Positive and Negative Network Effects in Crypto
Cryptocurrencies are systems of fungible tokens that exist on a blockchain. They use bulletproof encryption algorithms, and the nature of blockchains makes them impossible to forge or replicate. Each transaction is logged in a public ledger, making each user’s balance public, and making the entire system verifiable by a host of third parties. No one organization controls the system, but instead there are usually thousands of independent nodes (12000 for Bitcoin, 3500 for Ethereum), making it nearly impossible to hack. There are thousands of different cryptocurrencies available for investors to purchase.
Like fiat money (e.g. euros or the US dollar), cryptocurrency derives its value from how valuable others perceive it. The difference is, however, that fiat money like the US dollar is backed by the US government, giving it an automatic presence and value for people to hold, as well as stability. Cryptocurrency value is determined by the how the market perceives it, making it a lot more volatile and making things like network effects and hype affect its value a lot.
One cryptocurrency that I want to highlight is Ethereum. Ethereum is one of the oldest blockchains, and its native form of cryptocurrency is subject to strong network effects – both positive and negative. This directly relates to what we learned in class. We saw that for certain products, the more users use a product in an ecosystem, the more likely others are to choose that same one. There is an argument for the network effects of cryptocurrencies being even stronger than the ones for social media. This is because security of the currency is directly related to how many people are using the blockchain that the cryptocurrency is on. The more nodes there are running the protocol, the higher the difficulty of hacking is. A new blockchain with only a few nodes could be possible to hack, whereas Ethereum is functionally impossible to hack. Thus, important transactions wouldn’t be trusted on a new blockchain as opposed to Ethereum, making it harder to gain traction. Another network effect of Ethereum is the developer tools and audience for projects. When decentralized applications are made, there are is lot of technical knowledge needed and work to be done. Ethereum has the most mature developer tool suite, and the largest amount of knowledgeable developers. It also provides a large audience for projects (such as NFTs or games), making it attractive to use for startups.
One interesting thing about Ethereum, though, is that it has a very prominent negative network effect. Since Ethereum is a decentralized protocol, node operators need to have some incentive to mine blocks and keep the network running. This incentive is called gas, and users who want to execute transfers need to pay gas at the market gas price. However, there are a limited amount of miners and a limited maximum transaction throughput for Ethereum, so the more active users there are, the more expensive the gas will be. If transactions are too expensive, users will not initiate them, making the active user count decrease
Overall, I think cryptocurrencies are a great real-world case study of network effects, and in the case of blockchains like Ethereum, they can also highlight some instances of negative network effects. These negative network effects would get us graphs that look like the ones discussed in class, where there is a stable equilibrium somewhere below a market share of 1.0