How a Game Theory Expert Sold One Billion Bottles of Tea & What He Learned On The Journey with Barry Nalebuff

In this episode we discuss the fundamental principles of game theory, we correctly guess the answers to SAT questions - without every knowing what the question was! We look at how to use game theory in practical ways, and go deep on how a college professor and his student started a beverage company, sold a billion bottles of tea, and competed against Coke, Nestle, and other major players to become incredibly successful with our guest Barry Nalebuff.
Barry is a Professor of Economics and Management at Yale School of Management. A graduate of MIT, a Rhodes Scholar and Junior Fellow at the Harvard Society of Fellows, Barry earned his doctorate at Oxford University. Barry is the author of several books, an expert in game theory which he applies to business strategy, and the co-founder of Honest Tea which has been named one of America’s fastest Growing Companies
We discuss:
What is Game Theory?
What are the fundamental principles of game theory?
The difference between ego-centric and being alo-centric
How do you design a system that avoids death spirals?
Everything in life is a game
Barry grills me on game theory with a fascinating example
We crush through some SAT questions and find the correct answer - without every knowing the question!
We use a simple game to understand Nash equilibrium and how that explains third world development challenges and corruption
What is the prisoner’s dilemma and how does it apply to the real world?
How global warming demonstrates a multi-person prisoner’s dilemma
The concept of “signaling” in game theory and how Michale Spence won a noble prize studying it
A real-world example of how signaling can be used to change outcomes getting hired
How to use game theory to negotiate and create the best possible outcomes
A concrete example of how to "divide the pie” and reach a fair and “principled” conclusion in a negotiation
Why it's important to figure out what the pie is before you determine how to split it
How a professor and his student pooled their resources, started a beverage company, sold a billion bottles of tea, and competed against coke, nestle, and other major players
The concept of “declining marginal utility” and how that shaped the founding of Honest Tea
We explain why a function is maximized when its derivative is zero
The “Babysitter Theorem” and why it was critical to Honest Tea’s success
How Barry and Seth used the Lean Startup approach to launch Honest Tea
Would it make sense for Pepsi to release a perfect replica of Coke?
Barry’s advice for aspiring entrepreneurs
Be radically different
- Solve a challenging problem
- Succeed without being copied
How Honest Tea prevented their business model from being copied and knocked off
And much more
Thank you so much for listening!
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SHOW NOTES, LINKS, & RESEARCH

[Coursera Lecture] Negotiating Online
[Bio] Michael Spence
[Book] Mission in a Bottle by Seth Goldman, Barry Nalebuff, and Sungyoon Choi
[Movie] A Beautiful Mind (2001)
[Book Site] Mission in a Bottle
[Bio] Barry J. Nalebuff
Episode Transcript

[00:00:06.4] ANNOUNCER: Welcome to The Science of Success with your host, Matt Bodnar.

[0:00:12.7] MB: Welcome to The Science of Success. I’m your host, Matt Bodnar. I’m an entrepreneur and investor in Nashville, Tennessee and I’m obsessed with the mindset of success and the psychology of performance. I’ve read hundreds of books, conducted countless hours of research and study, and I am going to take you on a journey into the human mind and what makes peak performers tick, with the focus on always having our discussion rooted in psychological research and scientific fact, not opinion.

In this episode, we discuss the fundamental principles of game theory. We correctly guessed the answers to SAT questions without ever knowing what the questions are. We look at how to use game theory in practical ways, and we go deep on how a college professor and his student started a beverage company, sold a billion bottles of tea, and competed against Coke, Nestle, and other major players to become incredibly successful, with our guest, Barry Nalebuff.

The Science of Success continues to grow with more than 800,000 downloads, listeners in over 100 countries, hitting number one in New and Noteworthy, and more. I get listener comments and emails all the time asking me, “Matt, how do you organize and remember all this incredible information?” A lot of our listeners are curious about how I keep track of all the incredible knowledge I get from reading hundreds of books, interviewing amazing experts, listening to awesome podcast, and more.

Because of that, we’ve created an epic resource just for you; a detailed guide called How to Organize and Remember Everything. You can get it completely free by texting the word “smarter” to the number 44222. Again, it’s a guide we created called How to Organize and Remember Everything. All you have to do to get it is to text the word “smarter” to the number 44222 or go to scienceofsuccess.co and put in your email.

In our previous episode, we discussed why dieting actually predicts weight gain over the long run. How you can build a health style of habits that accumulates small advantages and create a healthy lifestyle overtime. How habit loops are formed and how you can leverage neuroscience to create habits that stick. The concept of mindful eating and how it can transform your relationship to the meals that you eat, and more with our guest, Darya Rose. If you want to build a healthy lifestyle, listen to that episode. 

[0:02:36.9] MB: Today, we have another amazing guest on the show, Dr. Barry Nalebuff. Barry is a professor of economics and management at the Yale School of Management. He’s a graduate of MIT, a Road Scholar, and a Junior Fellow at the Harvard Society of Fellows. He earned his doctorate at Oxford University. He’s the author of several books, an expert in game theory, which he applies to business strategy, and he’s the cofounder of Honest Tea, which has been named one of America’s fastest growing companies. 

Barry, welcome to The Science of Success.

[0:03:06.2] BN: Thanks for having me.

[0:03:07.4] MB: We’re very excited to have you on here. For listeners who may not be familiar with you and your story, tell us a little bit about your background. 

[0:03:14.8] BN: You gave me a nice intro. For many years, I couldn’t seem to hold a job, so I taught at Harvard, Princeton, and now, Yale. I’ve been here, I think, 27 years, so it’s home. I teach in the School of Management. My subjects are negotiation, innovation, strategy, and game theory. 

[0:03:34.5] MB: Game theory is something that I’m fascinated with. I love strategy and games and it’s something that I love reading about and thinking about. Actually, the original introduction I had to you and your writing was the old school book, Thinking Strategically, that you wrote with Avinash Dixit, and I’ve really enjoyed that. I’m curious, for listeners who may not know much about game theory, how would you describe sort of what game theory is and sort of the basics of game theory. 

[0:04:01.1] BN: Sure. It’s the science of interaction. You start with a simpler problem, called decision theory, and that is you make a decision and you think about how that will interact with nature. When an engineer builds a bridge, they think about tensile strength of steel, the load factor on a bridge, but you don’t have to think about how the bridge is going to respond to your actions. 

In contrast, when a strategist or a general takes a particular action, they have to think about how the other side will respond. What is their objective? What are they trying to accomplish? Only by taking into account the other side do you have a chance of being success. Normally, people tend to be egocentric, that is they’re focused on themselves. Game theory is all about being allocentric, understanding the perspective of others. 

[0:04:50.6] MB: Very interesting. Where does that tie into kind of the idea of strategic behavior?

[0:04:56.8] BN: Your strategy is both about predicting how other people respond to what you do, but also about shaping what it is that they’re going to do. If you think about the current healthcare debate, everybody would like to have a situation where people without preexisting conditions can just get insurance whenever they want, but the challenge is that if they can buy insurance anytime, then they’ll say, “Well, I’ll just wait until I need insurance, and then I’ll get it,” and then the problem is only the sickest people will go and buy insurance. That means that the cost of the insurance is going to be incredibly high and you get into what sometimes is called the death spiral. 

[inaudible 0:05:35.3] is how do you go and design a system which gives people incentives to sign up even when they’re not don’t currently need it. One tactic, like with the stick, which is we’re going to impose a tax penalty on you if you don’t sign up. The other view could be a carrot, which is if you do sign up, we’ll guarantee that you can continue to sign up and you can get continuous coverage and you can’t be denied insurance going forward so long as you’ve been continuously covered.

[0:06:05.9] MB: I think that’s a great real world example. I’m curious, for somebody who’s listening and thinking, “Game theory kind of sounds interesting, but why does it matter to my life, or why it is important?” Why do you think it’s so critical to study and learn and understand game theory?

[0:06:22.2] BN: Right. I think pretty much everything we do in life is a game. It’s not always called that way. Whether it’d be negotiating with your children, your spouse, or raise at work, to understand how competitors respond to you in a market place. So since you’re playing a game, you might as well play it well and understand, really, what’s going on. Game theory is everything in my view. It’s everywhere. I thought if you don’t mind, actually, I’d give you a little example that we could have some fun with. 

[0:06:51.8] MB: Yeah, that sounds great.

[0:06:53.7] BN: Here is a question I’ve taken from the SAT, and I’d like your — It’s a real question. I didn’t make this up. I’d like you to tell us what the right answer is. Here are the choices; A is merits, B is disadvantages, C is rewards, D is jargon, and E is problems.

[0:07:12.6] MB: All right. What’s the question?

[0:07:14.6] BN: Oh! No, I wasn’t going to tell you the question. You see, I think, by using game theory, you can actually figure out the right answer. Let’s imagine for a moment, you’re the person writing the test. What is your objective in this? 

I think there are a couple of objectives. One; you don’t want everybody to get the right answer. You don’t want everybody to get the wrong answer. You want to be able to spread people out. Two; you want to make sure there’s only one possible correct answer, ‘cause if there are two right answers, you’re going to have to go and re-grade the exam, and it will be a nightmare. Three; you never want somebody to get the right answer to the wrong logic. Okay?

Now, you understand the perspective of the person writing the test and your choices are merits, disadvantages, rewards, jargon, and problems. 

[0:08:02.7] MB: All right. Going back to my SAT days, and I definitely should have had another cup of coffee this morning. I’m looking at it and the one to me that seems to jump out and be the least like the other four, or five, is jargon. It seems totally disconnected to the others. 

[0:08:17.6] BN: Okay. That could be a good thing, or a bad thing, because if it’s just all by itself, then maybe it doesn’t have any good decoys. Let’s go and figure out if we can use any specific principles here; merits, disadvantages, rewards, jargon, and problems. I’ll get you started a little bit. I would say that disadvantages and problems are pretty similar to each other. 

[0:08:41.8] MB: I agree. 

[0:08:43.2] BN: And so if one is right, it’s kind of hard to imagine that the other would be wrong, that somebody could make a  good case that the other word would also be an appropriate choice. My view is that two of them knock each other out. Are you with me on that?

[0:08:57.7] MB: Yeah, let’s go with that. 

[0:09:00.3] BN: Now you are left with merits, rewards, and jargon. 

[0:09:04.6] MB: I think there’s definitely a distinction between — There’s obviously a distinction between merits and rewards, but they both have to me sort of this almost like positive connotation, whereas jargon just seems completely out on an island. 

[0:09:18.4] BN: The island part is dangerous, because it could be no decoys, but the question is how close are merits and rewards? Are they sufficiently close that somebody could make a valid argument that they would both work? I think the answer is yes, actually. 

Here is the first part of the question. It says, “Each occupation has its own.” You could see how both merits and rewards work for that and it’d be pretty hard to distinguish between the two as you go on. I think those cancel each other out and you’re left with jargon. 

The whole question is actually, “Each occupation has its own blank; bankers, lawyers, computer professionals, for example, all use among themselves language which outsiders have difficulty following.” You can see that jargon is the right answer.  

[0:10:06.6] MB: Ta-da!  

[0:10:07.6] BN: Okay? Now, as you understand it, let’s try one last one, because you’ve got the principle; accurate, popular, erroneous, widespread, and ineffectual. Accurate, popular, erroneous, widespread, and ineffectual. 

[0:10:25.1] MB: All right. I’m writing these down; accurate, popular, erroneous, widespread, and ineffectual.

[0:10:30.9] BN: Correct. 

[0:10:32.0] MB: Let’s see, popular and widespread obviously kind of synonymous. 

[0:10:36.6] BN: They cancel each other out. Great. Now, we’re left with accurate, erroneous, and ineffectual.  

[0:10:41.7] MB: Accurate and erroneous are kind of opposites. I think, ineffectual —  

[0:10:45.6] BN: They are indeed antonyms. That’s correct. 

[0:10:48.1] MB: Antonyms. There we go. We’re getting our vocab words in. I think that, to me, erroneous and ineffectual could do have sort of similar connotations. I’d probably — I don’t know. I don’t know —  

[0:11:00.0] BN: Let’s pause for a moment. Accurate and erroneous, because they’re opposites, actually are each great decoys with the other. That is, if a person reads a sentence backwards, or misunderstands the meaning of the word and flips it, they would choose the other one by mistake, but nobody could claim that that was the correct answer. 

That suggest that accurate and erroneous are our most likely candidates here.  Now, we have to figure out is there a good decoy for one of them. 

[0:11:28.3] MB: It feels to me like ineffectual could be  a decoy for erroneous. 

[0:11:33.0] BN: The question is if one was correct, but you really argue the other one is not correct. 

[0:11:38.5] MB: I think it’d be challenging. 

[0:11:40.1] BN: I don’t know. Actually, you could be correct. You could be accurate, but also ineffectual. My example here is totally spot on, but I don’t seem to be having the effect I want, and so I could be ineffectual in this example that I’m using even if I’m not erroneous.  

[0:11:54.9] MB: Good point.  

[0:11:55.7] BN: To me, the words actually are that there’s open water between the meetings as supposed to popular and widespread, where I think you can really make the case that there’s not open water there. To me, ineffectual is a good decoy, but a far enough decoy away that it really there isn’t both a right answer for erroneous. In fact, the question whether some people who think only the poor and less educated people use slang, but this idea is erroneous. 

Anyway, my point in this is that it’s actually possible by understanding how the test maker is trying to achieve — The test maker’s objective. You can figure out what’s the right answer without even reading the question. Of course, it’s easier to do the problems reading the questions. You understand what the other side is trying to achieve, then you can accomplish what it is that you’re trying to achieve. That’s the essence of game theory. 

[0:12:50.2] MB: That’s a great demonstration, and it’s really fascinating. I think it does an amazing job of kind of highlighting the point that just by understanding the other party and their incentives in the way that they think you can get a tremendous amount of information.  

[0:13:05.0] BN: That’s the idea. 

[0:13:06.3] MB: I’m curious, what are some of the kind of core mental models or concepts that come out of game theory? 

[0:13:13.4] BN: One of the most important is the idea of equilibrium, and this goes back to John Nash who won a Nobel Prize, had a movie done about him, A Beautiful Mind, starring Russell Crowe. This is the question of, “How do I figure out what the other side is going to do when they are trying to figure out what it is that I’m going to do?” That’s a challenge because, essentially, it can’t be I’m responding to your actual actions, I have to respond to what I think you’re going to be doing while you’re thinking about what it is that I’m going to be doing. 

Here is another simple game that we can play. If the two of us pick the same number, we’ll have a third party, your producer, each pay us that amount of money. We have to pick a number between 1 and 10. If we don’t pick the same number, we both get zero. Do you understand the game so far?

[0:14:09.9] MB: Absolutely.

[0:14:11.2] BN: All right. I think seven is really a lucky number. I like seven. I heard a lot of people — I understand pick seven. Of course, you could pick any other number. Now, you can see that there’s a little bit of a paradox that you have to choose. Which is we both pick 10, we both get more money. You might be saying, “Although I’d like to pick 10, I’m a little worried that Barry is going to pick seven. Barry might have to pick seven, cause he’s afraid that Matt is going to pick seven because he thinks Barry is going to pick seven.” We both end up worse off, or maybe we don’t even coordinate, I end up picking seven, and you pick 10, and we both get zero. 

One of the challenges that exists with Nash equilibrium is that it can be more than one and we may fail to find it, and this simple example, and she goes a long way towards explaining why we have development issues in many Third World Countries. We could like to be in a situation where nobody pays bribes and nobody asks for bribes. We want to get rid of corruption, but if I believe that the official is going to want a bribe, and I don’t pay the bribe, then I won’t get my new passport, I won’t get my new driver’s license, then I will have to offer the bribe, the person will end up taking it and we end up in a situation where the economy get stuck in this corrupt equilibrium and doesn’t advance as quickly as it might.

You can’t just change by having one person change them. I’d go from 7 to 10 and the other person doesn’t flip, it doesn’t help either. You have to have this coordinated move, and that’s not so easy to do.

[0:15:50.9] MB: That’s a beautiful demonstration going from a very simple game to an extremely concrete real world application. I’d be curious, could you explain — Another one I know is very popular and kind of the cornerstones of game theory; The Prisoner’s Dilemma. For listeners who may not know what that is, or maybe have heard it but don’t really understand it, I’d love to hear your kind of explanation of it and then maybe if you can think of one, perhaps a real world instance of the The Prisoner’s Dilemma as well.

[0:16:18.4] BN: Yeah, I sometimes shy away from it, not because it isn’t [inaudible 0:16:22.7] example, but because people end up thinking that’s all there is to game theory, is the idea of the The Prisoner’s Dilemma, and anyone who has seen a detective movie knows the drill. Two prisoners are interviews in separate cells and each one is told that if they can confess and they’re the first to confess, they’ll get a lighter sentence, maybe even get the turn state’s evidence. Whereas if they both confess, there’s a whole lot less value in those confessions, and so it doesn’t work out so well for them. On the other hand, if neither confesses, they may actually get a life sentence, or not even convicted. 

The problem is that if you’re colleague in crime doesn’t confess, it turns out that the leniency you are shown is a good — It really makes it worthwhile for you to confess. Similarly, if the arrival of your fellow criminal does confess — Oh my God! You surely better, because otherwise they can have the book thrown at you. 

Whatever happens, it’s in your interest to confess, and then when both sides confess, they don’t do so well compared to the situation where neither confesses. By the way, we use this not just for criminals, but also in antitrust enforcement, in corporate crime. If it turns out there’s been a conspiracy or an antitrust and one company comes forward, they end up often getting amnesty as a result. If you know that if you are rival — If your coconspirator has this incentive to come forward and be a whistle blower, then you may decide you have to do that too, because you’ll be left having the books thrown at you.  

It’s used in many context, and sometimes we think of this as a bad thing if you’re a prisoner, but it’s a good thing if you are the law enforcement. Then, the question — Go ahead.

[0:18:10.2] MB: Continue please. 

[0:18:11.9] BN: Then, the question is how do you get out of it? It could be that, “Well, okay. I’m going to meet up with you in jail. If I do that and you confessed, or other prisoners will say, “Wait a second. This guy was a rat. He confessed,” and they’re going to punish you quite severely in prison for that. That’s a good enough deterrent. 

If we’re actually coming across people again and again and we have the ability to punish them in the future for what they did in that confession, then that’s how the mob often prevents people from churning. What’s true and what’s possible in a single interaction much more is possible when you run into the same people again and again. 

We can also think of a multi-person prisoner’s dilemmas, and you can think of global warming often in that circumstance, which is it’s in my own interest to drive a car, to fly in an airplane, to heat my house, to use an air-conditioner, and if other people are all doing that and the planet is going to go and heat up, well, I can’t stop it, so I might as well enjoy life now. If nobody else is going to do it, then it doesn’t really hurt for me to go ahead and expend a little bit more carbon. 

In some sense, whatever anybody else does, I want to be a little bit more of a carbon user. Then, when everybody acts that way, we end up putting way too much carbon in the atmosphere and we globally suffer the consequences. Each individual has an incentive to do something that’s not good when it’s done collectively.

[0:19:50.1] MB: Is that the same instance of the concept of the tragedy of the commons, or is there a distinction there in this multi-person prisoner’s dilemma?

[0:19:57.5] BN: Nope. Strategies of the commons is pretty much the multi-person dilemma, and it’s one reason why people believe ole for government regulation, which is that we think of the invisible hand, Adam Smith, sort of prizes guide people to do the right things, but sometimes those prizes are unfair, because you’re not correctly charged anything when you take this action, putting carbon in the environment. If you don’t have a prize mechanism, there’s no sense in which what the way people will play these games will necessarily be good for themselves or for society as a whole.  

[0:20:34.1] MB: Another concept from game theory that I’ve heard you talk about before is the idea of signaling. Can you talk a little bit about that and kind of explain that? 

[0:20:41.1] BN: Sure. Michael Spence won a Nobel Prize for his work on Signaling, and it’s a little embarrassing to me, because part of the theory of signaling is that you go to get a degree, not for the stuff that we teach you, although we’ll teach you about signaling theory, but for what it says to the rest of the world. 

Let me give you an example with my MBA students. Imagine that you are a smart woman and you want to convince your employer that you are really going to be there and make a commitment to this company. The employer is sexist and, perhaps even illegally, is thinking about discriminating against women, because they’re worried they’re going to leave, have kids, and start a family. Therefore, this person doesn’t want to make the investment in the employee that they would make if they knew this person would be staying on. 

Now, the employee says to the firm, “Okay. Look, I’m really — I’m committed. I’m the kind of person who will stay here through thick and thin.” The problem is anyone can say that and it doesn’t mean anything. How do you take an action which conveys you’re the type of person who really means that as supposed to just saying it? 

One way of doing that is going and getting an MBA. You go and you spend $120,000 in tuition. You spend two years of your life listening to professors like me and you’re able to endure that. Why would you have done that and then leave labor force right away? You can say, “Look, I took these actions that only makes sense if in fact I am planning to be here for the next 20 years, next 15 years.” 

A lot of people who will say that they are committed to this company to being a professional, but you could look at the actions that I’ve taken and show that I’m not that average person, I’m really the one who is going to go and make this happen. 

A nice example, I think, from Steve Levitt, Freakonomics, is a dentist who’s getting a little on in the years and wants to convince patients that he or she is not about to retire goes and buys a new furniture for the office, like, “Look, if I was going to retire in the next six months, I would have just let that [inaudible 0:23:01.4] kinda hangout there a little bit longer, but it didn’t make sense for me to redecorate the office, buy a new furniture, a new equipment if I was about to hang out my shingle.” Anybody can say they’re going to be staying on, but the fact that I have made this investment suggest I’m really going to be around for a little bit longer.

[0:23:21.2] MB: One of the other concepts that you’ve talked about in the past is the idea of using principled arguments in negotiation and kind of the concept of dividing up the pie. I’d love to explore that idea briefly. 

[0:23:34.5] BN: Sure. I’ll put a little plug in. I’ve created a free online negotiation course at Coursera, coursera.org, and you can learn all of it there, but here’s the preview; a lot of people think that negotiation is about who can yell louder, and shake my hand, do this deal, five, four, three, two, one, shake my hand now, say yes. It’s sort of how Dwight negotiates in the office. That’s not a principled approach. 

I want to say, “What type of arguments can you make that might persuade other people about what is appropriate, what is fair?” I spent a lot of time thinking about what is the pie? Why are we having a particular negotiation? I can use a simple example, if you’d like. We have A and B, two parties who have nine to divide up. In the sense that if they can reach an agreement, there’s a pie of size nine that they can share. 

Now, in order to figure out what will happen, I also have to say what they should do — What they will do if they can’t reach an agreement. Let’s say A can get one on his own, and B get two on her own. If they reach an agreement, A and B together can get nine. If not, A can walk away with one and B can walk away with two. Now, the question is how do we divide up the nine?

What most people say is that B is, in some sense, twice as strong as A, and so B should get six and A should get three. That if B can get twice as much if they don’t reach an agreement. Perhaps B should get twice as much if they do. My view is we fundamentally misunderstand power and proportionality, and the right way of thinking about this is that A and B without an agreement can collectively get three; A gets one, B gets two, so collectively they get three. If they reach an agreement, they can get nine. There’s an extra six they can get by reaching an agreement. Who is more important for that agreement? A or B? My answer to that is they’re equally important. If A walks away, that six disappears. If B walks away, that six disappears. 

That means A and B are equally important to that six, so you should divide it three and three, so A will get four and B will get five. That is the principle, which is figure out what the pie is. Figure out what the two of you are able to create by working together, rather than not reach an agreement, and split those gains. 

[0:26:21.0] MB: I love that example, and I think it’s a great way to look at it, because if you think about sort of 50-50 split off the bat, it’s not quite equitable than if you think about a two-thirds, one-third split, it’s not quite equitable, but really looking at all of the different outcomes and what the parties can achieve on their own versus what they can create together. I think you’ve achieved the most sort of fair, and I guess as you would say, principles split of the proceeds. 

[0:26:46.6] BN: The argument doesn’t depend on which side you’re taking, and I think that that aspect of, “I can make that argument for either side,” is a critical component of what it means to be fair and reasonable. 

[0:26:58.7] MB: I think that’s a great segue to dig into Honest Tea, which we haven’t talked about yet. Obviously, you’re an expert in game theory, but on top of that, you and one of your students actually founded one of the fastest growing companies in America, a beverage company that has been incredibly successful. I’d love to just kinda here this story —    

[0:27:18.8] BN: We just sold our billionth bottle. 

[0:27:20.2] MB: Congratulations.  

[0:27:20.6] BN: [inaudible 0:27:21.2] McDonald’s signs up there, “Billions and billions served.” 

[0:27:25.4] MB: That’s amazing. That’s really cool. It’s so fascinating. I’d love to hear the story of how a professor and a student start a beverage company and go up and compete against the likes of Coke and Nestle and other giants in that space. 

[0:27:39.7] BN: You think it’d be a recipe for a disaster in the sense that neither of us had much experience in terms of starting a company, starting a beverage company, but we had some ideas. In fact, we had issues like, on our side, passion, we had luck, and we had economic theory. I’ll emphasize the economic theory, because that’s my job. 

One of the key lessons we say in economics is declining marginal utility. If you liked — The first scoop of ice cream is really good, the second is okay, and by the time you’re in the 10th scoop, it’s like, “I’m kinda full now. I’m not so interested in having a little more ice cream.” 

Same thing in terms of whether it’d be shirts, or shoes — Well, maybe not shoes. For most things, as you have more and more of them, the incremental value of the next one is less and less interesting. I think that’s true for sugar. You add a little bit of sugar to a beverage, it takes away the bitterness. The next, add some flavor, and each incremental one is less and less good, but it carries the same number of calories. 

It didn’t make any sense to us that all the beverages out there were either zero calories and often very sweet with diet, or 140 calories and basically turned into a liquid candy. Why wasn’t there a normal beverage with one or two teaspoons of sugar? We figured out that weren’t alone and wanting to have something like that. With that inspiration and insight, we thought we could just make a tea that tasted like tea and to use an old fashion recipe, kind of fire, water, and leaves, and not much else. That was the start of Hones Tea. 

[0:29:32.3] MB: I think it’s really interesting, and you talked about the concept of declining marginal utility. I don’t know if you still do it or not, but you used to actually put a curve on the bottles that demonstrated kind of the tradeoff between calories and flavor in terms of sugar content.  

[0:29:49.2] BN: I think that label may now be a historical item, although only pretty recently, it was on the Green Dragon Tea. This, again, is a case where only real wonks could get the inside line, but in calculus, we learn that the derivative of a function is — The function is maximized where its derivative is zero. What that means in normal person speak is that when you’re doing something and you’re right at the optimum, when you’re doing it as best as possible, if you make a small change, you had a little bit more, a little bit less, it has almost no impact on the result.
 
In particular, imagine that you came up with a recipe, which maximized the flavor based on how much sugar was in there. That one, the blind taste test. Now, we cut back the sugar 10%. Essentially, since the case was optimized, cutting back the sugar by 10% will have almost no impact in terms of what people think for the flavor, but it will cut back the calories by 10%. That is a direct linear result.
 
What’s interesting is the product, which wins the blind taste test, is not actually the best product in the market. Another way of thinking about this is a blind taste test. If you’d like your eyes are closed and your mouth is open. If I want to flip that, we’d have a test where your eyes are open and your mouth is closed. What is that? That’s a test where you go and read the label. The ideal label, if you like, has zero calories in it and nothing artificial. The problem is that doesn’t always taste so great. 

For the same reason that I wouldn’t want the product to win the eyes-open-mouth-closed test, I don’t want the product to win the eyes-closed-mouth-open test. Where I think the right test is is there something in-between the two where you read the label and you taste the product. That’s going to lead you to something which is less sweet than wins the blind taste test; and more sweet than someone that wins the eyes-open-mouth-shut test. So to speak, that’s a sweet spot that Honest Tea lives in.

[0:31:56.7] MB: Another theory you’ve talked about that that helped inform the start-up of Honest Tea was the idea of the babysitter theorem. Will you talk a little bit about that?

[0:32:04.5] BN: Yeah, the babysitter theorem. The basic idea here is that nobody goes and hires and babysitter to eat at McDonald’s. It’s going to cost you 50 bucks for the babysitter, 10 bucks for McDonald’s. Now, you should’ve said, “Wait a second. I just spent $50 to go to McDonald’s? That makes no senses at all.”

What is the larger — You might spend $50 to go out and get a fancy dinner at a white-tablecloth restaurant. The idea is if you have to spend a lot of money to get out the door, you’re going to go and do something of high quality, not low quality. To apply that result to Honest Tea, in our case, the babysitter is the bottle, the label, the cap.

If we were to fill up a bottle just with air, but put on the cap and the label, it could cost us $0.60 to get out the door. If you’re going to spend that much money on packaging, you might as well spend a little bit more on ingredients. 

The other guy who’s out there were spending a penny or so on tea, a couple more cents on high-fructose corn syrup. We think if we spend a nickel on tea, people can actually tell the difference. It’s going to raise the price maybe from $1 to $1.10. If you’re already spending your dollar, you might as well spend a buck-10 and get something truly amazing in terms of quality. The babysitter theorem helped us get there. 

[0:33:32.3] MB: Being a professor and a student, how did you take this idea and go from concept to purchase order and then, from a purchase order to product on shelves?

[0:33:46.5] BN: It’s a long story, which we tell in our book called Mission in a Bottle. That’s another plug [inaudible 0:33:53.7] I’m allowed. That’s where we had a huge amount of passion. Seth is brilliant. He’s tireless. He is inspiring. We started out using the Lean Startup approach, which in this case meant making tea in our kitchen. Taking an old snaffle bottle and washing off the label. Using rubber cement to glue on a hand-printed label, filling up the bottle with the tea that we had made, putting thee cap on back our self and bring it to a buyer at Whole Foods, who fortunately liked the way the product tasted and he ordered in a truckload. Then, we had a couple of months to figure out how to make it. 

If we couldn’t have sold it to the buyer at Whole Foods, that was our complete target customer, then we would have realized that we hadn’t truly understood the market that we thought we’d understood. 

[0:34:41.1] MB: For the listeners out there, we will definitely include in the show notes Mission in a Bottle. We’ll include the negotiating course on Coursera and links to everything else we’ve talked about. That stuff will all be in the website. Everybody can make sure to check that out. 

[0:34:54.2] BN: I’ll take you back again to one last bit. Imagine — We’ll stick in the beverage world. Imagine for a moment you get to be the CEO of — I don’t know. Pepsi-Coke, and you have the opportunity to get Coca-Cola’s secret formula. It’s not an ethical issue. It’s not a legal issue. What would you do with that if you had it?  

[0:35:16.7] MB: That’s a good question. Do you produce it or not? I don’t know. 

[0:35:21.5] BN: Yeah, that is the question. I’ll give you one shot and then I’ll flip the cards . 

[0:35:27.8] MB: All right. Fair enough. I would say — This almost happened with the fiasco with new Coke back in the 90s and it was a disaster for Coke and they ended up completely reversing course. I think you probably — I think it’d make sense to produce it in some way or another whether it’s under the same label or not. If nothing else just to try to kinda knock ‘em down a peg.  

[0:35:50.0] BN: Let’s say that you did that, and now there’s sort of another thing out, they taste just like Coca-Cola, separate from whether or not the taste of Coke is really what matters the most or is it really its association with being America and the brand. If that happened, that’s likely to bring the price of Coca-Cola down, because they’re now going to have to compete more aggressively against this perfect substitute, this generic version of coke that’s really more than generic, it’s a perfect replica. 

When the price of Coca-Cola comes down, what is that going to do to the folks at Pepsi?  

[0:36:21.8] MB: Lower their prices.  

[0:36:24.2] BN: It’s going to probably force them to respond with lower prices. The last thing you want to do is make the world of Coca-Cola more competitive, because that is going to come back and bite you. By playing out the moves and countermoves, you can see that, actually, the best thing to do along with probably the ethical and legal thing, is to throwaway that recipe and never look at it.  

[0:36:48.9] MB: That makes a lot of sense. In many ways, it’s kind of the same concept behind cartels like OPEC that would prefer to keep prices at a certain level in order to maintain all of their margins.  

[0:37:01.0] BN: Sure. They are actually doing what would be illegal in United States in terms of restricting output. Here, there’s a question of, “Do I want to go and make a perfect copy of what my rival is making in the market? I may not even be able to, but if I could, the answer is I probably don’t, because that forces my rival to be in a more competitive situation. If my rival’s prices come down, then mine will probably come down too.” That’s not colluding by not doing it. There’s no requirement that I go and force my rival into a greater competitive environment. In fact, I generally want to differentiate my products from a rival rather than copy them. 

People’s first instinct is often, “Ho-ho! I got it. I can really screw the rival. I can feed them up. I can trash them. Let me go and do it.” It’s a little bit of a game theory insight. You realized that unlikely to actually help you in the long run.

[0:37:57.8] MB: That’s a great lesson and, again, shows game theory is not something that just exists in textbooks with something that’s incredibly applicable to all kinds of different fields of our lives. I’m curious, what would be a piece of advice you’d have for somebody who’s listening who might be kind of an inspiring entrepreneur that wants to follow, in one way or another, kind of the footsteps of you and Seth and what you’ve done with Honest Tea? 

[0:38:24.9] BN: Find something that truly makes a difference. In economics, we sometimes say that if you’re just 10% better, or 1% better, the whole world will come to you, but it turns out that’s not true. You have to be radically different and better in order for folks to care and pay attention. I think that’s a starting point. That also is a reason to have a passion. 

I think there are two aspects you need to have a successful business. One is you have to have the solution to a great problem. That’s what most people focus on. You also have to figure out why you’re going to continue to succeed even after the world knows about what you’ve done. That is why won’t others copy you, or having copied you, why that you’ll still succeed after they’ve copied you? That’s an often harder challenge. The problem is that most good ideas are good ideas for somebody else. They’re not good ideas for you. Work on that as well when you’re trying to come up with your great entrepreneurial idea. 

[0:39:30.8] MB: What prevented Honest Tea from being copied?  

[0:39:33.7] BN: Let me take a step back. Before doing Honest Tea, I thought about mixing orange juice and club soda. I do that myself. I think it’s a great drink. If you’d like, it’s an organic, all natural soda that’s half the calories of oranges. You could sell it and it would have half the cost of making orange juice and sell for the same price. Better margins. It’s all good. 

The problem is that if we had made that, I think you’d be test marketing for Tropicana. If they could come in, perfectly will copy what it is that we’ve done, and I would be a bitter professor saying that others had stolen my idea. For 10 years, I didn’t do anything on this, because I was afraid that in the end it will be copied and you [inaudible 0:40:17.4] succeed, we wouldn’t have known anything in the long run. 

The nice thing about tea is that the way in which we are making it, literally, boiling water and putting in tea leaves, it was not something that the big players, whether in the time it’d be Nestle, or Snapple. Arizona were doing — They’re using syrup and concentrates and powders. Our more artisanal way of doing things was a little hard for them to copy in what they’re up to. 

It was also the case that they would suffer some cognitive dissonance, which is if we’re saying what they’re making as liquid candy, then it’s hard for them to also go and make a product which isn’t so sweet, because their customers are expecting stuff that’s really sweet. They’d had to say to their customers, “Look. If you like our regular product, now you’re probably not going to like this, and so don’t drink this.” That’s not so easy for them to say. That does mean in the end, that folks won’t copy you, but it means it will slow them down and allow us to have more a foothold than build up a brand which we’re able to do. 

[0:41:27.4] MB: What is one kind of simple actionable piece of homework that you would give to somebody listening that wants to take a first step towards implementing or learning more about what we’ve talked about today?  

[0:41:39.5] BN: Other than buying Mission in a Bottle, I’d say go and make your prototype. The best market research I think is will I able to pay for it? I’ll give you one quick example of some students of mine wanted to make and sell organic cotton shirts. How could you figure out if there’s a market for that? I think you could show them pictures. You could tell the story. What you could also do is go to a custom tailor and have the person make you organic cotton shirt. Then, you could show the person, they could look at it, they could hold it, they could touch it, and they could say, “Okay. Yeah, I’d buy that.” You’d say, “Great. Write me a check.”

Then, you know that it’s a real piece of demand, not just a hypothetical piece of demand. I may not have to have thousands of pieces of inventory, but having one piece of inventory makes a project look so much more real and will allow you to truly gauge demand in a much better way.  

[0:42:38.4] MB: It’s a great piece of advice and something that’s so critical. It’s very easy for people to say, “Oh, yeah. That sounds like a great idea.” Unless they’re willing to put hard dollars on the line and actually support it, that’s where the rubber meets the road. 

Where can people find you and Mission in a Bottle and all of your other books online? 

[0:42:58.9] BN: Well, missioninabottle.net, [inaudible 0:43:00.9] a little preview there, barrynalebuff.com have links to everything. The Coursera Course has the free online negotiation. That’d get you pretty well started, I’d say. Of course, Amazon, pretty much has everything. 

[0:43:16.3] MB: We’ll make sure to have all of those included in the show notes. Barry, thank you so much for being on the show. It’s been a fascinating conversation. I enjoyed having the tables turned and testing my SAT test taking abilities and my game theory knowledge. Thank you so much for coming on here and sharing all your wisdom. 

[0:43:33.4] BN: Thanks for being a good sport and for having me. I appreciate it. It was fun.  

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