Adoption of Decentralized Networks, A Mental Model
By: James Kilroe
Tags: Blockchain, Decentralized Networks, Mental Models

H/t to Qiao Wang from Messari whose writing on the theory of The Firm sparked this thought process.

Since its inception, the internet has structurally reorganized many industries, such as the newspaper industry. The internet has empowered aggregators and platforms who serve customers to the detriment of suppliers by forcing suppliers to compete on cost or attention. For example, the e-commerce industry builds its websites and invests huge amounts to optimize their rankings on Google. Google has fundamentally reorganized countless industries that rely on traffic.

There has been as a pushback over this new economic structure and over the next 10–15 years, we believe that decentralized and permissionless business models will again alter how economic activity is coordinated. We have developed a mental model of thinking through when decentralization will overcome centralized alternatives. The model reframes Coase’s “The Nature of the Firm” and shows where a new Paradigm of Economic Coordination is possible.

The Nature of the Firm

In 1937, Ronald Coase wrote a seminal paper titled “The Nature of the Firm” which asked a simple question: if markets are so good at allocating resources, why do firms exist? To elaborate, if the market is so good at incentivizing individual behavior, why do you need a firm? Why are all transactions not carried out between individuals, guided by the invisible hand of the market, in a completely decentralized manner?

Qiao Wang showed how the answer can be illustrated through a tradeoff boundary, where firms optimize for transaction cost efficiencies through sacrificing the incentives of the individual.

Understanding how Firms and Markets interact

To dig deeper into this tradeoff decision and answer the questions he posed to himself, Coase sought to understand what comprises market transaction costs and what makes them efficient. Market transaction costs, consist of three separate costs that are often significantly lower within a firm:

Search and information costs: As information flows more freely within the firm, the entrepreneur can more easily find a suitable employee to execute certain tasks.

As information flows more freely within the firm, the entrepreneur can more easily find a suitable employee to execute certain tasks. Bargaining and decision costs: With no or little negotiation, the entrepreneur simply issues an employee with a task.

With no or little negotiation, the entrepreneur simply issues an employee with a task. Policing and enforcement costs: The entrepreneur punishes underperformers through allocating resources elsewhere, perhaps punitively (e.g. letting them go).

Thus, Coase concludes that firms exist as they serve to lower the transactional costs in certain types of economic activities. (His conclusions also explained where firms are less efficient than the market. The full paper is available here.)

Web 2.0 Platforms

We believe that Coase’s theory shows why internet-based platforms have dominated different industries. Typically, Web 2.0 platforms have replaced previous inefficient analog market processes with digital centralized alternatives. In the process, these centralized platforms have reduced the cost of market transactions for users by lowering all three costs that comprise a market transaction. In turn, this has forced suppliers to compete ferociously in hyper-competitive marketplaces, resulting in the commoditization of their services or goods. Importantly, once a platform has achieved scale, it generates revenue through ‘rent-seeking’ by charging a fee on each transaction. Aggregation Theory explains why this is possible.

Decentralized Networks

We agree with Qiao Wang that decentralized networks have the potential to push the tradeoff boundary between maximization and cost efficiency outward by offering a more efficient frontier than the market, a centralized platform or the firm. Also, we believe that these networks have the power to eliminate platform rent-seeking.

Understanding how decentralized networks extend the efficiency frontier outwards

Decentralized networks can lower market transaction costs in the following ways:

Search and information costs: Decentralized networks reduce this cost as trusted information flows easily on a public blockchain. This information, which is forever stored in a publicly accessible, auditable and immutable ledger reduces information asymmetry. In turn, this reduction reduces easier and cheaper transactions.

Decentralized networks reduce this cost as trusted information flows easily on a public blockchain. This information, which is forever stored in a publicly accessible, auditable and immutable ledger reduces information asymmetry. In turn, this reduction reduces easier and cheaper transactions. Bargaining and decision costs: Bargaining is a process of discovery and acceptance between a willing buyer and a willing seller. Blockchains crystallize this discovery through open source software and price discovery mechanisms. The combination of open data and auction techniques eliminate bargaining costs.

Bargaining is a process of discovery and acceptance between a willing buyer and a willing seller. Blockchains crystallize this discovery through open source software and price discovery mechanisms. The combination of open data and auction techniques eliminate bargaining costs. Policing and enforcement costs: Enforcement through consensus and embedded logic.

Mental Model

So, where does a decentralized network outperform against a centralized platform in a broad sense? We believe decentralized networks will succeed where:

‘Costs’ include the broader interpretations of costs, such as opportunity costs, and implicit costs (e.g. convenience and mental transactions). This will be expanded on in subsequent posts.

We believe that the exponential improvements enabled by these new market efficiencies will disrupt sectors where incumbents are extracting significant rent and economic surplus from the market. Successful blockchain-based networks will, therefore, be governed by the above formula, which we call the Blockchain Coordination Frontier (or BCF).

Applying the Model

Let’s apply this mental model to the original use-case for Bitcoin, as P2P money transfer.

The early era of Bitcoin, where it was used as a P2P money transfer mechanism in gray markets, illustrates this point:

Market Coordination Costs

Transfer costs (for Bitcoin, these were low)

Volatility (High cost as it was much higher than fiat)

Fiat onramp costs (Using local bitcoin was costly in terms of convenience)

General poor usability (Sending and receiving bitcoin was non-trivial and required technical education)

Volatility, fiat onramp, and usability costs were relatively high.

Platform Rent Extraction Costs

Regulatory costs (i.e. Jail time)

Platform risk (A bank freezing your account)

Traceability cost (Bank transfers are easy to trace, and all accounts linked to a drug dealer could be identified)

Blacklisting cost (No bank account)

The regulatory, traceability and blacklisting costs are large in a gray market. Paying a drug dealer via bank wire is very risky. So people resorted to cash if they could, but this had geographical limits as you had to meet somewhere.

Summarizing, the combined ‘blockchain-based market coordination costs’ (although high) were still much lower than ‘platform rent extraction costs’. Thus, gray markets became Bitcoin’s first dominant market as Bitcoin lowered the transaction costs by such an exponential degree that it was successfully adopted.

In subsequent posts, we will use this model to predict which sectors blockchain will successfully disrupt. Also, we will show how blockchain-based networks can outperform Web 2.0 centralized platforms by exponentially reducing market transaction costs.