How To Solve The Chicken And Egg Problem Using Token Network Effect For A Web 3 Product?

Blocksurvey blog author
Written by Priya M
Jan 18, 2023 · 15 mins read
How To Solve The Chicken And Egg Problem Using Token Network Effect For A Web 3 Product?

Introduction

To reach your destination, you first have to begin. This is especially true for business. Instead of directly launching a business, people might need to create a network.

The blockchain and cryptocurrency space has experienced tremendous growth in the past few years. The structure of token networks reveals the underlying trust between different actors involved in the network. By analyzing the network, it is possible to identify the most influential actors in the network and the relationships between them. Such analysis can help to identify potential abuse of power or fraudulent activities. Furthermore, token networks can provide an understanding of the underlying economic incentives of the network, which can be used to guide decisions about the design of new protocols and incentives. Finally, token networks can be used to identify patterns of usage, allowing for better forecasting of future trends in the industry. Joel Monegro’s fat protocols explains how tokens incentivize protocol adoption.

One of the biggest innovations by the Bitcoin system is that it is a new way to develop open networks. This began with the introduction of Bitcoin in 2008 and accelerated with the introduction of Etherum in 2014.

Earlier, in 2016, crypto experts called out that the token adoption will solve the chicken and egg problem for startups, that is, how to build a base of customers/believers in spite of having no product but just an innovative world changing idea?

What are network effects and exactly what thing each effect is attached to?

One should have clarity on this question, in order to properly understand what network effects are at play in the crypto economic context. Thus, to start off, let us list a few of the major ones (see here for primary sources):

1. Security effect

Systems that are more widely adopted derive their consensus from larger consensus groups, making them more difficult to attack.

2. Payment system network effect

Payment systems that are accepted by more merchants are more attractive to consumers, and payment systems used by more consumers are more attractive to merchants.

3. Developer network effect

There are more people interested in writing tools that work with platforms that are widely adopted, and the greater number of these tools will make the platform easier to use.

4. Integration network effect

Third party platforms will be more willing to integrate with a platform that is widely adopted, and the greater number of these tools will make the platform easier to use.

5. Size stability effect

Currencies with larger market cap tend to be more stable, and more established cryptocurrencies are seen as more likely (and therefore by self-fulfilling-prophecy actually are more likely) to remain at nonzero value far into the future.

6. Unit of account network effect

Currencies that are very prominent, and stable, are used as a unit of account for pricing goods and services, and it is cognitively easier to keep track of one's funds in the same unit that prices are measured in.

7. Market depth effect

Larger currencies have higher market depth on exchanges, allowing users to convert larger quantities of funds in and out of that currency without taking a hit on the market price.

8. Market spread effect

Larger currencies have higher liquidity (i.elower spread) on exchanges, allowing users to convert back and forth more efficiently.

9. Intrapersonal single-currency preference effect

Users that already use a currency for one purpose prefer to use it for other purposes both due to lower cognitive costs and because they can maintain a lower total liquid balance among all cryptocurrencies without paying interchange fees.

10. Interpersonal single-currency preference effect

Users prefer to use the same currency that others are using to avoid interchange fees when making ordinary transactions.

11. Marketing network effect

Things that are used by more people are more prominent and thus more likely to be seen by new users. Additionally, users have more knowledge about more prominent systems and thus are less concerned that they might be exploited by unscrupulous parties selling them something harmful that they do not understand.

12. Regulatory legitimacy network effect

Regulators are less likely to attack something if it is prominent because they will get more people angry by doing so.

The first thing that we see is that these network effects are actually rather neatly split up into several categories: blockchain-specific network effects (1), platform-specific network effects (2-4), currency-specific network effects (5-10), and general network effects (11-12), which are to a large extent public goods across the entire cryptocurrency industry.

  • A currency is something which is used as a medium of exchange or store of value; for example, dollars, BTC and DOGE.
  • A platform is a set of interoperating tools and infrastructure that can be used to perform certain tasks; for currencies, the basic kind of platform is the collection of a payment network and the tools needed to send and receive transactions in that network, but other kinds of platforms may also emerge.
  • A blockchain is a consensus-driven distributed database that modifies itself based on the content of valid transactions according to a set of specified rules; for example, the Bitcoin blockchain, the Litecoin blockchain, etc.

Network effects are traditionally linked to high market concentration, early-mover advantages, and entry barriers, and in the market, they have also been used as a valuation tool.

How does network effect occur?

Network effects occur where the value of the network V grows supra-proportionately to the number of users n that participate in the network. Reverse network effects occur where the value V drops supra-proportionately to the number of users n that leave the network. Unless there is a reason to distinguish between positive and reverse network effects, we collectively refer to them as network effects. Therefore, we define network effects to occur in cryptocurrencies when a positive value change ∆V > 0 is larger than a positive user base change ∆u > 0, or when a negative value change ∆V < 0 is smaller than a negative user base change ∆u < 0. Notice that we do not consider that network effects apply when value and user base move in different directions, e.g. when the value increases while the user base decreases, regardless of which increases or decreases more

In simple terms, a network effect could occur if the value of a cryptocurrency increases as more users join the network, or if the value drops as users leave the network. In order for such an effect to be considered a network effect, the increase or decrease in the value must be larger than the increase or decrease in the user base. Network effects can also be caused by other factors such as the number of transactions taking place on the network, the number of applications built on the network, or even the amount of media coverage the cryptocurrency receives.

Do you wonder if this network effect is a new concept in Web3?

The answer is a Big NO.

Network effect can be correlated in everyday real-world applications such as Amazon, Twitter, Uber in Multi Sided platform (MSP).

Ok, then what is the origin of the network effect?

The theory originally emerged from Metcalfe's Law, one of the foundational principles of network economics. It suggests that as the network grows, its value grows much faster than its user base.i.e. the value of a network is proportional to the square of its users. ( V ∝ u^2). Many analysis were conducted to confirm whether cryptoassets comply with network effects, and in particular if it follows Meltcafe’s law.

Having understood the concept of network effect , let’s see how it affects a platform economy?

Size of a platform determines the value of MSP, as the utility of the platform depends on the number of other participants on the platform. Once the platform reaches a critical mass of users, these network effects take effect and accelerate platform growth that pave the way for the growth of companies.

In the initial stages, the platform users lack incentive to join the platform because of low platform utility. This is more prominent in the case of two sided markets, where buyers have little incentive to join the platform when there are less number of sellers and vice versa also holds good. Incentivising the early adopters is the need of the hour, in order to overcome this issue.

Before the launch of the platform , blockchain based entities issue tokens at a certain price and use it as a bootstrap to start an ecosystem. It limits the supply of tokens which inturn will increase the value. This acts as a financial incentive and investment vehicle for early adopters as the token value presumably increases.

Potential users follow the incentive to become an early part of the platform and benefit from  platform growth. This potential investment gain is associated with a positive effect on platform growth , the so-called token network effects. Every participant of the platform has an incentive to increase platform growth and gain from the increase in value of token. This leads to faster platform growth and even to bigger platforms.  These positive feedback loops can lead to rapid scaling once the flywheel begins to turn.

Digital platforms led to multiple settings of platform governance and there is no single owner of the core anymore. Web 2 companies spend a lot of money for marketing and advertising to develop their platform, whereas in blockchain there is no need to spend money on marketing as users are genuine owners, love what they do and love telling other people about it.

MSP providers like Amazon mediate product interactions between different participants in the platform. If there are several platforms competing for the same product , users can participate in multiple platforms and obtain the maximum network benefit. For instance, a customer can hold both Master and VISA credit cards, the merchant will obviously accept either one among this.

Let’s dive to know the role of network effect for a Web3 Project?

Web 3 projects introduce rewards programs to entice and retain customers. The key is through initial distribution of tokens through airdrop campaign, waiver of transaction fee in the initial stages, monetary rewards for good behaviour in the community, reward for continued participation.

Combining these ways of tokens, privileges, and rewards allow an application to offer enough value to early users to overcome the chicken and egg problem and reach the point where positive network effects kick in and drive future growth. When the network grows, the token adds value to the platform and accelerates network effect. Financial utility target users who are not among a product's early adopter cohort. They churn faster when the incentive is reduced.

Take an example of Uber: In a new city the wait time was long and drivers were idle for long periods in the initial days. But as the rider network eventually increased, drivers earnings improved and drivers came on board the wait times went down.

I must at this time thank the authors of the research paper “The token’s secret: the two-faced financial incentive of the token economy”  Benedict J. Drasch & Gilbert Fridgen & Tobias Manner-Romberg & Fenja M. Nolting & Sven Radszuwill that discuss about Blockchain- enabled utility tokens to overcome the “chicken and egg problem”

What is a Token Network effect ?

In an essay “Crypto Tokens: A Breakthrough In Open Network Design” Chris Dixon described how tokenization can actually increase the speed with which network effects take hold:

“Token networks…align network participants to work together toward a common goal — the growth of the network and the appreciation of the token…Moreover, well-designed token networks include an efficient mechanism to incentivize network participants to overcome the bootstrap problem that bedevils traditional network development.”

"Token networks align network participants to work together toward a common goal the growth of the network and the appreciation of the token.” — 

Tokens give early participants an incentive to join the network before the unit economics make sense. Bitcoin was initially worthless. When Bitcoin got a price on May 22, 2010 it motivated developers, miners, investors, entrepreneurs, criminals, exchanges, hardware manufacturers, and many others to contribute to Bitcoin’s success.

Through DAO, tokens now allow projects to work with millions of dealers, thousands of developers, and hundreds of entrepreneurs and build a strong network. Something that was previously only saved for big companies with billions of dollars can now be decentralized.

How does a financial utility happen in the first phase to enable application utility to kick off?

The initial distribution of on-chain tokens can take place in several ways as below:

  1. The issuing entity can spread the tokens for free to owners of specific cryptocurrencies as part of its marketing strategy in a process called “airdrop”.
  1. Second, developers of a blockchain project can earn tokens as a giveaway.
  1. The issuing entity can distribute tokens in Initial Coin Offerings (ICOs) in exchange for a payment of fiat currency or cryptocurrency. Usually, the sale process serves to finance an underlying blockchain project .ICOs became a popular alternative to traditional financing methods for organizations

Early platform adopters can participate in the financial success of a platform. Blockchain technology may enable entrepreneurs to raise funds directly, democratize access to financial capital, give investors the opportunity to invest in early-stage projects, restructure fundraising and investing, and facilitate user and developer communities.

Before the platform is accessible to users, the platform building entity issues tokens with the aid of smart contracts (e.g., during an ICO). These tokens are sold in exchange for fiat currency. The proceeds are used to finance the further development of the platform. In case of deflationary token supply, the number of tokens issued will not be changed at any point in time. These tokens can be traded on the secondary market. No transactional cost is associated and no interest rate.

Demand and supply drive the value of the token. If potential users have confidence in the platform and token, they buy the token in order to be part of the platform and earn a financial profit with the appreciation in value of the token. The token subscription at the initial date on ICO by investors also drives the value as it  is one of the critical factors of assessment for the potential buyers. In the initial stage when the platform is yet to be launched it may not be accessible for the buyers.In the development phase , no trade takes place on the platform. If the potential buyer believes that value platform is useful in future then he may buy the token in expectation of price appreciation.

After the platform launch use the token to transfer money, sell or hold the token.

Why tokens are critical for a Web 3 product?

Tokens are a breakthrough in open network design that enable:

  1. The creation of open, decentralized networks that combine the best architectural properties of open and proprietary networks, and
  2. New ways to incentivize open network participants, including users, developers, investors, and service providers.

For instance, people buy video game consoles only if there are games they can play. And game designers make games for a console only if there are enough people who own it. The proverbial chicken and egg problem. How do one solve this impasse?

Today, Airbnb is a huge company with a $35B valuation and 11k employees all around the globe. But in 2008 they were just starting with an idea of air beds and breakfasts for strangers. And like all marketplaces, they faced The Chicken and Egg problem:

  • landlords are not interested in adding their apartments to the service without visitors.
  • tenants have nothing to rent at the platform.

At a high level, the only way to address this problem is to link token incentives to network utility, i.e. ensure that users can only receive token incentives if they add value to the network. In other words, rewards need to be restricted to specific, desirable actions, not just adoption.

The concept of a network effect is pretty simple: the network becomes more valuable as more people use it. The more people take part in a system, the higher value it becomes.

Let's look at an example of token network effect from one of the existing project

In the early days of Dash, the ecosystem still needed infrastructure: mobile wallets, exchange adoption, etc to spur adoption. Dash decided to redirect a portion of the mining rewards to a fund. Users could then propose projects to the fund and then token holders in the masternode network would vote on them. Dash created a VC fund out of thin air and called it a decentralized governance by blockchain. It’s now starting to be adopted by other projects and protocols. Today, that fund is now over $750K per month supporting projects that build out the Dash ecosystem.

Chart showing increase in application utility as the network grows and decrease in financial utility i.e. reward distribution as below:

Key Takeaway

“Financial utility” refers to the incentives which get emitted. It is the supply that gets declined over the period of time. Incentives facilitate the growth of application.

“Application utility” is the activity in the network. In the initial phase, when the network is in the bootstrap stage the utility will be lesser.

If there are more consumers on the network, the more valuable the network is to the producers. When the utility increases then the token value also increases. Current investors and future investors drive the value of a token. Current investors will hold it considering the viability of the product which leads to demand for the token in the market and future investors would want to buy the token which will drive the price. This way Token Network Effect makes the network stronger and rewarding for all stakeholders and will solve the chicken and egg problem.

Further Reading

https://cdixon.org/2017/05/27/crypto-tokens-a-breakthrough-in-open-network-design

https://www.freecodecamp.org/news/token-network-effects-a-new-business-model-for-a-decentralized-web-6cde8b4e862/

Buterin, V. (2017). On Medium-of-Exchange Token Valuations. Retrieved

from https://vitalik.ca/general/2017/10/17/moe.html

Brousseau, E., & Penard, T. (2007). The economics of digital business

models: A framework for analyzing the economics of platforms.

Review of Network Economics, 6(2), 81–114.

https://doi.org/10.2202/1446-9022.1112.

Research paper on The token’s secret: the two-faced financial incentive of the token economy. Benedict J. Drasch1,4 & Gilbert Fridgen2 & Tobias Manner-Romberg3 & Fenja M. Nolting3 & Sven Radszuwill1,4

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blog author description

Priya M

Priya is the CFO of BlockSurvey. A year ago she made a career change and left the traditional finance world as a Chartered Accountant to work full time at BlockSurvey. She is specializing in “Tokenomics” in Web 3 space.

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