Introduction to The Economics of

Blockchain and Cryptocurrency

James Lee Caton

The modern era has seen many waves of innovation. During the late 17th and
18th centuries, financial markets blossomed in the Netherlands and England,
and with them unprecedented levels of interregional trade. At the same time,
science and trade journals proliferated, providing a new means of communi-
cation between scientists and innovators. An early wave of mechanization had
been supported with the harnessing of waterpower. This was followed by the
development and application of steam technology that would power ships and
trains during the 19th century. Before long, electricity and long-distance com-
munication enabled by the telegraph and telephone would allow information to
spread rapidly around the globe. During the 20th century, automobiles allowed
for personal control of one’s movement while air travel reduced travel times
from days and weeks to mere hours. The revolution in computing over the last
70 years has seen mass adoption of technology that was once only available to
scientists. The computers that the majority of consumers hold in their pockets
as smartphones are more powerful than early “supercomputers” that were
available only to a small number of scientists and professionals. Over the last
decade, these devices have become increasingly connected to our financial
accounts, our appliances and our vehicles, to name only a few domains.
It appears that we face yet another technological revolution, this one
centered on a new general-purpose technology: blockchain. Blockchain tech-
nology can enhance data security without requiring a third party. This enables
a wide range of applications.
The first application, Bitcoin, is a distributed accounting ledger that tracks
claims to cryptocurrency. Participants in the bitcoin blockchain all share this
ledger and mutually approve updates using a proof-of-work consensus algo-
rithm. This allows Bitcoin transactions to be administered without requiring
a third party to secure the transfer of funds. This algorithm allows the winning
miner who solves a cryptographic puzzle to securely establish the next block
in the Bitcoin blockchain and, for this service, so receive a fee from the highest
bidding transactors and win a reward in the form of new units of bitcoin so
long as there remain any units to be released. After 2140, no new bitcoin will

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 Introduction xi

be released and, therefore, winning miners will only be awarded transaction

fees.
The popularization of Bitcoin over the last decade has led many to speculate
whether Bitcoin can become a commonly accepted medium of exchange,
which also requires that it command a positive price (Chapters 2–4). This is an
interesting inquiry that requires that one also ask, “among whom?” We typi-
cally think of money as being a regional or national phenomenon. An object
might be accepted as money among a smaller group of users. For example,
gold from World of Warcraft commands value among the community of users
who play the game. Goods from the game and user accounts even command
a dollar value outside of the game, though this is technically against the rules
set by Blizzard. Similarly, there exist online exchanges where bitcoin and other
cryptocurrencies are predominantly accepted among users.
Can cryptocurrency become money? When we strictly define the bounds of
use, sometimes the answer to this question is yes. El Salvador recently adopted
bitcoin as legal tender and many African merchants who have created value
with the help of mobile money apps are increasingly attracted to mobile cryp-
tocurrency apps (Chapter 5). In other cases, for example in the highly regulated
financial centers of the world, such as New York and London, bitcoin is not
a predominantly accepted medium of exchange. The answer there is therefore
no. Both the qualities of the cryptocurrency in question and the existing insti-
tutional structure of a given domain play a role in determining whether a cryp-
tocurrency becomes adopted as a commonly accepted medium of exchange.
It is somewhat ironic that the provision of currency by blockchain is simply
an artifact of the technology. An especially useful artifact, no doubt. A unit of
cryptocurrency points only to itself. Blockchain technology can also record real
world assets to the accounting register. As with cryptocurrency, blockchain
can facilitate transfer of ownership of assets or transformation of the attributes
of ownership. The Ethereum blockchain, among others, provides this service.
The Ethereum blockchain facilitates the creation of “smart contracts” that
define obligations of each party to the contract and that can be automatically
executed. When the terms of a contract are met, assignment of ownership over
assets can be automatically transferred according to these terms. If information
from outside the blockchain is provided by an oracle, then “smart contracts”
can use this information external to the blockchain to trigger such an event.
For example, smart contracts may dictate the terms of repayment for a loan
intermediated by the blockchain. Or, when a delivery of grain is confirmed by
radio frequency identification (RFID), a financial transaction can be triggered
by this confirmation (Chapter 6). This transaction might consist of transfer of
traditional legal tender or cryptocurrency in exchange for the product deliv-
ered. And just as a transaction can be securely and automatically completed
using blockchain, so too can paperwork required to complete a transaction be

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xii The economics of blockchain and cryptocurrency

securely and automatically completed. The security and law-like characteris-

tics of blockchain facilitate incentive compatibility among transactors who use
the technology (Chapters 7 and 8).
From these examples, it is clear that blockchain reduces transaction costs.
Economists are specialists with the tools to analyze precisely these sorts
of phenomena. Many Nobel winning economists have contributed to our
understanding of the significance of transaction costs and their reduction to
economic development. Ronald Coase identified that the firm exists as a nexus
of contracts that reduce the cost of combining these contracted inputs in
comparison with the cost that would be incurred by accessing them à la carte
through the market. He also famously recognized that transaction costs prevent
externalities from being internalized. Producers whose activities generate costs
for those not involved in their transactions will continue in this manner unless
(1) there is a rule that forces them to internalize the cost or (2) an agreement
is made where the third party, who is negatively impacted, pays the producer
to reduce or eliminate the negative externality. In the first case, an externally
imposed rule that infringes upon status quo arrangements may or may not
be efficient. The second case, however, will generate an efficient outcome if
transaction costs are low enough to allow such an agreement to take place.
Blockchain is an institutional technology (Chapter 1). Recognition of trans-
action costs launched a revolution in the economic analysis of institutions.
Costs that prevent transactions from occurring also inhibit the realization of
value by would-be transactors. A prime source of transaction costs is uncer-
tainty. The more predictable the future, meaning that possible outcomes can
be defined in terms of content and probability of occurrence, the more likely
that plans made in the present will cohere with conditions as they arise in the
future. Presuming the definition and probability of expected future states are
correct, investors can estimate the expected value of their investment port-
folios. The lower the expected cost from uncertainty, the greater the level of
resources that investors will be willing to dedicate toward production. More
investment yields greater levels of production that ultimately translate to
greater prosperity.
Douglass North extended the logic of transaction costs to explain economic
development. Humans are inherently difficult to predict. Institutions act as
scaffolding that guide human decisions, making them more predictable. This
scaffolding is composed of rules that humans use to frame decisions in light of
costs and benefits that are expected from following, violating, or attempting to
transform these rules. Economic development tends to occur in regions where
institutions can transform to the benefit of both the governed and the govern-
ing. Often, an individual will don both hats, being both governed and gov-
ernor, a pattern embodied in institutional checks and balances that constrain
sovereign actors. Whether we consider firms as institutions of governance

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 Introduction xiii

or attribute this role to collections of norms that facilitate the formation and
existence of communities – these are often overlapping existants – the nexus
of institutions that we use to collectively navigate the social world exert tre-
mendous influence on our behaviors. Good institutions promote cooperation.
Bad institutions encourage opportunistic behaviors that make those not party
to mutually beneficial exchanges worse off and even lead otherwise mutually
beneficial relationships to unravel.
The blockchain revolution is a transaction costs revolution. The generation
of shared social infrastructures facilitates coordination of expectations around
a common language set, rules and mechanisms that enforce those rules.
As a new institutional technology, blockchain brings new opportunities to
coordinate resources and, in so doing, new opportunities to generate value
for oneself and others in the market (Chapter 9). New possibilities for govern-
ance, whether public or private, are radically different from forms to which
we are accustomed (Chapter 10). We are only just beginning to see the new
possibilities enabled by development and adoption of blockchain technology.
These possibilities exist and are being formed in the minds of entrepreneurs.
Only when these ideas generate tremendous value for consumers and other
producers will successful entrepreneurs elevate these ideas to the awareness
of the public.
Humans are inventive and sociable. These attributes very regularly interact
in technological development. We naturally create social technology – institu-
tions – to bring order to interactions. This order allows for more efficient plan
formation and execution. Likewise, we often integrate and develop productive
technologies into our plans. New inventions are adopted and further devel-
oped by those who adopt them. With each new technological development,
other possibilities for development of the same and existing technologies are
enabled. The vast space of possibilities makes the path of future technological
development uncertain. It is by the efforts of uncertainty-bearing entrepreneurs
that valuable developments are discovered. As a result of such efforts across
a multitude of generations, the human condition has been improved and oppor-
tunities for every member to contribute have expanded. With regard to block-
chain technology, the following chapters contribute to our understanding of
this most important pattern underlying widespread cooperation across society
that promotes human flourishing.

James Lee Caton - 9781800882348

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 James Lee Caton - 9781800882348
Downloaded from PubFactory at 07/03/2023 09:56:38PM
via free access