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Discussing Some Simple Economics of the Blockchain

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Introduction

This month's Communications of the ACM contains a review article titled, Some Simple Economics of the Blockchain, which is apparently a review of a 2019 NBER Working Paper by the same name.

The review specifies these as the main points of the article:

• We discuss how blockchain technology can shape innovation and competition by identifying two key costs affected by the technology: the cost of verification and the cost of networking.
• The cost of verification relates to the ability to cheaply verify state.
• The cost of networking relates to the ability to bootstrap and operate a marketplace wihtout assigning control to a centralized intermediary. This is achieved by combining the ability to verify state with economic incentives targeted at rewarding state transitions that are particularly valuable from a network perspective.

Beginning with coverage of the introduction of Bitcoin in 2009, the article discusses the technology from the perspective of an economist. As an introduction, the authors note that Bitcoin represented the first time that "value could be reliably transferred between two distant, untrusting parties without the need of an intermediary." This was accomplished through a novel and unique combination of principles from cryptography and game theory that led to the first platform where any participant can verify and settle transactions without a need for a central clearninghouse or market. In particular, it accomplished this through the use of a reliable shared ledger and an innovative cryptocurrency reward system.

Although many people see blockchain as a threat to nearly every established industry, these authors suggest that it only threatens incumbents under certain narrow conditions. These include the following:

1. Last mile problems are not severe and digital verification can be implemented in a novel or more detailed way as a result of cost reductions for verification;
2. Reduction in the cost of network allows participants to more efficiently allocate rents between users, developers, and investors
3. Combination of reduction in costs & networking allows for the definition of new types of digital assets
4. When there is a need for greater privacy and better ability for users to control the use of their data

To support this argument, the authors go into detailed discussion of blockchain from the perspective of verification costs and networking costs, suggesting that cost savings in these areas are primary drivers of blockchain success.

From the article, here is a video discussion with the authors:

Some Simple Economics of the Blockchain from CACM on Vimeo.

In the remainder of this article, I'll delve into some more detail on four topic areas from the article: (i) Blockchain as a novel technology architecture; (ii) Blockchain as a provider of novel capabilities; (iii) Cost reductions in verifications; and (iv) Cost reductions in networking;

Blockchain as a novel technology architecture

As a new technology architecture, blockchain shines because it enables participants to rely on a shared network and it eliminates some drawbacks of centralized systems. These include the increased market power that intermediaries possess in a centralized system, the control that they exercise over data, and their ability to renege on commitments.

Additionally, blockchain can provide lower barriers to entry for service providers and app developers, and it can provide an alternative monetary policy for people in countries that lack trustworthy financial institutions. Aspects of the monetary policy may include: fixed supply; a predetermined release schedule; and the requirement for achieving consensus before implementing rule changes. In contrast, however, the article suggests that blockchain may be less useful in countries with "trusted and independent central banks".

Drawbacks of blockchain include the observations that it introduced new vectors for illegal activity and that its value can fluctuate wildly.

Blockchain as a provider of novel capabilities

By providing the ability to track transactions, settle trades, and enforce contracts that apply to digital assets, the authors argue that blockchain is a multi-purpose technology. It can be permissioned or permissionless, and in its permissionless form, they go on to suggest that it is a general purpose technology akin to the steam engine, electricity, or the Internet.

As a multi-purpose technology, blockchain can represent things like ownership in a currency, digital content, intellectual property, equity information, financial or physical assets, and other sorts of contracts. All of this means that it challenges numerous incumbent business models.

After bitcoin launched, this general purpose nature inspired clones and extensions such as Ethereum, Filecoin (digital storage), Brave Attention Tokens (BAT/Digital advertising), and Blockstack (Digital Identity). Unmentioned is our own Steem blockchain-powered digital collaboration platform.

Cost reductions in verifications

Verification is the ability to confirm the current state of a system. In centralized systems, this has traditionally been accomplished by trusted intermediaries who derived disproportionate power and influence from their trusted and central role in the system.

By letting all participants settle and verify transactions against a shared ledger, blockchain reduces the disproportionate power that's held by central intermediaries. The authors suggest, however, that it doesn't eliminate intermediaries. Instead, it forces them to compete on a more level playing field and changes the nature of the services that they provide.

Instead of trusting in intermediaries, blockchain participants are able to trust in the incentives, technology, and consensus rules. Intermediaries may still exist, however, as providers of smart contracts or trusted oracles.

Verification cost reductions in blockchain are impaired by the so-called "last mile costs" which includes the need to convert between digital currencies and comply with requirements like Know Your Customer (KYC) and Anti-Money Laundering (AML) regulations.

Because of the last mile costs, and other factors, the biggest impact of the cost reduction in verification is to improve applications that are already in existence. It also enables the unbundling of services and recognition and adoption of digital property rights. Because of the shared nature of the digital ledger, verification comes to look like collaboration among competitors.

Cost reductions in networking

Another form of cost reduction that's made possible by verification cost reduction is the reduction in network costs. This is the cost reduction that supports innovation and the creation of new applications. The article describes it like this:

For example, the protocol can be used to incentivize behavior that builds network effects (both in terms of users and applications), ensures the network has sufficient resources available to meet demand, guarantees its security, encourages savings or spending behavior.

The effect of cost reductions in networking changes forms as the blockchain goes through its life-cycle. At the beginning, when bootstrapping the blockchain, mining rewards and ICO offering are used to attract users and investors who hope for future gains.

When bootstrapping ends, the focus of the protocol and incentives shifts to avoiding the so-called Tragedy of the Commons, an economic state of dysfunction where market participants are encouraged to consume a resource to the point of destruction, instead of nurturing and growing it.

Not all projects achieve networking cost reductions, but the article suggests that the ones that do are distinguished by the following characteristics:

• Less likely to leave market power in the hands of founders and early participants
• Less reliant on off-chain governments, contracts, and laws to support operations
• Lower privacy risk because no single entity has elevated access to information
• They induce architectural changes and innovation in the ways that firms in their markets "create and capture value".

Conclusion

In the introduction, I listed the key points that the authors or editors found from the article. I also stated the conclusion that blockchain projects only supplant centralized projects under narrow circumstances. I'm going to restate those conditions here, because from my perspective, this was the key point. Here are the conditions where the authors suggest that a blockchain project will outperform a centralized project:

1. Last mile problems are not severe and digital verification can be implemented in a novel or more detailed way as a result of cost reductions for verification;
2. Reduction in the cost of network allows participants to more efficiently allocate rents between users, developers, and investors
3. Combination of reduction in costs & networking allows for the definition of new types of digital assets
4. When there is a need for greater privacy and better ability for users to control the use of their data

When none of these conditions is met, the author suggest that a traditional, centralized solution may be preferred.

I have a few other articles downloaded that I plan to review in coming weeks, so keep an eye on this space!

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Thank you for your time and attention.

As a general rule, I up-vote comments that demonstrate "proof of reading".

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Steve Palmer is an IT professional with three decades of professional experience in data communications and information systems. He holds a bachelor's degree in mathematics, a master's degree in computer science, and a master's degree in information systems and technology management. He has been awarded 3 US patents.