NFTs Go to the Superbowl: The Economics of NFTs

Superbowl commercials have long been a barometer of what’s hot in the economy. Tomorrow as the Los Angeles Rams host the Cincinnati Bengals before 120 million some viewers, ads from Crypto.com, FTX and others will show that Crypto and NFTs have finally arrived. While Bitcoin has seesawed this year, the rocket ship growth of NFTs, or non fungible tokens, tokens that allow people to own unique digital goods, has driven a frenzy of enthusiasm showcased by the auction by Christy’s last year of an artwork by Mike Winkelmann (aka Beeple) for a cool $69 million. Earlier today Cryptopunk NFT #5822 sold on Opensea for $23 million. Web 3.0 is here!

Despite the hoopla, however, skepticism about NFTs remains. While marquee institutions from Sotheby’s and Christie’s to Andreessen Horowitz and Union Square Ventures hail the new technology, skeptics from Warren Buffet to Bill Gates are not convinced. Are the huge values accruing to NFTs real or a bubble? Could this year’s Cryptobowl as some have dubbed it echo the Dotcombowl of 2000 that debuted ads from Pets.com and others just months before sector collapsed. And while Web 3.0 is the banner of crypto proponents,, Web 2.0 giants, such as Meta, the company formerly known as Facebook, are betting on a centralized walled garden version of the metaverse hosted on its servers with no need for a public blockchain.

NFT skeptics make several arguments. They point to the timing of the NFT explosion during Covid when other asset classes from baseball cards to collectible cars also boomed thanks to easy money from central banks during lockdowns. The rush of celebrities such as Steph Curry and Snoop Dogg into NFTs ahead of hard-nosed financial firms raises flags for others. Lastly, while NFTs can technically be used to represent real goods — Propy sold the first house on the blockchain just last week — for the most part they tokenize goods that live in cyberspace.

Do NFTs deserve the hype or are they just the latest version of tulip bulbs or South Sea shares? While corrections are inevitable, I believe that NFTs are real and here to stay. Here is the economic case for NFTs.

In the 19th Century, a problem known as the Diamond Water Paradox perplexed economists. First raised by Adam Smith, it asked why water — that is essential to life is so cheap, while diamonds — largely superfluous — are dear. The common explanation — that diamonds require more labor to produce was unsatisfactory to many economists since even in a desert, water is far less expensive as diamonds. The solution elegantly expressed by the great English economist Alfred Marshall based on work by Walras in France, Jevons, Menger and others, lay in the recognition known as the Marginal Revolution that prices are set — not by overall need for a good but rather at the margin — by the last transaction. While humans need water and the first drink is essential to life, each subsequent gulp grows less valuable until, thirst quenched, the marginal value of a further gulp is zero. With the incremental cost of more water also low, the market clears at close to zero.

In contrast, additional diamonds do not sate demand so that the last diamond is just as valuable as the first. But the cost of mining a diamond, is always high. The result, Marshall showed: higher prices.

In his famous supply and demand curve, the Marshallian cross now taught in every economics class, Marshall showed how supply and demand curves cross at the point at which marginal demand meets marginal supply.

Most goods conform to the water diamond example. For example:

· Life saving medicines though some times expensive do not trade for as much as Picasso paintings because demand is temporarily sated with every dose.

· Coins with double printed dates trade for far more than ordinary coins used in commerce. Owning a coin does not sate the desire for coins. And the rarer the coin, the harder it is to supply.

· Limited edition sneakers endorsed by celebrities trade for more than sneakers used on the court. Owning a pair of collectible sneakers does not sate the desire for more, unlike a regular pair of sneakers where all you need is one. And supply is limited.

Yet while Marshall resolved the water diamond paradox, not everything rare is valuable. Besides non satiability and a high incremental cost of supply, a third quality is needed to make a thing valuable: demand. Diamonds like gold have long been in demand due to their beauty and unique characteristics, hardness in the case of diamonds and malleability in the case of gold. Celebrity limited edition sneakers are in demand because people desire to associate themselves with celebrities and companies like Nike and Supreme use social media and other techniques to build community around the product and brand to increase demand.

So where do NFTs fit into this model. The appropriate questions are:

· Is demand for NFT sated by possessing one or does it persist?

· Is the incremental cost of creating an NFT high?

· Is there demand for the NFT?

The proposers of the ERC 721 standard underlying most NFT tokens included a unique identifier not found in regular ERC 20 tokens to make each token unique. So NFTs satisfy the test of non-satiety. Owning one ERC does not sate desire for more NFTs and, if any thing, collectors may acquire a taste for more. Unlike water, there is no point at which one is likely to be fully sated upon acquiring an NFT.

Second, is the incremental cost of creating an NFT high? Here the answer is ambiguous. The cost of a blank NFT on the Ethereum blockchain is modest — currently about $100 in gas and perhaps fees to a website. However, the cost to create an NFT that someone would want can vary enormously. A solo artist might have to spend months to years to create a masterpiece of digital art. In contrast, a celebrity might just license a random image that is essentially worthless without the celebrity’s endorsement. So the cost of supplying the NFT can vary dramatically unlike, say, the cost of supplying a diamond.

Finally, there is the question of demand. What creates demand for NFTs?

As software products, NFTs allow endless variations so that demand can come from many sources. Demand can come from the quality of the good tokenized. A physical house, such as the one tokenized and sold last week by Propy, presumably, reflects the demand for other physical houses.

A particularly beautiful piece of digital art may generate demand due to the pleasure that viewers find in the art. An NFT that can be used in a game may derive some utility and value from that. Jack Dorsey’s first tweet that sold for $2.9 million may generate demand for its historical value analogous to the market that exists for letters by famous people. The value of the 2974 images of Steph Curry’s shoes the day he broke the record for 3 point shots is likely to depend on the number of Curry fans.

Still other NFTs, however, embody characteristics or properties across a category of NFTs — such as Cryptopunks and Cryptokitties — the first popular NFTs — or Bored Apes who have various characteristics in different combinations creating a spectrum of rarity. The value of the 10,000 Bored Apes purchased by celebrities including Paris Hilton, Jimmy Fallon and Eminem will ultimately depend on the number of people who care about those celebrities or the Bored Ape Yacht Club, the rarity of the characteristics and the longevity of the Bored Ape community. Creators of NFTs can use the platform to distribute bonus software — for example dogs in the case of Bored Apes with features similar to the apes to sustain demand for the NFTs.

Recognizing the role of brand, community and engagement in the NFTs, it is likely that creators over the long term will have to continue to add value and build community as the sheer number and proliferation of NFTs and communities will dilute the value of any one NFT or series.

So are NFTs a real quality investment vehicle or is the NFT craze a bubble? NFTs are clearly benefiting now from their novelty. Over time as they proliferate, what seems rare and unique now will be commonplace. It is unlikely that new competitors to Bored Apes will sell in the millions once the first large correction in NFTs occurs

However, the ability of NFTs to create scarcity and their innovative structure allowing, for example, for future payments to creators and additional distributions to owners fomenting community — structure that will itself evolve over time represents a real advance in the ability to invest in assets. Only some goods will retain demand over the long term. But the fundamental structure of NFTs — their ability to create scarcity and no satiation makes them a real investment force going forward.

Will the Cryptobowl be a Dotcom bowl? It is worth recalling that while the Dot com sector crashed in April 2001, the sector ultimately came back stronger than ever. In my view, NFTs are here to stay.

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Michael Moynihan

Michael Moynihan is currently CEO of Onehot.ai, inventor of Max. Formerly he was chief economist for New York City and founded the clean energy program for NDN.