Some Simple (But Profound) Economics of the Blockchain

If you're looking a well-structured, economics-grounded model to structure your thinking about blockchains, I highly recommend the recent paper by Catalini and Gans titled "Some Simple Economics of the Blockchain."

This paper was a treasure trove, and I will definitely be revisiting it later with a fine-tooth comb. At a high level, the authors frame the value of blockchain technology as a drastic lowering of two types of costs: (1) the costs of verifying and auditing transactions, and (2) the costs of building a network. Prong 1 helps you think about the implications blockchains will have on "cutting out the middleman," noting that the disruption will probably be most pronounced for transactions where verification and auditing costs are really high (and perhaps not so much for transactions where they are low). Prong 2 helps you think about how native tokens create value that "bootstraps" the development of networks, reducing the need for venture capital or other early funding mechanisms. This "cost"-focused model was one of the best resources I've seen so far to help me square blockchains with the existing literature I've read on firm boundaries and transactions economics (Coase, etc.).

The paper also addressed a bunch of my questions about the incentives and other economic drivers of decentralized projects (see my past posts here and here). For example:

Q: Is Steemit changing the way we weight pleasure vs. rewards in our decision to create content?

A:

Relative to open source projects, which have to rely on donations of time and resources…or signalling incentives and career concerns (Lerner, 2002), cryptocurrency protocols can offer direct, monetary incentives to fund their growth. This could expand the set of individuals interested in participating in an open source project, and in some cases could change how we fund the provision of public goods.

(By the way, I've always thought of cryptocurrencies as open source projects. But as the paper points out on page 23, given the real economic incentives at play, maybe this shouldn't be the way we characterize them anymore.)

Q: When is it advantageous to operate an organization in a decentralized manner (i.e., open source protocol, like many crypto projects) versus a centralized manner (i.e., legally-recognized corporation, board of directors, etc.)?

A:

Overall, these changes in the cost of verification and networking also impact the relative cost of using a price system (i.e., a market) over a vertically integrated structure….The design of blockchain technology will depend on how decentralized a market can be versus how much of it functioning will still need to rely on trusted intermediaries (also from a regulation perspective).

Q: Is cryptocurrency the future of everything, poised to decimate governments and incumbent companies alike?!?!?

A:

Whereas the utopian view has argued that blockchain technology will affect every market by reducing the need for intermediation, we argue that it is more likely to change the scope of intermediation both on the intensive margin of transactions (e.g., by reducing costs and possibly influencing market structure) as well as on the extensive one (e.g., by allowing for new types of marketplaces). Furthermore, for the technology to have any impact in a specific market, verification of transaction attributes …by contracting third-parties needs to be currently expensive; or network operators must be enjoying uncompetitive rents from their position as trusted nodes above and beyond their added value in terms of market design.

(That's economist-speak for "It depends.")

Congrats Catalini and Gans on this rigorous and super-helpful economic treatment of blockchains! I hope you receive all sorts of accolades.

Readers: Do you have any favorite books or academic papers on understanding the economics of blockchains?