Blockchain’s Key Economic Impact: Verifying Transactions and Operating a Network

December 11, 2016

While many organizations are exploring the capabilities of blockchain technology, a pair of researchers argue that cryptocurrencies will affect two key costs in the economy: the cost of verifying transactions, and the cost of running a network, platform or marketplace.

Their 30-page working paper, titled “Some Simple Economics of the Blockchain,” explains that blockchain technology lowers the cost of auditing transaction information and allows new marketplaces to emerge by enabling market participants to perform costless verification. The authors are Christian Catalini of MIT and Joshua Gans of the University of Toronto.

Unleashing Market Opportunities

When a distributed ledger is tied to a native cryptographic token, marketplaces can function without the need of intermediaries, lowering networking costs.

Bitcoin for the first time in history demonstrated value could be transferred reliably between untrusting parties without the need of an intermediary.

As the cost of verification falls, bits of information that were previously uneconomical to trade on their own can be individually verified and become part of how a marketplace operates.

In the way that Twitter’s 140-character limitation enabled new forms of communication, the ability to deploy costless verification for a single piece of information can fundamentally change how information markets are designed.

What once constituted a time consuming and costly audit becomes a process that can run continuously in the background to ensure market safety and compliance, lowering the risk of moral hazard.

Addressing Privacy Issues

The log of transactions in a distributed ledger is typically public, but users can protect their privacy by transacting under multiple pseudonyms (they can use a bitcoin address for each new transaction), by pooling transactions with to make the traceability of inputs and outputs more difficult, or by using a protocol that provides anonymity (like Zcash).

From a standards perspective, since there are advantages to being able to rely on a single blockchain because of economies of scale in security and network effects, a single blockchain will not be able to accommodate every type of transaction and use. The size of a transaction, its functionality (e.g., Ethereum’s advantage in the development of applications and smart contracts), and the degree of security and privacy required before executing it will push different marketplaces to different blockchains.

Blockchains Meet Varying Needs

Where each blockchain will provide costless verification, the market design choices made by its developers will define what will be verified and the degree of market power trusted intermediaries will retain in that specific marketplace.

In bitcoin’s case, the choices were driven by the desire to make the cryptocurrency as decentralized as possible. There are no trusted intermediaries, anyone can be a miner, anyone can add transactions to the blockchain, and no one can block other participants’ transactions from being added to the chain. While this makes bitcoin resilient to attacks, it makes it less efficient than a centralized payment network like VISA.

Private blockchains, which are distributed ledgers where participants must be granted permission to add transactions, can deliver higher bandwidth since they don’t need to rely on proof-of-work for maintaining a shared ledger.

While private blockchains benefit from costless verification, they don’t take full advantage of the cost reduction of networking enabled by cryptocurrencies, as control over transactions is still in the hands of trusted nodes.

While costless verification can increase economies of scale and market power (as it lowers costs on the intensive margin of transactions), the reduction in the cost of networking brought by cryptocurrencies can bring a counterbalancing effect on competition.

Disrupting Markets

When assets are digital and ownership is not overseen by trusted intermediaries, new business models can emerge and new entrants can compete at a lower cost.

Because the costs of blockchain technology will be relatively high at the beginning (due to scarcity of the complementary human capital, learning and adaptation costs), high-value applications that can be deployed on top of existing blockchains are likely to be seen, including private blockchains targeted at making existing infrastructure more efficient (e.g., in finance and accounting), as well as extensive margin applications that enable new marketplaces.

Early market applications are also not likely to have high volumes. They will rely on simple transaction attributes (e.g., existence, timestamp), easily integrated into existing value chains, and will rely on an intermediary to complete some of the steps of costless verification.

Also read: MIT digital currency initiative seeks to loosen institutions’ hold over the Internet

IOT And Blockchains

Internet of Things (IoT) devices, when combined with a cryptocurrency, can seamlessly exchange resources with other devices on the same network. If the device also contributes to mining the underlying cryptocurrency (e.g., by dedicating computing cycles during idle time to securing a digital ledger), this may also allow new business models to emerge (e.g., a cellular phone’s plan could be partially subsidized through its mining chip).

Applications include forms of intellectual property registration and content licensing. Royalties for using IP or digital content can be tracked in a granular and transparent way on a blockchain by market participants, which is useful when different parties have conflicting incentives (e.g., in a principal-agent relationship). Artists that license music to Apple or Spotify could track how many times their songs are played by consumers, or receive royalties from other artists for remixes that include parts of their songs according to a smart contract.

For markets to thrive, participants have to be able to efficiently audit and verify transaction attributes. As more attributes can be cheaply linked to distributed, shared ledgers, new types of transactions and marketplaces and transactions are likely to emerge.

Through the use of cryptocurrency tokens, distributed ledger technology can bootstrap networks of exchange that don’t rely on traditional intermediaries. In such a context, intermediaries can still add value to transactions by focusing on the market design layer not commoditized by the use of a cryptocurrency (e.g., they can provide screening services, monitoring etc.), but they will face increased competition on account of the ability to cheaply generate and trade digital assets on a more open platform.

Hence, existing revenue models and incumbents’ market power are challenged, creating opportunities for novel approaches to regulation and the provision of public goods, software, identity, exchange platforms and reputation systems.

Images from Shutterstock.

Last modified (UTC): December 11, 2016 17:52

Tags: mit
Lester Coleman

Lester Coleman is a media relations consultant for the payments and automated retailing industries.