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Some Simple Economics of the Blockchain


We build on economic theory to discuss how blockchain technology can shape innovation and competition in digital platforms. We identify 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, including information about past transactions and their attributes, and current ownership in a native digital asset. The cost of networking, instead, relates to the ability to bootstrap and operate a marketplace without assigning control to a centralized intermediary. This is achieved by combining the ability to cheaply verify state with economic incentives targeted at rewarding state transitions that are particularly valuable from a network perspective, such as the contribution of the resources needed to operate, scale, and secure a decentralized network. The resulting digital marketplaces allow participants to make joint investments in shared infrastructure and digital public utilities without assigning market power to a platform operator, and are characterized by increased competition, lower barriers to entry, and a lower privacy risk. Because of their decentralized nature, they also introduce new types of inefficiencies and governance challenges.

Introduction :

In October 2008, a few weeks after the Emergency Economic Stabilization Act rescued the U.S. financial system from collapse, Satoshi Nakamoto (Nakamoto 2008) introduced a cryptography mailing list to Bitcoin, a peer-to-peer electronic cash system “based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party.” With Bitcoin, for the first time, value could be reliably transferred between two distant, untrusting parties without the need of an intermediary. Through a clever combination of cryptography and game theory, the Bitcoin ‘blockchain’ – a distributed, public transaction ledger – could be used by any participant in the network to cheaply verify and settle transactions in the cryptocurrency. Thanks to rules designed to incentivize the propagation of new legitimate transactions, to reconcile conflicting information, and to ultimately agree at regular intervals about the true state of a shared ledger (a ‘blockchain’)1 in an environment where not all participating agents can be trusted, Bitcoin was also the first platform, at scale, to rely on decentralized, internet-level ‘consensus’ for its operations: Without involving a central clearinghouse or market maker, the platform was able to settle the transfer of property rights in the underlying digital token (bitcoin) by simply combining a shared ledger with an incentive system designed to securely maintain it.

Literature:

The paper contributes to the nascent literature on blockchain by providing an economic framework for understanding how the technology changes the types of transactions and networks that can be sustained in the economy. By focusing on the two key economic costs the technology influences, the paper abstracts away from some of the idiosyncratic choices different protocols make (e.g. in terms of privacy, consensus algorithms, presence of mining versus not, etc.), and surfaces high-level dimensions that have implications for market structure and competition with existing digital platforms. This level of analysis allows us to highlight commonalities between protocols that may be different at a more finegrained technical level, but ultimately share a similar trust and competition model, and will thus have a similar impact on how rents are allocated between users, developers and nodes providing resources to a network. The Appendix provides additional technical details on how some of the most popular cryptocurrencies work, and a taxonomy of transactions that the technology can support (e.g. auctions, smart contracts, digital identity and property rights, audit trails etc). Previous research in this emerging area has focused on providing an overview of Bitcoin and its operations (B¨ohme, Christin, Edelman, and Moore 2015, Narayanan, Bonneau, Felten, Miller, and Goldfeder 2016); has combined theory and data to explain the velocity of Bitcoin and its use across countries as an investment vehicle, for gambling and illegal online markets (Athey, Parashkevov, Sarukkai, and Xia 2016); and has studied the role early adopters play in the diffusion and use of Bitcoin within a large-scale, field experiment (Catalini and Tucker 2017).

Cost of Verification:

Markets facilitate the voluntary exchange of goods and services between buyers and sellers. For an exchange to be executed, key attributes of a transaction need to be verified by the parties involved. When an exchange takes place in person the buyer can usually directly assess the quality of the goods, and the seller can verify the authenticity of the cash. The only intermediary involved in this scenario is the central bank issuing and backing the fiatcurrency used in the exchange. When a transaction is performed online instead, one or more financial intermediaries broker it by verifying, for example, that the buyer has sufficient funds. Intermediaries add value to marketplaces by reducing information asymmetry and the risk of moral hazard through third-party verification. This often involves imposing additional disclosures, monitoring participants, maintaining trustworthy reputation systems, and enforcing contractual clauses. As markets scale in size and geographic reach, verification services become more valuable, as most parties do not have preexisting relationships, but rely on intermediaries to ensure the safety of transactions and enforce contracts. In the extreme case where verification costs are prohibitively high, markets unravel, and beneficial trades do not take place.

Cost of Networking:

The ability to verify state (e.g. the current ownership status of a digital asset) at a lower cost because of the reduction in the cost of verification allows a blockchain protocol to not only reach consensus about the history and proposed evolution of a digital asset, but also to define rules for state transitions that are particularly valuable from a network perspective.These transitions can be used to reward participants for performing actions that accelerate adoption and increase network value and welfare. 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, etc. Taken together, these incentives lower the cost of networking, i.e. the cost of bootstrapping, operating and scaling an economic network.

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