In both of these lectures, I will follow economic tradition and demonstrate the ideas via models – tales or fables. I will try to present the models precisely, with each claim accompanied by a real proof. But I will not use formal language, which would indeed make the models easier to understand for the few who are familiar with this language, but would pose an impenetrable barrier for all the rest.

Throughout this chapter, we will skip back and forth between the two lectures: jungle, market, jungle, market, and so on. You can consult two means of illustration – one for the jungle model and one for the market model – that are posted on the book’s website. When we are done, you will be asked a somewhat banal question: what are the similarities and differences between the two?

First lesson in the introduction to jungle economics course

Ladies and gentlemen, distinguished students, welcome to the first lecture in the Introduction to Jungle Economics course. In this lecture, we will study the principles of the economic system practiced in our society. We will see how an iron hand – not an invisible one – leads to an efficient result without the need for government intervention.

Common interests and conflicts of interests intermingle in the jungle experience. There are things we can achieve only through collaboration: nearly every act of production requires a series of coordinated activities conducted by many people. It is vital for all of us to mobilize for defend and conquer missions. Nonetheless, the resources available to any society, even a flourishing society like ours, are limited. Everyone seeks to receive as much as possible of what he likes. And, often, what one person likes others also like.

In our view, economics is no more than a tool that helps us to achieve common objectives and to overcome conflicts of interests. Our economic perspective is part of our broader social and political outlook. We are aware of the fact that some countries try to separate economics and politics. Economic questions that ought to be decided democratically via the political system are treated there as if they were professional matters and are deferred to experts to decide. We believe this is a ploy that serves the stronger members of society (including, just by chance, the community of experts). In this course, we will see that our economic system brings order to the chaos, leads to an effective allocation of what we have, and enables us to realize our aspirations for territorial expansion.

In the lecture today, we will see that recognizing that each individual should grab what he can with “a strong hand and an outstretched arm” brings about an efficient outcome, prevents (or at least reduces) the need for wasteful and corrupt government intervention and frees us of the central planning mechanisms that have failed time and again throughout human history.

In the best economic tradition, we will understand the economic mechanism of the jungle via a model, which we will affectionately call the jungle tale.

First lesson in the introduction to market economics course

I salute you for being accepted into the economics program, the most popular in our university. You are here thanks to your wonderful achievements in the SAT (Scholastic Assessment Test), which predicts – among other things – your ability to succeed in multiple-choice tests, a skill that is essential for the final exam in the course. The Introduction to Market Economics (or Principles as it is commonly named) is a challenging course. As Paul Samuelson used to say: “Take a good look at the man on your right, and then on your left; because next year one of you won’t be here.”

We cannot start the lecture without first saying something about the question, what is economics? Economics deals with individuals’ and society’s decision making processes. It examines how people make decisions. For example, should we send our son to university or buy him a car? Should we develop the health system or build highways? Should we enjoy more leisure time or try to increase our earnings? Economics helps us to best exploit our limited resources. It enables us to anticipate the changes engendered by government measures or environmental change. Economics has something to say about almost every issue, public or private. Economics will help us to conduct our lives rationally.

In the best of economic tradition, we will present the economic mechanism of the market via a model which we will call the market model.

The jungle tale

The territory controlled by our tribe is divided into a number of homesteads, inhabited by our notables, the heroic warriors whose courage enabled us to conquer our homeland. The number of heroes is equal to the number of homesteads. Each homestead can accommodate one hero, and each hero occupies only one homestead. The homesteads differ from each other. Each hero ranks the homesteads according to his own individual preferences. One might think that the conflict of interests between the heroes would generate chaos: a number of heroes might claim the same homestead, arguing “I deserve it” or “I was here first” or “God promised me this homestead” or “my ancestors were here 3,000 years ago.” In this lecture, we will see how the laws of the jungle allocate homesteads among the heroes.

The Jungle Model

A mechanism is needed to allocate the homesteads and we can envisage many such mechanisms. One mechanism is the lottery. The homesteads are raffled between the heroes. They might grumble about the result of the lottery, but they cannot change it, even by consent. This mechanism is known to us from biblical times: “Notwithstanding the land shall be divided by lot; according to the names of the tribes of their fathers they shall inherit. According to the lot shall their inheritance be divided between the more and the fewer” (Numbers 26:55–56). When Joshua conducts this lottery in the biblical tale, God was also in the picture. But we’ll disregard this fine detail. In any case, here in the jungle, we cannot accept the idea that a toss of the coin will determine who wins the land flowing with milk and honey, and who gets stuck with the desert wasteland. Here, we have a Basic Law of Good Reasons: every public decision must be predicated on appropriate and well-formulated reasons. The casting of lots is not listed in the Book of Good Reasons and Joshua’s mechanism would not meet the criteria of the Supreme Court. Moreover, there are likely to be many dissatisfied individuals after the lottery who would be happy to engage in “swaps” between them if they could. Just imagine if the one who is allocated the Beach homestead cannot swim and the one who gets the Forest homestead is afraid of bears.

And now we come to the mechanism that drives our prosperous economy. The allocation of homesteads in our society is dictated by the relative strength of the heroes. The balance of strength between any pair of heroes is defined unequivocally: either the first is stronger than the second, or the second is stronger than the first. In addition, we assume that if one hero is stronger than a second hero, and the second hero is stronger than a third hero, then the first hero is necessarily stronger than the third. In the table, the numbers assigned to the heroes are the strength indices. The numbers themselves have no significance beyond the fact that the higher the number, the stronger the hero.

In our tale, as in a real jungle, the heroes cannot forge alliances to fight shoulder to shoulder for the interests of the members of the alliance. In the absence of a legal option to sign binding agreements, they find it impossible to organize into groups, even though they realize that they would benefit from forming such a coalition. In addition, we also have an antitrust law that prohibits individuals from organizing with the aim of exercising force against other heroes.

Another realistic factor that is not included in the model is that each evacuation of a homestead entails costs for both the one who is evicted and the one who expels him. These costs sometimes prevent a strong hero from exploiting his advantage over a weaker one. Some of the costs are real, such as removal costs. In addition, sometimes the weaker hero makes an error in judgment and rejects the demand of the stronger one and in the ensuing conflict the stronger one also pays a price and makes sacrifices. Some of the costs are mental ones: our warrior heroes are all sensitive souls, who experience profound discomfort when they are compelled to expel someone weak from the homestead he occupies.

In summary, the jungle tale begins with a presentation of the heroes and the homesteads, a description of the strength ranking and a list of each hero’s preferences regarding the homesteads.

The market tale

The territory controlled by our society is divided into homesteads. A number of traders operate in the market, and each one owns a different homestead. There is no ownerless homestead. The ownership of a homestead cannot be divided among several traders, and each trader can own only one homestead. The homesteads differ from each other and each trader ranks the homesteads in a way that reflects his own preferences.

The Market Model

One might think that the process of allocating the homesteads is very chaotic, with several traders descending upon one trader and demanding that he swaps with them, making such claims as: “I deserve it,” or “I have more to offer you,” or “I came to you first,” or “I’m the man, and if you don’t comply with my demand I’ll kick you out.” In this lecture, we will see how the market mechanism imposes order on trading and leads to a stable and efficient allocation of homesteads.

We are aware that the concept of ownership in our model is simplistic. Sometimes there are disputes over ownership, resulting in violence between the rivals. Our legal system is designed to prevent situations in which two people try to occupy the same homestead, with each person insisting “It’s mine.”

In our model, the traders act as individuals. They are not allowed to form themselves into a group that coordinates the activity of its members in the market in order to obtain better assets. Such unions are also prohibited in real life by antitrust laws – laws that we enforce… sometimes.

In summary, the presentation of the market model begins with introducing the traders and homesteads, a listing of homestead ownership, and a ranking of each trader’s homestead preferences.

Solution of the jungle tale

Every tale seeks an ending. The conclusion of the jungle tale must be an allocation – that is, a description of which hero holds which homestead. There are many possible allocations, with the number increasing rapidly as the number of heroes grows. When there are only six homesteads and six heroes in the jungle, there are 720 possible allocations. We are interested in possible endings in which the force that might generate instability is neutralized – that is, no hero has an interest in exploiting his strength against those who are weaker than him.

A trumpet blast and we will unveil the solution concept that guides us in selecting the tale’s ending.

Definition: We say that an allocation of the homesteads to the heroes is a jungle equilibrium if no hero prefers a homestead held by a weaker hero. In other words, in an allocation that is not an equilibrium, there is a hero who has his eyes on a homestead that is held by a weaker hero and is therefore up for grabs for him.

Jungle Claim 1: For each beginning of the jungle tale, the tale has an ending that is a jungle equilibrium.

Proof: We will prove the claim by constructing an algorithm that will always lead to a jungle equilibrium. The algorithm is no more than a tool for proving the claim. It is an imaginary process and does not purport to describe the jungle dynamics.

We summon the heroes, one after another – from the strongest to the weakest. First, we enable the strongest to choose one out of all the homesteads. Then we call upon the second strongest hero and allow him to choose any homestead, except the one already chosen by the stronger hero. And we continue onward: at each stage, we call upon the next hero in the ranking of strength and let him choose from among the homesteads that were not selected in the earlier stages by the stronger contenders. Each hero chooses the homestead that he considers the best one for him among those still available.

Let’s apply the algorithm in the proof to the example of the six homesteads. Hero A is called first and chooses Vineyard. Hero B is called next. He would have liked to take Vineyard, but this homestead is already held by A. Of the homesteads that remain after A’s selection, Hero B chooses Beach. Hero C will take the homestead that he ranks highest, Oil, since it was not allocated in the first two stages. Hero D can choose one of the three homesteads that remain after the three stronger heroes took Vineyard, Beach and Oil, and he decides to settle for Forest. Hero E will take Tomb and the weakest hero, F, is left with only one “choice,” Nightclub, the only homestead that was not taken by one of the others. Fortunately for him, this homestead happens to be his heart’s desire. The allocation of the homesteads is marked by asterisks in the table in the jungle model.

Jungle Claim 2: For each beginning, the jungle tale has only one ending that is a jungle equilibrium.

Proof: To prove that there is only one allocation that constitutes a jungle equilibrium, we will show that in this equilibrium each hero must hold the homestead allotted to him by the algorithm from the proof of Jungle Claim 1.

First, we will demonstrate that this is true with respect to the strongest hero. According to the jungle equilibrium, this hero does not prefer a homestead held by any other hero to the one he owns. Hence, in equilibrium, of all of the homesteads in the jungle he necessarily holds the one that he prefers. This is also the homestead the algorithm allocates to him. In order to see that in equilibrium all the other heroes also hold the homesteads allocated to them by the algorithm, we will use the method called proof by induction.

Inductive step: If, in equilibrium, each of the N strongest heroes holds the homestead the algorithm allocated to them, then this is also true for the (N+1)th hero in the hierarchy of strength.

Let’s summarize: the concept of the jungle equilibrium predicts a single ending for each jungle tale.

Solution of the market tale

Let’s go back and look at the example of the six homesteads. There are many barter transactions that would improve on the starting positions of the traders. Which of these transactions will be executed? It is worthwhile for C and E to swap Tomb and Nightclub. Will they indeed do so? Will B, who owns the Oil homestead, trade it with E for Nightclub (despite the fact that Nightclub is less preferable to B than his current holding) because he plans to make a trade with D subsequently in which he will receive Nightclub, his greatest dream, in exchange for Vineyard? The traders D and E compete to obtain the Beach homestead owned by A. Trader D can offer A the Vineyard homestead and E can offer Nightclub. Will the fact that D has more to offer help him get the Beach?

Not every set of prices posted on signs will direct the flow of commerce without collisions. It is very possible that a certain homestead will be sought by more than one trader. We are looking for a set of prices that will steer commerce in such a way that each homestead will be the right one for only one trader. The fateful hour has arrived. The clamor of Wall Street can be heard in the background, creating a festive atmosphere as the moment when we announce the central concept of the lecture approaches.

Definition: A set of prices is called a set of competitive equilibrium prices if it satisfies the following requirement: for each homestead, there is exactly one trader who regards it as the best among the homesteads whose price is not higher than the price of the one he owns at the start of trading. The allocation that results from the traders’ choices is called a competitive equilibrium.

Underlying the definition of competitive equilibrium, we have a story about the way prices change: in a situation in which more than one trader would like a certain homestead, its price rises; and when no trader wants it, the price goes down. One can imagine an announcer declaring the prices, revising them, and revising again and again… until, wonder of wonders, each homestead has a single trader who is still interested in it and can afford it. But there are only a few markets that have such an announcer. In the absence of an announcer, the long arm of the invisible hand operates, steering the prices toward competitive equilibrium.

Does a competitive equilibrium always exist? The following claim states that whatever the traders’ preferences and the initial state of ownership, there is always at least one equilibrium.

Market Claim 1: A competitive equilibrium always exists.

Proof: We will prove the claim by constructing an algorithm that always leads to a competitive equilibrium.

We will continue the algorithm without the homesteads whose prices we just set and without their initial owners. At every stage, we will identify a cycle of traders in which each trader regards the homestead held by the next trader in the cycle as the best of the homesteads that were not allocated during the earlier stages. We will assign to the homesteads of the traders in the cycle a lower price than the prices assigned to the homesteads in the earlier stages. We will allocate the homesteads whose prices we just set and their initial owners and we will continue this as long as traders and homesteads remain.

We will prove that this set of prices is one of competitive equilibrium. Given a set of prices, we will see that each homestead has a single trader who would like it.

A trader whose initial homestead is assigned price P considers purchasing a homestead from among the group of homesteads whose prices are not higher than P – that is, all of the homesteads whose owners were not involved in the previous cycles of trade. The algorithm built the series of cycles such that his preferred homestead, among those left in his cycle, is the one that belonged to the next trader in the cycle of trade at the start of trading. Thus, each homestead has a single trader who would like it: the trader who appears before its owner in the current cycle of trade.

We will illustrate the algorithm with the example of the six homesteads: A is most interested in the homestead of D, who is most interested in that of A. Therefore, A→ D→ A is a cycle of trade: each of the traders in the cycle is most interested in the homestead of the trader who comes after him. We will arbitrarily determine that the price of each of the two homesteads they own, Vineyard and Beach, is 25. After removing these two homesteads and their owners, we are left with four traders (B, C, E, F) and four homesteads (Oil, Tomb, Nightclub and Forest).

The wealth of a trader in the market means his ability to choose a homestead from among many. The source of the wealth in the market is based on a meeting of interests among the traders. For example, A is very interested in D’s homestead and D is very interested in A’s. Their homesteads have a relatively high price. On the other hand, the fact that there is someone (F) who wants E’s homestead very much does not guarantee that E will be wealthy; the market price of E’s homestead may be low because there is no one who really wants F’s homestead.

There are many price systems that have competitive equilibrium. Nonetheless, the following claim shows that the market model still has a single ending.

Market Claim 2: All competitive equilibria result in the same allocation (the proof of this claim is more complex than the other proofs in this chapter and the reader who is interested can find it in my article with Michele Piccione, “Equilibrium in the Jungle”).

The efficiency of the jungle equilibrium

The jungle equilibrium makes the use of force unnecessary. In equilibrium, no hero can or wants to take over a homestead held by another hero.

In our jungle, a hero’s takeover of another hero’s homestead by force is a legitimate action, but – unlike in the market – there are no mechanisms that allow a group of individuals to trade homesteads of their own volition. It is easy to imagine the unrest in the jungle if a number of heroes were to discover that they could enhance their situation if they adopted foreign ways and agreed among themselves on a round of homestead swaps. If they did this, the masses would accuse the economic system of the jungle of inefficiency and would demand reforms. The next claim shows that there is no reason for concern. Before formulating it, we will present one definition: an allocation is efficient if there is no cycle of homestead swaps between some of the heroes that would enhance the situation of all of those participating in the swap.

Jungle Claim 3: The jungle equilibrium is an efficient allocation.

Proof: We start with a situation in which each hero possesses the homestead allocated to him in the jungle equilibrium.

Let’s summarize: After the jungle reaches equilibrium, any cycle of homestead swaps would worsen the situation of at least one of the participating heroes. Therefore, the allocation of the jungle equilibrium is efficient.

Until now, we assumed that each hero is concerned only with the homestead he owns and does not care which ones the other heroes own. In reality, the situation is sometimes different and the location of each hero affects the welfare of another hero. For example, we all want the strongest ones to live in the outlying areas so they can protect us from our enemies. A matter of concern for many of us is who lives in the neighboring homestead. In the language of economists, we say this is a situation where externalities exist. In such circumstances, the jungle equilibrium may not have the attribute of efficiency.

We will illustrate this point with an example:

Note that Hero C is primarily concerned with the homestead he receives. On the other hand, Heroes A and B also attribute importance to the homestead in which the other heroes settle. Each of them wants the other to settle in the Oil homestead.

The definition of equilibrium in the jungle with externalities is a bit subtle. The hero who sets out to grab a different homestead must take into consideration not only which homestead to choose; he must consider also how the displaced hero will react. Here, we’ll assume that the evicted hero moves to the homestead of the hero who evicted him. Thus, we’ll say that the allocation is a jungle equilibrium if there is no hero who prefers the allocation that would result from an exchange of homesteads with a weaker hero. For example, the allocation marked in the table with two asterisks (**) is not a jungle equilibrium. B could impose a swap with C and the result of this exchange (Forest, Beach, Oil) is ranked higher by B than the allocation marked by two asterisks.

The allocation marked with one asterisk (*) is an equilibrium allocation, but it is not an efficient allocation: the three heroes prefer the allocation with the two asterisks. It is possible to implement a more efficient allocation, but in order to do this the government would need to declare the Beach homestead a closed military area and use its power to ensure the allocation of Beach to C.

The efficiency of competitive equilibrium

Competitive equilibrium is defined by the existence of a price list in which each homestead has a single trader who is interested in acquiring it and able to do so. We will now see that the action of the invisible hand which leads to a competitive equilibrium also achieves the virtue of Pareto efficiency: there is no other allocation of homesteads to traders that would benefit some of them without being detrimental to any others. (Incidentally, under the conditions of the model, this characteristic is equivalent to what we called efficiency in the jungle.) Achieving Pareto efficiency is a central goal of our economy. An allocation that is not Pareto efficient is not a good allocation because it is possible to improve the welfare of at least some of the individuals without this coming at the expense of one of the other individuals. The following statement (which is called in the economic literature the first fundamental theorem of welfare economics) stipulates that the market mechanism achieves the ideal of efficiency.

Market Claim 3: The allocation in a competitive equilibrium is Pareto efficient.

Let’s summarize: After the market reaches competitive equilibrium, any other allocation, even if it is advantageous to some of the traders, is detrimental to at least one of the others. Therefore, the allocation of competitive equilibrium is Pareto efficient.

There is usually no need for the government to intervene and disrupt the market forces from doing their work. But we realize that there are exceptional situations in which Pareto efficiency is not achieved and there are grounds for considering government intervention in the market mechanism, for instance by offering benefits to traders to settle in sensitive regions. These situations might arise, for example, when there are traders who care not only about their own location, but also about the location of the other traders. In the language of economists, we say that this is a situation in which externalities are present. In such a case, there is room for payment to traders who settle in sensitive regions. We will elaborate in another course.

Summary of the first lecture on the jungle economy

I hope that the first lecture was not too intensive, despite the fact that I crammed a summary of the entire course into it. Before I conclude the lecture, allow me to make a few more comments.

Yes, we are proud of the fact that our economic system compensates the strongest heroes, and that the weaker ones receive only the stronger ones’ leftovers. Our economic system encourages people not to be weaklings. The School of Economics is named after mighty Samson. Our business school awards the MBA degree to those who have specialized in taking over the assets of others in elegant and original ways. Our best people devote their energies to the army, security, and the construction of walls and fences, and do not waste their talents on luftgeschäft, pie in the sky ideas.

True, the use of power to grease the wheels of our economy sometimes leaves victims in its wake. Our heroes are also human and sometimes make mistakes. A weak hero sometimes gets confused, fails to recognize his weakness, and resists when a stronger hero demands that he evacuate his homestead. A commotion ensues and the stronger hero must resort to force – reasonable force, of course – to remind the weaker hero of his inferior standing. In the language of economists, we call the damages incurred in such clashes transaction costs. We will remember the victims of the jungle economy, upon whose backs the system was built, and continue on.

Of course, we understand the feelings of the social lobby which is frustrated that the jungle economy is liable to generate an unfair allocation. Those who have asthma or who suffer from humidity in the summer prefer to live far from the sea. If the asthmatic is weaker, the outcome of the jungle economy will be unjust. Alas, the jungle is green, but it is not the Garden of Eden.

Summary of the first lecture in the market economy

I know that the first lecture of the course was quite a load. No wonder. My colleagues say, with a wink, that the Introduction to Market Economics course contains all the ideas an economist really needs to understand. Before I conclude the lecture, I would like to add a few more points.

Some argue against us that our system encourages people to be greedy and hedonistic. That is not true. We have a marginal influence on the nature of human beings. Human beings bring credit to evolution. By nature, they always aspire to obtain the best of what is possible. Many people engage in a feverish search for business opportunities. When someone is ready to sell something at a low price and someone else is willing to buy it at a high price, there will always be someone who immediately identifies the opportunity to buy from the former and sell to the latter.

The commerce in the market entails transaction costs – the time and effort needed to identify and execute a transaction. But these are negligible costs that we can ignore, and we can move on.

We will sadly note the sense of frustration among members of the social lobby, who argue that the laws of the marketplace ignore considerations of fairness. If someone who suffers from asthma and someone who is allergic to sweat in the summer would benefit by living in a homestead far from the sea, but the desirable homestead is owned by a wimp who happened to inherit it from his parents, then the outcome of the market is unjust. Yes, alas, the market is only almost the Garden of Eden.

To summarize the first lecture on the market economy, we will say only: behold, look and see how great are the wonders of the market.

End

The presentation of the two Introduction to Economics lectures is over. In one lecture, the model of the market took center stage. It is a familiar model that is taught in every Department of Economics. It is conventionally regarded as a basis for understanding the economic world in which we live, even though it is quite unrealistic, imaginary, does not provide an explanation for the wonder of equilibrium prices, and its predictive qualities are limited. The other lecture focused on the model of the jungle, a model that does not appear in the textbooks and seems to be taken from a Walt Disney movie, completely detached from the developed world in which we live.

But when we speak about the use of force as a factor that determines the distribution of goods in a society, we are referring not only to military power. In our world, it is not uncommon for people to use gentle force to allocate goods, and in some cases we do not even see anything wrong with this. The power of rank determines the parking arrangements even at universities. The power of seniority determines priority in awarding special privileges in elite army units and in nursing homes. The power of persuasion leads participants in negotiations to agree to what they are not interested in. And let’s not forget the power of attraction, male or female, that drives the process of allocating men to women and vice versa. Let’s say He-1 is with She-1 and He-2 is with She-2. But now He-1 prefers She-2 to his present partner, bless her soul, and He-1 is more attractive than He-2. So He-1 appears before She-2, exercises his manly powers – and the deal is closed. I shudder at the thought of using the market mechanism to make matches between the sexes.

The models presented in the two Introduction to Economics lectures are nothing but fables. Neither of them describes reality, but both of them still describe something from reality. Neither of them provides an unequivocal argument in favor or against this or that economic system, but studying both of them together helps to some extent in understanding economic mechanisms.