing dumplings or abuela’s tacos, you are competing with the most valuable business that could have rented the space. Not just other restaurants. You are competing with Starbucks and Chase. Landlords will charge the rent that the most profitable business that could occupy the space could make. That’s why there are so many coffee shops while other storefronts remain vacant. The law of rent acts as a constraint on the profitability of a brick and mortar store since the landlord can encroach on excess profitability by raising rents so that the tenants’ margins revert back to fair market rates.
  • A digital example of this has been making waves recently. By scraping a popular site, Google is able to display the result of the most popular search directly rather than forcing you to click through. Google’s monopoly on search has let it go beyond just intercepting, but on to what many entrepreneurs are calling a shakedown.

4.  Wholesale transfer pricing: Tren Griffin shows how the law of rent is an instance of this broader economic concept.

  • When negotiating in this unfair world, you need to understand what kind of cards you are holding. Griffin’s discussion of wholesale transfer pricing will give you a powerful model for understanding your bargaining position. Read it here to see Anthony Bourdain demonstrate the Law of Rent in Manhattan and so much more.
  • For extra credit, check out Griffin’s related discussion on the Free Parking business model. This explains how large businesses which generate network effects can outcompete smaller competitors. It’s especially powerful when marginal distribution costs are close to zero. For double extra credit see if you can recognize this dynamic in the music streaming business, in the ‘net interest margin’ game played by the large asset managers (ie Fidelity), and for those of us in trading, how banks use this model when ‘holistically’ pricing clients’ business. It must be discouraging when a small business finds its entire profit margin being given away as a “throw-in” by a broader business that loss-leads in one vertical to cross-sell in a more lucrative one.

Having a good hand

Since we know the world is unfair, we cannot be naive about power and our own bargaining positions. My favorite advice for ensuring you have a strong hand can be extracted from Naval Ravikant’s algorithm for getting rich. His 3 steps are specific knowledge, accountability, and leverage. The first 2 steps ensure your value, the 3rd step is about amplifying that value.

  1. Specific knowledge is knowledge that you cannot be trained for. If society can train you, it can train someone else, and replace you. Specific knowledge is found by pursuing your genuine curiosity and passion rather than whatever is hot right now. Building specific knowledge will feel like play to you but will look like work to others. When specific knowledge is taught, it’s through apprenticeships, not schools. Specific knowledge is often highly technical or creative. It cannot be outsourced or automated.
  2. Accountability. Take business risks under your own name. Society will reward you with responsibility, equity, and leverage. The most accountable people have singular, public, and risky brands: Oprah, Trump, Kanye, Elon.

The full summary is here if you want to dig deeper and understand different forms of leverage.

By being very accountable in this context your reputation becomes a source of both upside and risk. To get a sense of how great the upside can be in owning your own work in a world which technology makes creation and transmission so cheap, check out this case for how much Howard Stern might be shortchanging himself if he renews his deal with Sirius.

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