Exploration of the Use of Basic Economic Theories in Blockchain Economic Model Design

Authors’ Note

The design of an economic model in a blockchain system plays a crucial role in the success of the project. Many project leaders are keen to understand how to design these models. In this process, identifying the supporting theories and methodologies for the economic model is often a primary concern for designers. Having explored the blockchain field for many years and read numerous whitepapers on blockchain projects, I have conducted in-depth analyses and comparisons of some projects’ economic models. Additionally, our team is developing a Web 3.0 project, which also involves the design of an economic model, prompting me to compile an article summarizing the underlying theories of blockchain economic model design.

The design of an economic model in a project is closely related to the protocol design (or application design, hereinafter referred to as protocol). The economic model serves the protocol, with the protocol being the primary carrier of the economic model. This requires those designing the economic model to know both of these related fields or for the design team members to possess knowledge in both areas. My background in computer science and years of professional experience, coupled with systematic economic studies at Renmin University, led to the publication of my book “Blockchain Economic Model” in 2022. It covers basic and introductory concepts without detailed analysis, which inspired me to write an article on the theoretical support for blockchain economic model design.

While writing, I had numerous concerns. Economic theories are broad and profound, with many contentious issues among economists. Blockchain projects also have their unique characteristics. How would the quality of such an article be? Could there be significant errors or misleading information? Regardless of right or wrong, I first organized an outline of thoughts and contexts, providing a target for criticism. In the article, I tried to use basic and universally accepted economic theories and methodologies, illustrating with easily understandable scenarios. I also hoped that more capable individuals could contribute and refine it.

Note Explanation: For ease of reading, I have summarized the main content of several economic disciplines. The article utilizes knowledge related to macroeconomics, microeconomics, and monetary banking, which I summarized from my previous study notes and textbooks, with a brief overview provided by ChatGPT3.5, and there should be no significant ambiguity in the main content. My exposure to game theory is limited to scattered content and a few non-textbook books, summarized and generalized with ChatGPT3.5.

1. Considerations in Economic Model and Protocol Design in Blockchain Projects

In our previous discussions, we established that the design of an economic model in a blockchain project is closely intertwined with the project’s protocol design. The economic model serves the protocol, and the protocol is the main carrier of the economic model. In Web3 projects, these two aspects support and enhance each other. Fundamentally, it’s also essential that the design of the protocol or application delves deeply into human nature.

1.1 Considerations in Protocol or Application Design

The design of a protocol or application is often considered from the perspective of human nature or more foundational principles. Whether it’s a game or a utility application, it’s crucial to consider the product’s selection and positioning. Why would users want to use it, participate in it, and share it with others? At its core, these needs can generally be traced back to human nature or desires.

We can explain this by referring to two well-known theories: Maslow’s Hierarchy of Needs and the traditional concept of the ‘Seven Emotions and Six Desires.’

(1) Maslow’s Hierarchy of Needs

From Maslow’s hierarchy of needs, we can design tokens to satisfy different levels of needs.

• For physiological and safety needs, tokens with financial attributes are more appropriate. These tokens encourage contribution and focus on generating external value, making fungible tokens (FTs) more suitable.
• To satisfy the needs for love and belonging, tokens designed with the concept of memes and cultural values encourage ownership and focus on internal cultural value, making non-fungible tokens (NFTs) more suitable.
• What about the need for esteem and self-actualization? Should we use a proof token design like Soulbound Tokens (SBTs)? Encouraging proof and showing off, focusing on the expression of value to a group? This doesn’t seem entirely accurate and perhaps pertains to a higher level of needs.

(2) The Tree of Desires

The general interpretation of the seven emotions and six desires are as follows:

• Seven emotions: The seven emotions of people, generally refer to joy, anger, sorrow, fear, love, disgust, and desire.
• Six desires: In Buddhism, these refer to the desires for physical appearance, posture, speech and voice, tactile sensations, and human forms, broadly indicating various human desires.

The Tree of Desires is more suitable for product designers to analyze. The desires are as follows:

• Survival desire: Includes eating, drinking, excreting, sleeping, self-protection, avoiding risks, and evading guilt.
• Knowledge desire: People always enjoy acquiring unknown information of interest.
• Performance desire: To gain recognition, participation, and a sense of existence by showcasing oneself.
• Comfort desire: Seeking ease, freedom, comfort, leisure, and pleasure.
• Social desire: Longing to connect with others to gain a sense of identity, recognition, and belonging.
• Justice desire: Seeking psychological balance and fairness through rewards, curses, revenge, and law.
• Achievement desire: Pursuing wealth, fame, and status, longing for success, respect, and acknowledgment.
• Power desire: Longing for strength, leadership, dominance, and influence.
• Health and beauty desire: Wishing for health, beauty, vitality, charm, and eternal youth.
• Sexual desire: Driven by the instinct to reproduce, pursuing sexual attraction and fulfillment.
• Emotional desire: Longing for love, familial affection, and friendship.

StepN’s product design emphasizes the concept of the desire tree many times. Every product detail is designed from the perspective of the desire tree and what problems the user solves. Friends who need to know more can check out their project’s white paper and some of Jerry’s interviews.

The design of protocols or applications is an area that requires in-depth thinking. Here we only mention two dimensions of thinking, human nature or desire, and will not discuss them in depth. A16z has also written some articles related to economic model design and protocol design, which can be consulted online.

1.2 Considerations in Economic Model Design

As blockchain technology matures, an increasing number of related projects are emerging, both native blockchain projects and subsequent Web3 projects (based on blockchain infrastructure), all involving the design of economic models. The design of economic models is closely related to protocol design.

Generally, when designing the economic model for a blockchain project, the following factors need to be considered:

• Total Token Supply Design: The total supply of tokens should meet the development needs of the protocol, and the distribution proportions among various participants must be determined. Generally, there are fixed and non-fixed total supplies.

• Token Issuance: Decide on the method of token issuance and the distribution mechanism for various participants. This includes initial issuance and issuance during project development. Token issuance during project development is closely related to liquidity management.

• Incentive Mechanism Design: Design incentive mechanisms to actively engage participants and promote the prosperity of the protocol. This is more reflected at the protocol level in terms of application functions and rights, such as the application attributes of tokens, payment, and value storage; and the rights attributes of tokens, like voting rights and proposals in DAO organizations. The design of these incentive mechanisms must ensure that the development of the project aligns with the community’s wishes. Incentive mechanisms include positive incentives (rewards) and negative incentives (penalties), such as rewards in Ethereum staking for positive incentives and slashing (penalty) for negative incentives in the event of problems. A good incentive design should be able to utilize both positive and negative incentives.

• Liquidity Management: Ensure that the total liquidity of tokens matches the development of the protocol. Ensure supply-demand balance within the protocol, this involves liquidity management methods and inflation and deflation mechanisms. This includes internal issues, as well as external issues like market size, supply and demand within the application, user growth, and competitors’ strategies.

• Risk Management: A crucial aspect of token design is risk management. On one hand, it primarily focuses on compliance, ensuring the development of the protocol adheres to local laws and regulations of users. On the other hand, it includes considering systemic risks of the project, such as severe theft incidents, and loss of control in fund management. Additionally, corresponding protocol risks such as the sustainability of the project, organizational management methods, and other internal issues must be considered.

As stated above, if we are to consider these issues, what theoretical frameworks should we generally follow? Here, we mainly examine the design of blockchain’s economic model from the perspective of economics. Summing up, we mainly start from several key areas of economics: macroeconomics, microeconomics, monetary economics, and game theory. We look at the principles of design from these aspects, as well as the interaction between the economic model and the protocol in the design process.

1.3 A perspective on the relationship between protocols and economic models

The external economic model of traditional protocols or applications usually presents traffic thinking, that is, finding ways to introduce traffic, promote the prosperity of applications, and then consider commercial monetization. Web3 applications with economic models generally present value thinking because of the existence of Token and the specific growth of Tokenomics. Between traffic thinking and value thinking, a kind of thinking that achieves a balance or mutual influence is market-making thinking, which not only promotes the value growth of Tokens through the prosperity of applications but also promotes the prosperity of applications through the value of Token, that is, market-making thinking…

To sum it up in one sentence: Protocol or application is traffic thinking, Token is value thinking, and between the two is market-making thinking.

Translation:

2. Dimensions of Thought in Economic Model Design

We analyze the dimensions of thought in designing economic models from several theoretical support systems in economics. For each theoretical system, we first summarize its main research content or methodology and then list the issues that need to be considered in the design of economic models and protocols in a project.

2.1. The Role of Macroeconomics in Economic Model Design

Macroeconomics is the discipline that studies the operation of the overall economy and macroeconomic phenomena. Its main research contents include the following aspects:

Macroeconomic Policy: Mainly studies the content and related impacts of fiscal and monetary policies.

Money and Finance: Macroeconomics investigates the functions of money, money supply, and the impact of monetary policy on the economy. It also examines the effects of financial markets and financial institutions on economic operations.

Government Policy and Economic Cycles: Macroeconomics studies government economic policies, including fiscal and monetary policies, as well as their effects on economic cycles, such as prosperity and recession.

Aggregate Demand and Supply: The scope of aggregate demand and supply, and the impact of considering both demand and supply on the economy.

Economic Growth: Macroeconomics focuses on the long-term growth trend of total economic output and the factors driving economic growth, such as technological progress, capital accumulation, and labor force growth.

Inflation and Price Levels, Employment Situation: Macroeconomics studies changes in price levels and the causes and impacts of inflation. Key research areas include the effects of money supply, demand, and costs on price levels. Unemployment and Employment: Macroeconomics focuses on employment and unemployment in the economy, studying the changes and causes of unemployment rates, and the impact of government policies on employment.

International Trade and International Economics: Macroeconomics studies international trade and international economic relations, including the causes and impacts of international trade, balance of payments, etc. Generally considered a separate field of international economics.

Economic Imbalances and Fluctuations: Macroeconomics studies economic imbalances, such as economic fluctuations, crises, and structural adjustments, analyzing their causes and impacts.

The main points of disagreement in macroeconomics include Monetarism, Neoclassical Macroeconomics, and Keynesian Economics.

In summary, the main research content of macroeconomics is to focus on the operation of the overall economy and macroeconomic phenomena, studying issues such as economic growth, inflation, unemployment, money and finance, international trade, government policy, etc., from a macro perspective.

Note: The economic terms here can simply correspond with the things in the protocol as follows: aggregate demand and supply in the protocol are the same as in the economy; economic growth corresponds to the number of protocol users; employment and unemployment can be likened to the extent of participation in the protocol; inflation and price levels can be compared to the extent and price of Token in the application of the protocol; international economics can be likened to other projects outside the protocol. Such comparisons make it easier to understand the relationship between different objects in these economic principles and the things in the project.

For the research content of macroeconomics and the work content of protocol design, we summarize a preliminary design content inspection table:

Table 1: Analysis of Macroeconomic Theory in Blockchain Projects**

Key Considerations with Potential Controversy or Expansion:

• Appropriate Total Supply:

  The appropriate total supply is closely linked to the market size envisioned by the project developers. It can be designed on a grand scale, such as an application that meets the needs of global users, or it could target the needs of users in a specific region. Different considerations will lead to different decisions regarding the total supply. Typically, blockchain or Web3 projects are aimed at a global audience. It is recommended to match the total supply design with the team’s capabilities, avoiding an excessively large or small design. An oversized supply means a lower base price for the tokens in the early stage, which is not conducive to attracting users and the development of early applications. Conversely, a too-small supply may lead to the demand for additional issuance in the later stages of application development. In blockchain projects, additional issuance can easily become a controversial issue.

• Design of Multiple Tokens and Various Types of Tokens (FT, NFT):

  Here, we consider a relatively simple scenario where the project involves only one type of token, typically suitable for public blockchain projects. For application-level designs, many scenarios involve the design of multiple tokens, as well as the use of NFTs to meet different scenario requirements. The subdivision will depend on the specifics of the project. This is similar to our real-world economy. For example, a central bank deals only with the concept of money (like M0, M1, M2, etc.), while a company has cash, fixed assets, and some intellectual assets, which are generally converted into a monetary total value when calculating total assets. The method of accounting for the total economic volume and the conversion between different forms should be determined based on the specific scenarios.

2.2 The Role of Microeconomics in Economic Model Design

The primary subjects of the microeconomic study include:

• Demand and Supply (Supply-demand relationship and market mechanism): This involves the study of the relationship between supply and demand in markets, as well as the mechanism of price formation. It primarily examines how individual decision-making behaviors and transactions in the market affect changes in price and quantity.

• Utility Theory (Individual decision-making behavior): This area explores how individuals make decisions when faced with different options, including consumer purchasing decisions, production decisions by firms, and labor supply decisions.

• Production and Cost: This field examines the production processes of firms, including the combination of production factors, production technology, and efficiency. It also studies the cost structure and cost control of businesses.

• Market Theory (Market structure and competition): This involves the study of different market structures in the market, such as perfect competition, monopoly, oligopoly, etc., and the behavior and market efficiency of firms under these structures. The main focus here is on the “invisible hand.”

• Government Role (Market failure and government intervention): This studies situations of market failure, such as externalities, public goods, information asymmetry, and the intervention measures and policies of the government in these issues. The main focus is on the “visible hand.”

• Government Role (Income distribution and wealth gap): This field investigates the methods of income distribution, the formation and factors influencing the wealth gap, and explores how economic policies can reduce inequality. The main focus is again on the “visible hand.”

• Factors of Production Market: Mainly studies topics related to producers, including profits of firms, labor supply, interest, and other influencing and determining factors, as well as the specific conditions under different market theories.

• General Equilibrium Theory and Welfare Economics: This studies general equilibrium theory and the impact of economic activities on social welfare, evaluates the effectiveness of economic policies and discusses how to achieve maximized social welfare.

These are the main contents of the microeconomic study. Through the study of individual behavior and market mechanisms, microeconomics provides theories and methods for understanding and solving practical economic problems.

Note: The economic terms here can be simply correlated with things in protocols as follows: Market demand and supply correspond to demand and supply in specific application scenarios of the protocol; Utility theory relates to utility issues in the protocol; Market theory in economic models and protocol design is identical to reality; Government theory generally does not exist in blockchain projects, but foundations or DAO organizations partly assume related responsibilities; Factors of production market can be compared to functions in protocols based on FTs, NFTs; Equilibrium theory and welfare economics can be understood as similar issues arising in the protocol ecosystem for overall development, such as rewards for product usage, Grant rewards for supporting ecosystem development, airdrop rewards for completing certain tasks, etc.

For the study of microeconomics and the work content of protocol design, we have summarized a preliminary design content examination table:

Table 2: Analysis of Microeconomic Theory Content**

The content designed in microeconomics generally involves specific scenarios. There are few controversial or extended issues, and they can usually be resolved using the theories of microeconomics based on specific events. Many of these scenarios involve the use of game theory, which is described in Section 2.4. The role of microeconomics and game theory can be roughly understood as follows: the results produced by protocols are processed and analyzed using microeconomic theory, while the rules that control the production of results are designed using game theory.

2.3 Tasks of Monetary and Banking Studies in Economic Model Design**

The main contents of monetary and banking studies include the following aspects:

• Monetary Theory: Studies the essence of money, the origin and development of money, the functions of money, and theoretical issues related to the supply and demand of money.

• Interest and Exchange Rates: Studies the theory and role of interest rates for the same currency, and the theory and role of exchange rates for different currencies.

• Monetary Policy: Researches the formulation and implementation of monetary policy, including tools of monetary policy, choice of monetary policy objectives, and the effectiveness of policy implementation. Studies the objectives, tools, and mechanisms of monetary policy, as well as its coordination with fiscal policy.

• Financial Intermediary System: Mainly studies the composition of the financial intermediary system and the structure of the international financial system. This includes research on the organizational structure, operational models, risk management, and capital adequacy of banks.

• Financial Markets: Focuses on the system, functions, and relevant theories of financial markets. Researches the impact of financial innovation on economic development, including innovative products in financial markets and the application of financial technology.

• Financial Regulation: Studies the principles and theories of financial regulation, including the establishment of regulatory bodies, formulation and implementation of regulatory policies, and the use of regulatory tools. Also researches the stability and risk management of the financial system, including risk assessment in the banking sector and early warning and response to financial crises.

• International Monetary System: Studies the international influence of influential currencies and regulations related to the international monetary system, as well as theories of internal and external balance.

The above are the main contents of monetary and banking studies. Different researchers and scholars may have different research focuses and contents.

For the study content of monetary and banking and the work content of protocol design, we summarize a preliminary design content inspection table:

Table 3: Monetary and Banking Theory Analysis Content**

Monetary and banking theory plays a crucial role, encompassing both macroeconomic and microeconomic perspectives. From a macro perspective, it involves monetary policy, mainly focusing on using monetary policy to manage liquidity. On the micro level, it deals with the use of monetary tools for specific liquidity management. This type of liquidity management includes internal tools and methods, as well as external financial intermediaries and markets.

2.4 The Role of Game Theory in Economic Model Design**

Game theory is a discipline that studies the interaction between decision-makers, and it mainly includes the following key concepts:

1. Definition and Classification of Games: This involves the elements of a game such as participants, strategies, payoffs, and classifications of games into zero-sum and non-zero-sum games.

1. Nash Equilibrium: Nash Equilibrium refers to a state in a game where, with each participant choosing their strategy, there is no incentive to change their strategy. Game theory studies the existence, calculation methods, and properties of Nash Equilibrium.

1. Minimization and Maximization: Game theory explores how to maximize or minimize one’s benefits, including the minimization and maximization of pure strategies and mixed strategies.

2. Solutions to Games: This involves the concept and methods of solving games, including pure strategy equilibrium, mixed strategy equilibrium, partial cooperation equilibrium, and full cooperation equilibrium.

3. Cooperative Games: Cooperative game theory studies the issue of participants maximizing their benefits through cooperation, including the core, stable set, and properties of solutions in cooperative games.

1. Dynamic Games: This examines the evolution of games over time, including sequential games, repeated games, and evolutionary games.

2. Equilibrium Selection: Game theory investigates how participants choose equilibriums, including rational choice, fair choice, evolutionary choice, etc.

Game theory has widespread applications in economics, political science, sociology, biology, etc., such as in market competition, auctions, cooperation and conflict, social norms, etc. These applications are reflected in the design of protocols, considering the interests of multiple parties to create rules that are more conducive to the development of the project. For the relationship between game theory and microeconomics, refer to Section 2.2.

In this area of design, the focus is more on analyzing game-theoretical scenarios within protocols and applying game-theory principles to achieve desired outcomes and balance. Although game theory includes some rational assumptions, in design, it is essential to consider complete rationality, as there are many savvy participants or experts involved who can exhaust all scenarios. Once a theoretical loophole that can be exploited is identified, it can lead to significant disruption.

The content in the following table is brief, as it involves separating all game-theoretical scenarios within a protocol and then determining if game-theory principles can solve these issues. Therefore, the table lists several methods of game theory, followed by corresponding specific business scenarios. It would be easier to break down with specific cases. Hence, an analysis of an airdrop case is used later:

Table 4 Game Theory Analysis Content

3. Case Study - A Web3 Email Airdrop Design

Designing a complete economic model is very time-consuming. It requires the designer to be familiar with the business scenario and to consider the underlying economic theories comprehensively and extensively.

As Web3 matures in various fields, the economic model design for projects like GameFi and SocialFi becomes more complex. For instance, StepN’s whitepaper not only covers the macro design of product and economic models but also includes many micro-design details, extensively utilizing game theory content (including actions in community operations such as manually deleting bot accounts and inactive accounts).

Due to the vastness of this topic and to provide a basic understanding, I have chosen a simple scenario for analysis - a project’s airdrop. Although it is a minor scenario and does not cover all the principles and methods mentioned earlier, it reflects the approach to applying these theories.

We use our Web3 email project as a case study, which provides a basic scenario consensus. Others can also practice using cases they are familiar with. In this scenario, we analyze the specific task of airdrops, using perspectives from macroeconomics, microeconomics, monetary banking, and game theory as previously explained, to observe the process of economic model and protocol design.

The table below decomposes all the scenarios in the business where game theory is present, and the basic information is organized as follows:

Table 5 Effective Action Decomposition

3.1 Macroeconomic Considerations

Based on the macroeconomic theory analysis content in Table 1, we need to know some information:

• How many total economic models are designed?

• What percentage of the total economic models is airdrops? (This will involve liquidity management later)

• What is the total KPI target for the airdrop to achieve? (It is the total demand part in the ecological construction)

• What measures are there for liquidity management of the airdropped amount?

• What are the external influences and risks?

Regarding the above questions:

• Based on the market size, we have designed the total amount of Tokens to be 100 billion;

• The airdrop proportion uses a part of the early customer contributions, which is a maximum of 10%. This includes some NFT products (ordinary NFTs, SBT-type NFTs) to record some non-homogenized contributions.

• The KPI target for the airdrop is to attract a certain number of early customers and generate paid actions. The number is not yet determined, and the proportion of payment is 1/5 to 1/2 of the total airdrop amount.

• The liquidity management for the airdropped amount uses charged funds plus a portion of investor funds, and the airdropped Tokens have a withdrawal period. There will be direct repurchases and promotional drives on both sides (i.e., market-making theory).

• External influences and risks: Legal and regulatory risks, program quality risks, etc.

3.2. Microeconomic Consideration

1. According to the content analysis of microeconomic theory in Table 2, we need to know some information:
2. • Who are the specific participants?
3. • What are each participant’s expectations of the airdrop?
4. • What constitutes effective actions?
5. • What are the generative elements in the airdrop?
6. • How is value captured in the airdrop?
7. • What are the external influences and risks?
8. • What are the start and end times?

Based on the above questions:

1. • The participants include B2C customers, B2B application providers, and project parties. B2C customers can be further divided into freebie hunters and genuine users.
2. • Expectations of B2C customers from the airdrop: earning tokens and enjoying real services; B2B customers aim to earn tokens, sell products or services, and make profits.
3. • The breakdown of effective actions is shown in Table 5.
4. • The airdrop includes the project’s tokens, as well as some NFTs and SBTs, which indicate other characteristics of the participants.
5. • Value capture: installation and usage of the client-side, acquisition of real users, relationship building, validation of detailed products, validation of business models, etc.
6. • Risks include project development risks, external regulatory risks, etc.
7. • The start time is August 2023 and the end time is June 30, 2024. The rules will be announced first, followed by gradually cultivating users and refining the product. The airdropped tokens will have a lock-in period and can be redeemed in advance at a discount, but the general principle is to release the airdropped tokens to users during the early or upward phase of the next bull market.

3.3 Game Theory Considerations

Based on Table 4’s Game Theory Theoretical Analysis and Table 5’s Effective Action Decomposition, we summarize as follows:

Each subdivided action incorporates game theory design and considerations. Moreover, the design of a game scenario is completed using a combination of actions. For example, the qualification for participating in an airdrop, using the whitelist feature of a task platform, and the combination of client installation and payment actions, are all designed to strategize against bonus hunters, attract genuine users, and control the cost of acquiring real users.

4. Conclusion

The above theoretical and case analyses are attempts at exploration. Currently, blockchain or Web3 projects are still in their early stages, and often, a single factor can determine the success or failure of a project, making other design factors seem less important. A noticeable phenomenon is that as long as the project is doing well, the overall value of the Token tends to increase. Many adjustments and rule settings do not affect its development. Ethereum is one such case, which has undergone many economic model adjustments during its development, including a major consensus mechanism change from PoW to PoS.

The early extreme price volatility of various cryptocurrencies also reflects significant uncertainties. However, such theoretical analysis and practical application are very necessary. For instance, if the Fcoin exchange had analyzed its business design based on these economic principles, it would have identified the irrational aspects of its design, such as insufficient application of game theory and macroeconomics (lack of a mid-to-long-term liquidity management mechanism). A thorough comparison could reveal many more issues.

Overall, compared to blockchain native projects before 2021, many current projects are increasingly demonstrating substantive work quality and focusing more on mid-to-long-term considerations. Therefore, the design of economic models in these projects is becoming increasingly important and plays a crucial role in the success or failure of the projects.

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