The Blockchain Effect: Network Effects without Market Power Costs

The recently launched MIT Cryptoeconomics Lab is the first academic research initiative in the blockchain and crypto space bridging the fields of economics, computer science, and business. Academic economists are starting to take notice of the industry and beginning to study it using their own analytical tools. The research coming out of the MIT Cryptoeconomics Lab generates important findings relevant to ventures in this space.

Christian Catalini of MIT Sloan and his co-author Joshua Gans of University of Toronto Rotman School of Management have a working paper called “Some Simple Economics of the Blockchain”, which is among the first papers to help economists understand blockchain technology in their own language. The paper contains a number of insights that are just as useful to entrepreneurs and startups in the industry as they are to economists. In this blog post, I will focus in on one of those insights and explain why it is important for blockchain startups to understand.

Economists view technology adoption through the lens of reducing or eliminating inefficiencies: improving outcomes at the micro and aggregate levels. One of the inefficiencies that blockchain will help eliminate is what Catalini and Gans call ‘the cost of networking’: inefficiencies that arise due to the market power of internet giants like Google, Amazon, Facebook and others.

Reducing the cost of networking will be a game changer for the economy, because it will disentangle the benefits from network effects from the detrimental impact of market power.

Network effects are a phenomenon whereby the value to the user or consumer of a product or service increases as its user base grows. Facebook, for example, is more compelling to potential users (including Harvard undergraduates) today than it was when it was limited to only Harvard undergraduates; there are more people to connect to, making it a more useful product.

Network effects can only be leveraged if users are able to interact on the same network. So even if the overall market for a networked product is very large, it will have less value if that market is segmented. For example, early on in the telephone industry, even if a friend had a telephone, you would not be able to call them unless the two of you were connected to the same provider. Such fragmentation decreased the value of having a phone.

Economists have long argued that network effects lead to natural monopolies for exactly this reason; the overall value delivered to users will exponentially grow if instead of having competing networks, everyone uses the same one. While it has become apparent that digital platforms such as Facebook and Uber aren’t necessarily monopolies, there is no doubt that increasing returns to scale give these platforms with tremendous market power.

Market power arises when users or customers have few comparable alternative options for sources of the good or service being provided. This gives the seller the ability to raise prices, or in the case of some internet giants to charge transaction fees, compile and sell user data, all as a condition for giving users access to the platform.

Each of the aforementioned monetization strategies, using market power as a tool, creates inefficiencies. These inefficiencies emerge in the form of users opting out of a platform that would deliver them value above the marginal cost incurred by the supplier. They also come at the cost of some transactions that would otherwise result in gains from trade not occurring because fees outweigh the benefit.

The market power exerted by internet platforms reflects a fundamental tenet of capitalism: that private property rights foster innovation by ensuring that those who develop new technologies can then profit from their inventions. Over the last several centuries we have found that the best possible way to structure an economy is by awarding and enforcing private property rights: the ability to control assets, including having the right to refuse service. Property rights make ‘big’ and ‘powerful’ inextricably linked.

Under these conditions, we have assumed that we must accept any inefficiencies that arise due to market power if we want to leverage the potential for network effects.

However, Blockchain technology challenges this dynamic because it creates assets — ones that are potentially extremely valuable and are able to leverage network effects — that cannot be owned.

The first major implementation of blockchain technology — Bitcoin — is a publicly accessible distributed ledger, designed so that its maintenance and production can be contributed to by anyone: a permissionless blockchain. Bitcoin has served as a blueprint for any person or group seeking to leverage its underlying technology in order to circumvent inefficient centralized intermediaries.

A permissionless system guarantees that no single entity can control the network. If you cannot control it, then you cannot exert market power over it.

Positions of authority on a permissionless blockchain are open for anyone to join and free for anyone to leave. This fact, combined with the fact that open source code is the basis for permissionless production and maintenance, means that if some entity or concentrated group were to gain control of a permissionless blockchain — and/or attempted to draw disproportionate revenue from it — users would have the ability to either initiate a hard fork and replicate the system (including compatibility with past transactions) in order to redistribute power.

Removing market power from digital networks increases the efficiency of those networks, unlocking a great deal of potential economic value. Without market power inefficiencies, ‘the cost of networking’, users and developers of complementary applications are not priced out of the market, leading to more participation and greater network gains.

Conversely, permissionless blockchains have no owner, and even developers cannot expect to indefinitely extract profits from their products following launch. For blockchain startups who may want to raise funds or earn revenues from their creations, this presents a challenge.

Initial Coin Offerings (ICOs) introduce one funding solution: developers can collect funds up-front, not by selling equity — because there is no ownership — but by pre-selling access, in the form of tokens, to the platform they are planning to build.

As the market matures, new business models will emerge, and entrepreneurs will discover novel solutions to the funding, revenue and ownership challenges blockchain technology poses.

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The Blockchain Effect: Network Effects without Market Power Costs