Blockchain Series – The Economics of Blockchain

To understand what the economics of Blockchain, we need to first define and understand the term economics. Hopefully after the Blockchain series, there will be a post of what is economics. For now lets stick to the general understanding of the term.

There are two lenses through which the economics of Blockchain could be understood.

  • Blockchain as an ICT technology – Economics of information, innovation and technological change.
  • Blockchain as an institutional technology for making economic transactions – New institutional economics

Economics of decentralization, information, innovation and technological change

The first lens of Blockchain as an ICT technology is the default setting today. Most of the literature around Blockchain looks at it only as an ICT technology or a general purpose technology innovation and its stages of development (McKinsey 2015, Oliver Wyman 2015). This view looks at the banks or institutions adopting Blockchain on a large scale, with huge efficiencies that it can bring in, the disruption that it will cause and various other insights on the lines of Schumpeterian phases of adoption and diffusion throughout industries and the economy. The analysis of the value chain and the impact in this study also follows a similar approach. This line of thought could be extended to understand the relation between market structure and innovation based on how certain domains in BFSI are taking a more proactive approach to the technology as compared to the others.

The five stages described in the previous section describe the workings of the technology. When applied together, they are capable of replacing any centralized system that records, reconciles and verifies transactions. There are three laws which make a case for Blockchain being an effective solution.

Table 1 : Laws of The Technology Market and Their Implications

Law Statement Implication
Moore’s Law Computing speed doubles every 18 months Cost of processing halves every 18 months
Kryder’s Law Storage capacity doubles every 12 months Cost of storing information halves every 12 months
Nielsen’s Law Bandwidth doubles every 21 months Cost of transmitting ditigal information halves every 21 months

 

Based on these three, the long run cost and output curve would be a downward sloping curve, that with time, the cost of technology will fall rapidly. This could have significant impact on the current operations of organizations. Assuming the scale to be constant, with time, the cost will fall by half at the end of a particular time period. Given the network effects and switching costs, substation, once the technology is proven, will happen at a non-linear pace.

Cryptoeconomics ensures the system keeps going. The word ‘cryptoeconomic’ is used to describe any decentralized cryptographic protocol “that uses economic incentives to ensure that it keeps going and doesn’t go back in time or incur any other glitch.”. As the entry barrier to become a miner is limited (only the computing power, electricity and internet connection), the system cannot be held hostage by miners.

 

Institutional Economics

The institutional economics approach looks at Blockchain as an enabler in a new type of economy. When the whole process logic of Blockchain is put together, it enables the evolution of Decentralized Autonomous Organizations or DAOs. These organizations are self-governing and have governance rules which are formalized and enforcement is automated. The implication this can have to service enables whose services are commoditized or are on the verge of being commoditized are serious. To understand the impact, it is necessary to understand the characteristics of Blockchain from an economic perspective.

Why is Decentralization important?

Adam Smith has argued that while individuals may not know what is best for them, a decentralized system through trial and error can successfully help develop rules required to achieve individual goals as well as social order (Paganelli 2006). Smith believed that decentralized systems can cope with human imperfections at an individual as well as group level.

Complex systems have always evolved from basic centralized system to decentralized systems. Centralization has been the starting point given the ease with which rules can be created, established and enforced. In the event of a dispute, the hierarchy in the system and the guidelines can address them effectively. As the costs of the centralized systems begin to become exploitative through the follies that come with concentrated power such as corruption, rent-seeking behaviour and so on, the decentralized structure comes across as a solution to the problems caused by the existing structure.

While organizations are centralized, it is important for the market to be decentralized for it to be efficient (Glode & Opp 2016). One of the primary functions Blockchain performs is to decentralize any sphere it is applied to.

Governance

Ronald Coase explained why firms exist by relating them to the market through the idea of transactions costs. The basic unit of analysis is the transaction. Any economic activity to take places, requires coordination with various other units in the economy. To produce, there has to be coordination with suppliers, buyers, labour unions, financiers and various other entities. Coordination problems arise from uncertainty. In a world of uncertainty, contracts are incomplete and need to be renegotiated at intervals. Asset specificity allows the firm to be vulnerable to opportunism, where the counter party may renege to extract a more favourable deal for itself. The costs of renegotiation can be painful and costly under conditions of asymmetric information and asset specificity. This leads to a question of why some transactions occur in firms and not in markets. Here, Coase introduces a concept called Transaction Cost and that transaction costs determine how transactions are done. With the help of some additions, Blockchain, through DAOs, can solve the problem of opportunism by reducing transaction costs through cryptoeconomics, public transparency and automatically enforceable smart contracts. Smart contracts can eliminate “one of the most frustrating aspects of contractual drafting: the inherent ambiguity” of language. Incompleteness of contracts due to bounded rationality or any other reason increase transaction costs, according to Coase. Contrary to such contracts, smart contracts will have to be complete. A smart contract can be used to ensure that a contractual condition is executed, forcing the parties to remain bound to their respective obligations (Wright & Filippi, 2015). This has serious implications for traditional firms. DAOs require the full business logic to be laid out and the process integrity ensures the entire transaction is carried out without any trust.

Transaction costs arise from information problems and the cost of writing and enforcing contracts. Blockchain, through DAOs, will reduce the cost of writing contracts. The cost of enforcing contracts depends on the element of human judgement allowed in the system. If the entire process of enforcement is also automated, the cost will be lowered again. The public ledgers address the informational problems to a certain extent.

Blockchain as a Catallaxy

As Blockchain can be used as an alternative governance institution, the same business logic, with some additions such as a constitution, private money, can be applied to a create self-organizing and constitutionally ordered catallaxy. This views Blockchain as a spontaneous organization that competes with traditional organizations without really being an organization.

Hayek defines a catallaxy as a “special kind of spontaneous order produced by the market by people acting within the rules of the law of property, tort and contract”.

This enables Blockchain to facilitate transactions and not just exchange, making them superior to markets. However, it isn’t an economy. Hayek defined an economy as “an organization or an arrangement in which someone conspicuously uses means in the service of a uniform hierarchy of ends”. Hayek goes on to say “the two advantages of a spontaneous order or catallaxy: it can use the knowledge of all participants, and the objectives it serves are the particular objectives of all its participants in all their diversity and polarity.”. This enables the Blockchain to have multiple markets within its ambit.

A catallaxy is characterized by a multitude of agents living within an ‘extended order’. Its agents are

  • Social, and governed by social rules
  • They have specialised/distributed knowledge
  • They form their own plans
  • These are mutually coordinated through the market/price system

Blockchains are ‘orders of economies’ in the same way a market order is a catallaxy of mutually adjusting individual plans (economies). The first remarkable property of emergent economies built on Blockchains is that they are non-territorially unbundled. Second, the price system in Hayek’s conception operates at the level of a system of markets, as in a region or nation, but a further surprising property of Blockchains is that they provide a mechanism to radically reduce the size and scale of effective catallaxies. (MacDonald, Allen, & Potts)

Blockchain can enable better sharing economies. The Blockchain’s trust protocol allows for cooperatives, or autonomous associations, to be formed and controlled by people who come together to meet common needs. All revenues for services, except for overhead, would go to members, who also control the platform and make decisions (Tapscott & Tapscott, 2016).

 

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