Economics of NFTs: Why We Pay Millions for a JPEG online?
Researching and investing in the Web3 based NFTs could be approached like studying economics.
A bit of a boomer statement, but hear me out 👂
Although the most popular definition by Paul Robin Krugman describes economics as “the social science that studies the production, distribution, and consumption of goods and services”, my favorite one refers to the basic economics concept of scarcity.
To put it simply, economics is a science on how to distribute limited resources to fulfill limitless human wants and needs.
Without scarcity, the rest of the economics (production, distribution and consumption of goods and services) wouldn’t make any sense. It wouldn't exist.
In theory, if there was no scarcity the price of everything would be free, so there would be no necessity for supply and demand. There would be no need for government intervention to redistribute scarce resources. One could think of macroeconomic problems like economic growth and unemployment. But, if there is no scarcity, then a fall in economic growth would be meaningless.
The physical reality we live in is unimaginable without scarcity. There are limited resources of food, oil, iPhones, BMWs, cats and economists.
Out of scarcity, the second key economic principle of supply and demand comes up. The higher the need or desire for economics professors in relation to the amount of economists, the higher the salary universities need to pay.
If the costs of hiring an economics professor is too high relative to the benefits the university and its students receive, the university might decide to skip teaching economics at all. This costs and benefits analysis is a third basic economic principle.
Humans being rational 😅, we will evaluate the best course of action to maximize our own benefits. To increase the likelihood of a specific action, incentives or rewards are used. If a university cannot pay a high salary to a highly praised economics professor, it might offer him other benefits, such as shorter working hours, freedom of which topics to teach etc.
Thus with this fourth economic principle of incentives, we have a general overview to explain many decisions that humans make. In short:
As a result of scarce resources, humans are constantly making choices that are determined by their costs and benefits and the incentives offered by different courses of action — Andrew Beattie.
This is how the PHYSICAL world works. You have specific unlimited needs, and companies offer you those goods/services in exchange for money. In this world you are the consumer.
How scarce is your favorite internet meme?
In contrast, the current digital world of the Internet (Web2) works differently. Most of the memes, news articles, your Facebook (Meta) feed, torrented movies, videos on YouTube are free to consume. They can be copy pasted anywhere and anytime. They are not intrinsically scarce.
Secondly, in the Web2, the websites are mostly monetized with the ad revenue thus for the free content WE create and consume, we receive targeting advertising in return. We become the product.
Some of the virtual goods are not free, like iPhone apps, Netflix movies, Bloomberg news subscription etc., even though the digital copies in itself are not scarce. What is scare is the developers, creators, journalists who create and make the virtual content valuable and in demand.
So, what it has to do with the NFTs?
Again, SCARCITY!
Web3 is more like the physical world and less like the current web.
NFTs are part of the third wave of the Internet: Web3.
The concept of Web3 is still somewhat hazy, but mostly focus on the idea of decentralization with the use of blockchains. Blockchains enable shared ownership in form of tokens or NFTs and organizations are run by a decentralized entities, most often token holders, represented by rules encoded in a smart contract.
Web1 consisted of read-only static pages. Individual was a consumer. Web2 Big Tech companies revolutionized the internet allowing to interact and produce content. At the end, a user became the product and the consumer.
In the Web3 the focus switches back to consumption but with an added perk of ownership.
While being the original creator of a crazy popular meme on the Web2 brings you bragging rights to your friends, it is essentially free for everyone to copy-paste, edit and consume. Take a time to appreciate my copy-pasted image turned into a meme below 👇
However, blockchain technology enabled NFTs allows to claim ‘ownership’ of the same picture. This ownership “is managed through the uniqueID and metadata that no other token can replicate. NFTs are minted through smart contracts that assign ownership and manage the transferability of the NFT’s.”
Crucially, blockchain enabled NFTs create digital SCARCITY. Without scarcity ownership is not economically valuable. The difference here is ‘having’ many screenshots of the ‘Disaster Girl’ on my phone, and ‘owning’ the digitally scarce ‘Disaster Girl’ NFT which sold for $500,000 USD! You can right click on the picture, but you cannot right click on that $500,000 USD.
This NFT is simply a digital certificate of the original picture. I can resell it, give the ownership to someone else or even destroy the access to the NFT by sending it to a ‘burn address’. Some of the NFTs might give you commercial, licensing, distribution rights etc., but most of them do not.
The scarcer it is, the more you want it!
In the previously discussed economic concepts, this NFT is scarce💎 and is in high demand📈 due to its online popularity. The supply is limited to only 1️⃣, and the buyer might have been incentivized to acquire it for social bragging rights😎, opportunities to profit from a higher resale price, or some other individual motivations.
In his book “Influence: The Psychology of Persuasion” Robert Cialdini explores factors that affects the decisions people make, in particularly to purchases we make. He identified 6 core principles: reciprocity, scarcity, authority, commitment and consistency, liking and consensus (or social proof).
The less of something there is, the more people tend to want it.
The original creator of the “Disaster Girl’ might have decided to mint 10, 100 or even thousands of the same NFTs. Even with a few thousand NFTs, they would have been scarcer than the ‘right clickable’ NFTs on the Web2. The logic driving this decision would have been of the basic supply and demand principle: the higher the supply the lower the price. As the quantity increases, the price decreases. To the NFT creator it wouldn’t have made any difference if he sold 1 NFT for $500,000 USD or 100 NFTs for $50,000 USD. Thus the flat lines in the supply and demand graph below.
Yet the higher the number of the NFTs, the lower the SENSE of scarcity thus the demand. It is very probable that minting 10 ‘Disaster Girl’ NFTs would have fetched the original creator less than $500,000 USD in total (10 NFTs x $50,000 USD), because of the mismatch between the Marginal Value vs Marginal Utility which causes scarcity costs.
In some contexts, marginal utility and marginal value can mean the same thing. Marginal value is what one more unit of a good is worth to you. Remember when you really wanted to eat that one candy and it tasted delicious? But then you kept eating them one by one until you felt nauseous and almost puked? Every piece of candy brought to you less joy.
Same for the NFTs. The more copies of the same JPEG there are, the less you want it. That is why the demand curve is not flat in the graph above. Notice that the “Disaster Girl’ NFT scores high on the marginal value at scarcity point ‘q’, while the ‘Disaster Girl’ JPEG scores 0 for marginal value at ‘Qmax’.
But sir, why does one Bored Ape Cost $300,000 USD even though there are 10,000 of them?
In short, the more expensive it is, the more you want it!
There are a few exceptions to the general Law of Supply and Demand. One of them refers to the Veblen Goods.
An American Economist Thorstein Veblen coined a term ‘Conspicuous Consumption’ for recognizable high-end and expensive items for which demand increases as the price increases. These goods are exclusive, and are a status symbol.
Interestingly, when the price of the Veblen good goes down, so does the price due to the decrease of perceived exclusivity.
Veblen goods are commonplace and easy to identify, such as rare diamonds, works of art by renowned artists, luxury watches etc. Those goods have a strong brand which the majority of the population cannot afford.
Bored Ape NFT is a Veblen good. Similarly to owning a painting by Vincent van Gogh, Bored Ape ownership elevates your perceived social status, gives you access to an exclusive community of members. It does not matter, if the item itself is virtual of physical. It just needs to be scarce, in high demand and perceived as exclusive.
For Veblen NFTs, it shouldn’t even matter (though it helps) how ‘cool’ looking the JPEG itself is. It does not even have to be a picture at all. LinksDAO, for example, raised $10.4 million USD by selling NFTs with a goal of creating “one of the world’s greatest golf clubs.”
Therefore, to really understand the high price tag for a Bored Ape, we need to understand that they are not selling a picture, but access to the special group of people. In this case, even a blind person might appreciate owning a Bored Ape NFT.
Most of the NFT ‘communities’ settle to sell out around 10,000 units of NFTs. Every NFT of the collection is similar, but not exactly the same.
The 10k NFT trend started with the first CryptoPunks NFT, and the model has stayed until now. It seems that the number is high enough to create a community, but exclusive enough to instill a sense of exclusivity. Some newer projects issue lower number of NFTs, for example RaidParty Heroes issued 5,300 items. Yet what really matters is the ability to strike a balance between scarcity and creating sense of exclusivity, thus demand.
CryptoPunks has one more feature that makes it unique: provenance. Michael Findlay, the author of “The Value of Art: Money, Power, Beauty” elaborates that the market value of a work of art is based on five attributes: provenance, condition, authenticity, exposure, and quality.
Owing to the provenance exclusivity of being one of the first NFT projects, CryptoPunks NFTs cost almost same as the Bored Apes.
This also explains why CryptoKitties are not as popular as CryptoPunks or the Bored Apes. Even though CryptoKitties is one of the first NFT projects (high in provenance), its high number of NFTs in the collection (2 million NFTs) with no cap of the total NFTs issued in the future (due to breeding) makes the collection less popular.
Mental economic model to invest in NFTs
We can now see that the basic principles of economics applies to the NFTs.
- Scarcity. Blockchain technology enables to claim ownership of a digital content, making previously unlimited digital content scarce.
- Supply and demand. The Laws of Supply and Demand (with its exceptions!) originally created for the physical goods, are a applicable to the digitally scarce goods.
- Costs and benefits. Consumers of NFTs being rational😅, will evaluate if paying the price tag for an NFT is worth the benefits.
- Added incentives. Same NFT can have different value to a different person. For one it can serve as a social status symbol, for the other it is simply an investment instrument. Some people can JPEG’s beauty itself. Other incentives can be added later on too, for example, Bored Apes are launching APE token, which might attract a different kind of consumers.
These for basic principles are applicable to any NFT project, which could help investors before deciding to consume the NFTs.
Being good economic students, let’s take some of the most popular NFT projects as examples.
- Axie Infinity. Axie NFTs are scarce digital goods, but similarly to CryptoKitties the number is not capped. Yet they have value due to in game mechanics (added incentives) which allows users to earn money in form of SLP tokens. To get started users need to acquire an Axie NFT beforehand (driving the demand up), which forces ecosystem players to evaluate costs and benefits (does the initial investment and time spent playing the game worth the added benefits?).
- The Sandbox. Consumers can purchase and own digital land in the game. The land’s max supply is limited to 166,464. Its virtual world allows users to create digital assets, avatars and even 3D games and can sell those on the marketplace. Like in the real world economy, the Sandbox items are valued by their scarcity and utility (thus supply and demand), and users are incentivized to participate in the Sandbox economy with different monetization options. For example, the Sandbox is a popular place for crypto companies to gain exposure by acquiring LAND and featuring its own logo on the Map. Nice merge of the Web2 and the Web3.
- The Wolf Game. The game is unique by how it complicates costs and benefits analysis by introducing a risk element into the core of its game mechanics. In a brutal simplification, players can own sheep or wolf NFTs. Wolf NFTs are a lot more scarce than the sheep NFTs, because they can ‘tax’ the sheep owners with the in-game tokens for their sheep safety. Sheep owners though, can stake their sheep NFTs to earn passive income with the in-game token or they can take a risk to mind another NFT with those tokens. The user might get a sheep, a wolf (10% chance) or might lose a sheep when claiming WOOL tokens.
To be fair, many of the popular non NFT games can be analyzed the same way. The traditional games have their own incentive mechanism making gamers to take decisions based on costs and benefits analysis. Some of the in-game items can be extremely rare too, but their scarcity is not actually built in.
What makes NFTs different is their built in scarcity, ownership (your item cannot be simply taken from your account), liquidity and ease to trade on platforms like OpenSea as well as their provenance value. The origins of NFTs are recorded on the blockchain and consumers have more assurances that those scarce assets are actually scarce. That ‘s why Web3 is also know as Open Economy.
To sum up, as a wise rational 😅 investor in NFTs, you need to evaluate how scarce the NFTs are relative to the demand. What drives the demand in the short and long term? Will supply outpace the demand? What are your private motivation to purchase the NFT (social status, passive income, play-to-earn etc.)? And finally take time to investigate ecosystem incentives for the NFTs that drives the demand up (i.e. staking NFTs to receive tokens).
🙏 for reading!
