Chief Thunderhooves didn’t like the balloon. Early the next morning Twilight and the gang were on the road to Appleloosa in a hurry.

“I can’t believe you did that,” Fluttershy muttered. For Fluttershy, it was pretty confrontational.

“What?” Pinkie Pie said. “I was trying to say sorry.”

“You—you can’t just apologize for killing two ponies!”

“I wasn’t apologizing! I didn’t kill anypony! I was saying sorry, like, ‘I’m very sorrowful.’ Hello?”

Fluttershy winced. “I mean, two buffaloes.”

“I didn’t kill them either!”

“You don’t go to funerals very often, do you, Pinkie?” Applejack said wryly.

“Maud had funerals for her rocks sometimes. They were somber affairs.”

“You really got to introduce me to your older sister some time.”

“I will! She’s just always so busy with her rocks.”

“Tell me about it,” Twilight grumbled. “Older siblings never have time away from their stupid hobbies.”

“This isn’t about you!” Fluttershy said. “This isn’t about any of you! Can’t any of you focus on another p—another p—p—p….”

Twilight watched Fluttershy struggle for an alternative. “Just say ‘pony.’ It doesn’t mean anything.”

“Check your privilege!”

“Well, I do like checking things—“

“If you want to talk about the buffaloes,” Rarity cut in, “how about the fact that they’re planning to attack the Appleloosan settlement?”

“How do you know that?” Rainbow Dash said.

“My horrible little monster told me,” Rarity said, nuzzling the parasprite with her snout.

“Put a leash on that thing,” Rainbow Dash mumbled.

“I’m worried bout my cousins,” Applejack said. “Buffaloes are real mean in a tussle, and the town must be covered in smoke by now. Let’s hurry.”

The smoke was getting even worse. The sky serpent couldn’t go on any further. Fluttershy instructed it to fly back to the wreckage of the train and wait there, and if they weren’t back after a day, to return to Ponyville. The Cerberus, however, looked strong.

“Six lungs,” she said, smiling with three mouths.

The parasprite seemed totally unaffected, as was Spike, and as for Bloomberg, the sapling from the Everfree Forest…Twilight wasn’t sure, but she thought it might have been breathing in the smoke, absorbing it with its leaves like normal plants absorbed oxygen. It was definitely taller now, and moving, stretching and twisting to reach the smoke with its leaves.

The smoke was high enough, and the…world was big enough that none of the ponies were too badly affected. But the air stank of sulfur,  each breath was noxious. Twilight couldn’t wait to be rid of the dragon and breathe fresh air again.

“Why would the buffaloes want to fight with Appleloosans, anyway?” Rainbow Dash said. “They should team up to fight the dragon.”

“It’s hard to work together with someone who stole your land,” Fluttershy said.

“Not really,” Twilight said. “I can get along with buffaloes, even though technically they’re stealing Princess Celestia’s land by claiming it as their own. No, the real problem,” she said as Fluttershy spluttered indignantly, “is externalities.”

“You’ve mentioned externalities before, mon petit poney,” Rarity said. “You clearly want to talk about them, so skip the suspense and fill us in.”

“Externalities,” Twilight said, “are the absence of friendship. Whenever you do something without taking into account the feelings of other ponies, that’s an externality.”

“Or other buffaloes?” Fluttershy said, a little nastily.

“Exhibit A,” Twilight said, a little impatiently. “Each pony—or each buffalo—acts as an individual even when the group’s welfare is at stake. Ever heard of the prisoner’s dilemma?”

Judging by the looks of confusion on everypony’s face, they had not. That meant it was time for an economics lecture. Twilight smiled manically.

“Uh…Twilight?” Applejack said nervously. “Why’re you smiling like that?”

“The prisoner’s dilemma is a classic puzzle in game theory. Suppose you and your criminal confederate get caught and locked up.”

“Caught doing what?” Pinkie Pie said.

“I would never get caught,” Rainbow Dash said. “I’m too fast.”

“It doesn’t matter—just go with it—okay, fine. Suppose you and your friend trampled somepony’s garden.”

Applejack let out a low whistle. “I reckon that could get a pony in trouble.”

“So you’re locked up in two different cells. You can’t see or hear each other. You have no way of communicating at all, and the police come to you with an offer. They say that if you testify against the other pony and they don’t testify against you, you’ll only get a slap on the hoof.”

Rarity winced. “How brutal.”

“And they say that if you don’t testify against the other pony, and they testify against you, you’ll get a slap on the hindquarters.”

Applejack looked green. “They wouldn’t.”

“Just do it!” Rainbow Dash flapped her wings nervously. “Testify against them!”

“So much for loyalty,” Twilight said. “It’s a little more complicated than that. They also say that if you testify against them, and they testify against you, you both get a slap on the hoof and a flick on the nose.” Fluttershy gasped. “And if neither of you testify against each other, you both get a flick on the nose.”

“So you should sit tight and say nothing, and then you’ll both be okay,” Pinkie Pie said. “A flick on the nose isn’t that bad.”

“Unless they testify against you,” Rainbow Dash countered. “Then you’ll get a slap on the hindquarters!”

“So you should testify against them,” Rarity said. “À bon chat, bon rat. That way you can protect yourself.”

“But they’ll do the same, and then you both get a slap on the hoof and a flick on the nose,” Applejack said. “It’s better if you both just sit tight after all. But then they’ll testify against you…this is a puzzle, all right.”

“Let me help you break it down,” Twilight said. “Since you can’t influence what the other pony will choose to do, you should consider your actions as a response to their choices. They will do one of two things: testify against you, or not testify against you. In each case, what should you do?”

“Well, if they testify against me, and I don’t testify, then I’ll get a slap on the hindquarters,” Rarity said slowly. “I mean, I probably won’t get a slap on the hindquarters. They wouldn’t dream of blemishing a beauty such as me. But if I were another pony, I would want to testify against them so that I only got a slap on the hoof and a flick on the nose.”

“And if they don’t testify against me, and I don’t testify against them, then I get a flick on the nose,” Rainbow Dash said. “But if I testify against them, then I only get a slap on the hoof.”

“Seems like testifying is the only rational thing to do,” Fluttershy said. “No matter what the other pony does, testifying against them is better for you.”

Twilight beamed proudly. “Exactly. Betraying your confederate is called the dominant strategy. That means that no matter what your confederate does, you’re better off betraying her. An example of a game that doesn’t have a dominant strategy is rock-paper-scissors, where your best option depends on what they choose. You can’t just throw out rock every time.”

“Why not?” Rainbow Dash said. “It’s the fastest one.”

“Rock-paper-scissors isn’t a race, Dashie,” Pinkie Pie said.

“It isn’t?”

“The reason this game is so interesting,” Twilight said loudly, “is that your confederate is in the same dilemma you are. Her dominant strategy is to betray you!”

“I knew I couldn’t trust her!” Rainbow Dash said.

“So you’ll betray her, and she’ll betray you,” Twilight said. “Then you both get a slap on the hoof and a flick on the nose.”

“But that’s just silly,” Pinkie Pie said. “If you both said nothing, then you’d both just get a flick on the nose.”

“But if she says nothing, then I can testify against her and get just a slap on the hoof,” Rainbow Dash pointed out.

“Exactly,” Twilight said. “You both betraying each other is called a Nash equilibrium. A Nash equilibrium is an equilibrium no pony has an incentive to escape from, even if, like in this case, you’d be better off if you could.”

“What does that have to do with externalities?”

“What the Prisoner’s Dilemma proves is that sometimes ponies have an incentive to do what is best for them even when doing so is harmful to the group’s overall welfare,” Twilight said, making sure Rainbow Dash was paying attention. “And when everypony acts that way, it makes everypony worse off, and yet they’re still going to keep acting that way.”

“You need a way of making the whole group move as one,” Rarity said. She tossed her hair. “I’ll do it, for a fee.”

Twilight nodded. “That’s one reason we have governments. Princess Celestia takes our voluntary defense funds and uses them to encourage ponies to act as a whole when acting as uncoordinated individuals can be problematic.”

“Say it again,” Rainbow Dash sniggered.

"That’s one reason we—"

“No, just Princess Celestia’s name.”

“Princess Celestia—“ Twilight cut off, glaring as Rainbow Dash fell to the ground, laughing. “What?”

“Your voice turns a mite funny when you say her name,” Applejack said, cheeks red and clearly trying not to laugh.

“Anyway,” Twilight said loudly, “the reason the Prisoner’s Dilemma turns out badly is because you can’t coordinate with your confederate. You have no way of communicating, so you can’t act in concert. Ultimately you have no choice to betray each other. It’s not even a matter of being mean! It’s not like you can ask each other not to.”

“I wouldn’t betray my confederate,” Applejack said.

“Applejack, no!” Rainbow Dash said. “You’ll get a flank-spank!”

“A flank-spank is a terrible thing,” Applejack said gravely, “but not so terrible as losing my integrity.”

“Whoa, that’s totally awesome,” Rainbow Dash said. “I’m not betraying either!”

“I wouldn’t betray my confederate either,” Rarity agreed. “I know she wouldn’t betray me. She wouldn’t dare.”

“It wouldn’t be nice to betray,” Fluttershy said. “I wouldn’t want to hurt my confederate.”

“And I’d just talk to her beforehand to make sure we both didn’t betray each other,” Pinkie Pie said.

Twilight facehoofed. “Pinkie Pie, you can’t communicate with each other. That’s part of the game.”

“I still would though.”

"All of your solutions, except for Pinkie Pie's, are actually ways the problem gets solved in real life," Twilight said. "My solution, by the way, is to refuse to be swayed by such manipulative incentives, and to only trample gardens with ponies who know that and are the same way. And there are other solutions, like changing the incentives so that an individual pony actually worsens their position by betraying the other, such as when two or more ponies face a common threat. You could betray the other pony, but then you lose to the outside threat."

"Like a dragon, for example," Applejack said. "Mighty convenient."

"But the point is, normally you don’t have to betray each other. Normally ponies can communicate with each other. Instead of ignoring or betraying each other, we work together.”

“Oh, like friendship,” Pinkie Pie said.

“Like economics, yes. Do any of you know how a pencil is made?” They shook their heads. “It’s very difficult. It takes ponies from throughout Equestria working in concert to create a single pencil. No pony could possibly do it on their own. What’s even more amazing is that most of the ponies who help make the pencil have no idea that they’re part of an incredible chain of production. Most of the ponies who work together to make the pencil aren’t friends with each other, and they probably aren’t friends with the pony the pencil is for either. Yet they work together to make a pencil for her anyway. Isn’t that amazing?”

“It sounds impossible,” Pinkie Pie said. “How can ponies who aren’t friends work together?”

“It’s called the price system.”

“Are we there yet?” Rarity whined.

“Hush. Ponies need two things to achieve coordination, to work together to achieve their various goals: they need an incentive to speak honestly about their wants, and they need an incentive to listen and respond to other ponies’ wants.”

“This is why we gotta learn to talk to each other to beat the dragon?” Applejack said.

“Yes. In small groups, ponies can communicate with words. But it’s not like you can shout all the way across Equestria. And if everypony is talking at the same time, then no pony will be able to hear anypony.”

“So how does it work?” Rainbow Dash said anxiously. “I have to beat Little Strongheart!”

“Imagine everypony is at an auction. Things are being sold—pencils, labor services, you name it. The winner of any auction is whoever manages to convince the other ponies to let her have it.”

“Why would anypony be so generous?” Rarity said.

“That’s an important question. One of the rules of the auction is that the more you tell ponies you want one thing, the less you can tell ponies you want another thing.”

“And other critters just aren’t invited?” Fluttershy sniped.

Twilight studied her seriously. "All creatures are united by the laws of economics. That's the whole point of this adventure, probably. What is the consequence of a rule that says the more persuasive you are at getting one thing, the less persuasive you have to be at getting another?”

Fluttershy, to her credit, actually thought about it. “Ponies wouldn’t try to persuade other ponies to give them just anything. They’d try harder for things that were more valuable to them.”

“Exactly. This rule encourages ponies to be honest about their desires. They won’t ask for just anything, but only the things most important to them. And there’s another rule: you can earn more persuasive power by being the one who gives another pony want they asked for. The more persuasive she was, the more persuasive you become by listening to her.”

“I see!” Rarity said. “That encourages ponies to be persuaded by the needs of others.”

“Uh-huh. Now picture it: all the ponies—and critters—in the auction-house that is the Equestrian economy. Each of them wants something. As long as they have to obey the rules of the auction, then they can only get what they want by honestly persuading others that their want is greater than other ponies’. And the best way to be able to persuade other ponies is to listen when they try to persuade you! You might imagine at the auction that everypony is focused on themselves and their selfish desires, focused solely on the auctions they want to win, but the opposite is true. You’ll see ponies practically fighting for the opportunity to help others get what they want. Ponies will search out the most needy and provide them with the things they desire so that they can get what they want. And that’s exactly how markets work. We bid on things with bits, our persuasion-tokens, which can’t be spent on other things, so we have an incentive to spend our bits on things we truly want. And we get more bits by selling things that ponies want, so ponies work hard to help each other."

“That’s very kind of them,” Fluttershy said.

“Kindness has nothing to do with it. It’s all about self-interest.”

“You mean ponies are selfish?” Rainbow Dash said. “Ponies are motivated by other things than money, you know.”

Rarity was surprised. “Rainbow Dash, do you mean you—“

“Like winning!”

Rarity sighed. “I should have known.”

“Self-interest isn’t the same as selfishness,” Twilight said. “Self-interest means what it says: ponies are interested in themselves. You speak and listen to yourself all the time. Your stomach growls and says, ‘I’m hungry,’ and when it does, you listen. You go get it food no matter what. But when another pony is hungry, even though her stomach is growling, you don’t always hear. Usually you don’t. There are ponies hungry all over the world right now, and you’re doing nothing to feed them.”

“They’ll have lunch soon,” Pinkie Pie said.[1]

[1]It was understood that there were hungry fillies all over Equestria. It was also understood that they had eaten a snack not even an hour ago, and it would be mealtime soon.

“But the point is, you’re not responsive to their wants. It’s not a matter of being selfish. You don’t hear them speak, so how are you supposed to listen to them? But you always hear yourself speak. That’s self-interest.”

"That's terrible," Pinkie Pie said. "Everypony is so separated! They'll be lonely."

"Ponies are incredibly diverse," Twilight said. She caught Fluttershy's look and rolled her eyes. "And if you throw in critters, I'm sure the diversity is only multiplied a thousandfold. And there are some things that can't be communicated. No matter how strong a friendship is, you can never truly understand your friend as she understands herself. You'll never feel what she feels quite like she does."

Pinkie Pie looked distressed. Twilight got to the point. "But look at what trade does! Two different ponies come together and meet at a common point, even though neither completely understands why the other is here. These two different minds meet at a common point through trade. It's a point of similarity without identity, empathy without understanding, mutual other-prediction without knowledge. It's like a point of isomorphism between two different objects. This happens any time a pony steps outside and shouts, "I want something!" and Equestria responds to her demands. That's friendship."

Rarity beamed. "Oh, like blackmail, but...but from the other side! The source of many a true friendship, I find."

"Um, no...that's not, um...."

The ponies were silent for a while as they continued toward Appleloosa. Twilight was thinking of how to kill a dragon. She hoped Spike was doing the same. She couldn’t have all the good ideas.

“I feel like we got sidetracked,” Rarity said. “What does all this have to do with externalities and why the buffaloes can’t work together with the Appleloosans?”

“Imagine trying to keep yourself alive and well when you can’t listen to yourself,” Twilight said. “Imagine you didn’t get hungry when you needed food or tired when you needed sleep, if you didn’t feel pain when you were cut or cold when you were out in the snow. You’d starve, work yourself to exhaustion, bleed and burn and freeze and never know it. You wouldn’t last long.

“Self-interest is what causes you to preserve and enhance your welfare. The amazing thing about markets is that they cause you to be other-interested without actually having to know very much about anypony else. All you need to do is see how much they want to pay for something to know how much they want it.”

“So like when you’re hungry, you know you want a cupcake,” Pinkie Pie said. “And when somepony else is willing to pay for a cupcake, you know they want one too!”

“Exactly. But what happens when there isn’t a market for some good, like clean air? What then?”

Pinkie Pie frowned. “Then…then no pony will be able to hear anypony else asking for clean air.”

Twilight nodded. “So somepony—like a dragon, for example—might pollute the air and fill it with all kinds of bad stuff, not because she’s evil but because no pony tells her not to. Because the friendship point doesn't exist, no isomorphic commonality between dragon and pony.”

“I’ll tell her not to!” Rainbow Dash said. “Uh, I mean, him.”

“We’ll give that dragon the Pigovian tax of a lifetime,” Twilight agreed. “In the absence of a market, direct methods might be needed. And it’s the same story for buffaloes and ponies. There’s no market in interspecies cooperation, so any particular buffalo will listen to herself talking about how much it dislikes the Appleloosans rather than the need to face a dragon together.”

“A pony will listen to herself too,” Fluttershy said.

“Yeah.”

“It seems like the dragon would be a lot louder,” Applejack said.

“That’s because you all think this whole conflict is a matter of buffalo vs pony, when I’d bet anything it’s really buffalo vs buffalo and pony vs pony.”

“Pony vs pony…?”

“The same chain of friendship that binds ponies all over Equestria in the great circle of communication that we call an economy isn’t necessarily tight enough to hold a single town together.”

“Chain of friendship?” Rainbow Dash said. “Oh! It’s like matrices!”

“Oh!” Fluttershy gasped. “It’s like the end of the world.”

Twilight stopped walking. The valley at the base of Hark Mountain where Appleloosa was supposed to be was filled instead with thick black smoke.

“Oh, no,” Applejack said in a stricken voice. “We’re too late.”

Next Chapter: Pinch Estimated time remaining: 1 Hour, 30 Minutes