Sample Chapter: Token Economy, Shermin Voshmgir
Purpose-driven tokens incentivize individual behaviour to contribute to a collective goal. This collective goal might be a public good or the reduction of negative externalities to a common good. They introduce a new form of collective value creation without traditional intermediaries. Individuals are hereby rewarded with a token when they contribute to the maintenance of public goods or common goods. Purpose-driven tokens provide an alternative to the conventional economic system, that predominantly incentivizes individual value creation in the form of private goods.
Bitcoin and the underlying blockchain technology can be described using many metaphors and characteristics: (I) distributed ledger, (II) universal state machine, (III) governance machine, (IV) accounting machine, (V) decentralized autonomous organization. However, all these characteristics are derived from the fact that the Bitcoin network is first and foremost (V) an incentive machine.
Its “Proof-of-Work” consensus mechanism introduces a mechanism to get network actors to collectively manage a distributed ledger in a truthful manner, by rewarding them with tokens. The idea of aligning incentives among a tribe of token holders introduced a new type of public infrastructure that is autonomous, self-sustaining and robust. The Bitcoin network showed us how it is possible to create a public infrastructure, by rewarding people with native network tokens, if and when they contribute to the security of the network (read more: Part 1 — Bitcoin, Blockchain & other DLTs).
This open and public infrastructure can be now used by anyone. The Bitcoin payment network represents a public good similar to the ones governments usually provide to their citizens: public utility networks like railroads, waterworks, or electric grids. However, as opposed to state-controlled public goods, blockchains have distributed upkeep, development, and control, which are all aligned and incentivized by the native token.
“Proof-of-Work” consensus mechanism introduced a novel approach that transcends classic economic value creation. The protocol introduced an operating system for a new type of economy that made it feasible for anyone to issue their own purpose oriented token by either forking the Bitcoin protocol and creating their own purpose oriented native blockchain token, or even simpler, by creating an application token on top of the Ethereum blockchain with a few lines of code. It inspired many new projects ever since to build on the principle of incentivizing behavior with what I would like to call “purpose-driven tokens”.
Bitcoin has inadvertently introduced a new form of collective value creation without traditional intermediaries. It provides an alternative to the conventional economic system, that predominantly incentivizes individual value creation, allowing private actors to extract raw materials from nature, transforms these into products, and in the end, disposes of these products in nature, externalizing costs to society while internalizing (and maximizing) private profits.
Purpose-driven tokens incentivize individual behavior to reach a collective goal or a common good. This collective goal might be a public good (Bitcoin payment network) or the reduction of negative externalities of a common good (CO2 emissions). The public good in the case of Bitcoin is a P2P payment infrastructure, that resolved the double-spending problem, circumventing the necessity of third-party service providers. Purpose-driven token hereby set an incentive for individual actions, with the goal of a common good, and could possibly resolve many “tragedy of the commons” problems society faces today.
Tokenized networks provide a new operating system for a global society. We can now create completely new types of economies where we can model behavioral economics into a smart contract. Any purpose can be incentivized. Examples thereof are: (I) incentivizing people to plant trees instead of cutting and rewarding them with “tree tokens”; or (II) to incentivize people to reduce CO2 emissions by using a bike instead of a car, or use solar energy instead of energy that comes out of a coal mine, by rewarding them with “CO2 tokens”; (III) Incentivizing contributions to a social network with a native social network token.
Other tokens could incentivize or nudge towards other types of actions. Purpose-driven tokens are fundamentally different from tokens that represent an asset or an access right. While purpose-driven token contributes to a collective good, tokens that represent assets and access rights represent ownership and access to mostly private goods. The question of who defines and manages the collective goal of a purpose-driven token is an important governance question (read more: Part 2 — Governance of Tokenized Networks). Purpose-driven token can either directly incentivize or subtly nudge actors towards a preferred behavior. Bitcoin directly incentivizes adding security through energy expenditure.
In this context, it is important to note that incentivizing behavior is not a new concept. It has been a subject of study in economic literature, in specific behavioral economics and came to public fame with concepts of “nudging” in the 1990s. However, the speed and scope with which purpose driven tokens are being discussed and conceptualized is strong an indicator that cryptographic tokens might be a catalyst for such behavioral concepts in applied economics in the future. While blockchain has made it easy to incentivize any kind of behavior with a token, the questions of how to design the governance rules of such purpose-driven tokens are subject to questions of public good theory, free-rider problems and externalities, behavioral economics, nudge theory, behavioral game theory, and behavioral finance.
Public goods & The Tragedy of the Commons
To understand the concept of “purpose-driven tokens”, it is important to understand the theory of public goods. With purpose, I refer to the concept of a “higher purpose” than only maximizing one's personal profit. Purpose-driven tokens allow contributing to the creation of a public good, or the reduction of externalities to a public good, while at the same time generating a private profit.
The term public good in economics refers to goods that any individuals can use without paying for it (non-excludable, or permissionless), and where use by one individual does not reduce availability to others (non-rivalrous, or unlimited). Public goods that satisfy both conditions only to a certain extent are referred to as impure public goods. Public goods can be provided by a government, or be available in nature. Global public goods have no geographical restrictions and are globally available. Examples thereof are knowledge, the Internet, certain natural resources. Bitcoin as a P2P payment network can be seen as a new form of tech-driven public good, albeit an impure one. Usage of the network to a certain extent is permissionless and non-rivalrous, but only as long as capacity limits are not reached. In their current form, public blockchains don’t scale well an can be considered as rivalrous when the network becomes clogged. The question is whether, when and how, scalability solutions will resolve this issue (read more: Annex — Scalability Solutions).
Public goods are often subject to “free-rider” problems, where some individuals would benefit from it without contributing to it. Consumers can take advantage of public goods without contributing sufficiently to their creation. If too many consumers decide to “free-ride” the market will fail to provide a good or service for which there is a need. Open-source software is public goods that are subject to the free-rider problem. Bitcoin is also a good example of this free-rider problem, as only a few contribute to the code, with little or no direct incentive to do so, but many people use it.
If public goods become subject to restrictions they become club goods or private goods. Exclusion mechanisms might be in the form of copyright, patents, paywalls to access them. Club goods represent artificially scarce goods. Federated ledgers could be seen as such club goods, where only members of the federation (club) have access to the distributed ledger and can write transactions to it.
Common goods are similar to public goods as they are non-excludable (permissionless), but they are rivalrous, which means that the consumption of a good by one person excludes others from consuming it. Examples of common goods are water and air, forests, and natural resources in general. They are public but scarce, often to varying extents. If natural resources are exploited or polluted beyond their sustainable capacity it affects others from consuming them. Tragedy of the commons occurs when individuals withdraw resources to secure short-term gains without regard for the long-term consequences. This might be avoided with regulation to limit the extraction of the goods beyond a sustainable level. While the world’s fish stocks can be seen as a non-excludable resource, it is finite and diminishing because of continuous deep-sea fishing by different private actors worldwide.
In the case of private goods, it’s owner can exercise private property rights, preventing those who have not paid for it from using the good or consuming its benefits (excludable). With physical goods, consumption by one person prevents that of another (rivalrous). The case is different for digital goods, but artificial scarcity can be created with digital rights management tools (copyright protection). A private good can be rented out to another person granting temporary access rights. Private goods and temporary access rights can be represented by a token, but the are not purpose-driven. Patents also create artificial scarcity providing temporary monopolies, or, in the terminology of public goods, providing a legal mechanism to enforce excludability for a limited period of time.
Positive & Negative Externalities
In economics, externalities are the costs or benefits that affects a party who did not choose to incur that cost or benefit. A negative externality is an activity that causes an indirect cost, or “external cost”, or negative effects on an unrelated third party. It can arise either during the production or the consumption of a good or service. Pollution is an example thereof. Consuming goods with a negative CO2 footprint is another. Manufacturing can cause air pollution, imposing health and clean-up costs on the whole society. If those costs are not “internalized” through government regulation, those who create the externalities will continue to do so.
A positive externality is any difference between the positive effect an activity imposes on an unrelated third party. It can arise either on the production side or on the consumption side. A typical example of positive externalities is two neighboring companies: a beekeeper and an apple tree plantation, that influence each other in a positive way. Incentivizing CO2 emission reduction with a token could be another example of a positive externality. Incentivizing CO2 emission reduction could contribute to the wellbeing of a public good like air quality. Incentivizing Bitcoin mining also creates positive externalities — providing a public infrastructure for P2P money exchange. However, the act of Bitcoin mining itself is energy-intensive and thus also produces negative externalities. The production of public goods in general results in positive externalities, but does not necessarily other exclude negative externalities.
Behavioral Economics & Nudging
Behavioral economics is a field of economics that studies how economic decisions of individuals and institutions are impacted by psychological, cognitive, emotional, cultural and social factors. It is based on the assumption that people make over ninety percent of their decisions using mental shortcuts or rules of thumb, especially under pressure and in situations of high uncertainty. They often use mental filters that rely on a collection of anecdotes and stereotypes to help them understand and respond to events more quickly. Behavioral economics opposes the classic economic theory of the “homo-economicus” which reduces economic decision making to simple profit maximization based on an individual utility function of “perfect selfishness”.
Cognitive psychologist compared their cognitive models of decision-making under risk and uncertainty to economic models of rational behavior. Among others, they found that when individuals make decisions, their rationality is limited or “bounded” by factors like the tractability of the decisions, their cognitive limitations and the time available. When making decisions, individuals therefore often seek a satisfactory solution rather than optimal ones. This is why people take shortcuts that may lead to suboptimal decision-making, defying the theory of the homo-economicus. Behavioral economics, therefore, enriches the model of the individual utility function of the homo-economicus by studying fairness, inequity aversion, and reciprocal altruism, thereby weakening the neoclassical assumption of perfect selfishness.
One method to counteract mental shortcuts that have been described in behavioral economics is the concept of nudging. Nuding suggests that choice architectures are modified in light of the so-called “bounded rationality” of economic actors. It suggests that individuals can be supported in their decision-making process by for example placing healthier food at sight level in supermarkets in order to increase the likelihood that a person will opt for that choice instead of a less healthy option. As such, it is complementary to other ways of how societies can achieve compliance with their rules, such as education, legislation or enforcement.
A nudge is not mandatory. To count as a nudge, the intervention must be easy and cheap to avoid. It introduced a positive reward function, without giving direct economic incentives, but by influencing behavior without punishment. Nuding has been applied to business environments, especially in the context of health, safety and environment, and human resources, to increase the productivity and happiness of employees. As such, purpose-driven tokens can also be used to nudge individuals towards certain actions like reducing CO2 emission reduction. Critics, however, argue that nudging is a euphemism for psychological manipulation as practiced in social engineering.
Nudging is a rather novel concept developed in cybernetics by James Wilk in the 1990s which among others, drew on influences from clinical psychotherapy. The concept of nudging was adopted by some politicians in selected countries. So far findings of behavioral economics have been applied in the context of policymaking and for the modeling decision-making process for applications in artificial intelligence and machine learning. Behavioral economics will also be an important area of research when it comes to designing “purpose-driven tokens”, whether it is modeling consensus algorithms of blockchains or incentivizing CO2 emission reduction with a token.
Behavioural Finance & Behavioural Game Theory
Behavioral finance is an academic cousin of behavioral economics that explains why market participants make irrational systematic errors that affect prices and returns. It analyzes resulting market inefficiencies, and how other participants take advantage of such errors. Among others, behavioral finance explains how under- or over-reactions to information can cause market trends like for example bubbles and crashes. It analyzes phenomena like “limited investor attention”, “overconfidence”, “overoptimism”, “mimicry” of the behavior of the herd, and “noise trading”. Behavioral finance furthermore looks at the asymmetry between decisions to acquire or keep resources and the unwillingness to let go of a valued possession. Findings from behavioral finance will be important aspects to consider when modeling tokens. As we will see in the later chapters, token curated registries (TCRs) built on simplistic assumptions of homo-economicus. Talking into considerations behavioral economics and behavioral finance could help develop more sophisticated TCRs (Read More: Part 3 — Token Curated Registries).
Behavioral game theory is a subfield of behavioral economics that analyzes interactive strategic decisions and behavior using the methods of game theory, experimental economics, and experimental psychology. In blockchains, game theory is used to model human reasoning to build networks that need no oversight but have positive outcomes for the greater good. However, planning for unpredictable human decisions first requires that we understand what motivates people. Traditional game theory seeks to pinpoint the decisions rational players should choose. Rationality is a primary assumption of game theory, so there are not explanations for different forms of rational decisions or irrational decisions.
Behavioral game theory seeks to describe phenomena rather than prescribe a correct action. It attempts to explain decision making using experimental data. Behavioral game theory began in the 1950 when researchers described multiple paradoxes in decision making by participants in a game which do not reflect the benefit they expect to receive from making those choices. Experiments showed that there are many variations of traditional decision-making models such as “regret theory”, “prospect theory”, and “hyperbolic discounting”. For example, a person might want to minimize the regret they will feel after making a decision, and might, therefore, weigh their options based on the amount of regret they anticipate from the outcome of each decision.
As the field of crypto economics and purpose-driven tokens matures, it is likely that behavioral game theory will find its way into crypto economic modeling. For now, most academic approaches to modeling of tokens are based on the assumption of rationality. All agents act egotistically profit maximizing and logically consistent with their preferences and beliefs and base their decisions on full use of information.
Types of Purpose Driven Tokens
There are many different types of purpose-driven tokens. A selected sample of which are listed below and discussed in detail later in the book:
Incentivizing consensus on the state of a blockchain: In a Proof-of-Work blockchain, a consensus among the nodes is reached by incentivizing miners with native network tokens to use their computing power to secure the network. The aim is to reach distributed consensus among untrusted network actors on the state of the network. The reward mechanism is based on the assumption that all network actors are potentially corrupt, therefore the process of writing transactions to the blockchain is intentionally made difficult and inefficient, making it costly for malicious actors to attack the network. Bitcoin and the token governance rules specified in the Bitcoin blockchain protocol have introduced a new form of value creation, where a network of actors agree on a specific goal — in the case of Bitcoin it is fault tolerant P2P money remittance without banks. The value is created when someone proves that they have contributed to a previously defined collective goal — in the case of Bitcoin this would be Proof-of-Work and the subsequent block reward, also called Bitcoin mining. (read more: Part 1 — Bitcoin, Blockchain & other DLTs).
Incentivizing social media contributions: Steemit is a blockchain based social network designed to incentivize content creation and content curation. The aim is to reward those who contribute to the growth and resilience of the network. Steemit is an application similar to Facebook or Reddit, where contributors to the network get paid for any action through it’s integrated Steem wallet. Users who create and curate content on Steemit get rewarded with native network tokens. How much you get paid is a function of the number of contributions, and the popularity of your contributions. Steemit is permissionless, allowing any user to join and contribute for free, and as such represents a public good (Read more: Part 4 — Steemit).
Incentivizing contributions to a listing: Token Curated Registries (TCRs) are a crypto-economic primitive to incentivize quality curation of public lists. Tokens are hereby used to prove an economic incentive to curate lists, or ranking of information in such a list, including content feeds in a social network. The idea is to incentivize collective curation of listings. TCRs introduce an incentive mechanism to enable coordination and allocation of tokens to achieve shared goals, where each list has its own native token. The game theory in a TCR aims to align token holder incentives in order to produce lists that are valuable to consumers. They aim to provide a reliable signal of quality on something a user cannot directly observe (Read more: Part 4 — TCRs).
Incentivizing CO2 emission reduction: Cryptographic tokens issued by a smart contract can be used to incentivize individuals and corporations to act in a sustainable manner. Such incentives can be used as a representation of the rewards collected. People who can prove that they reduced CO2 emission by riding a bike, walking, or using public transportation instead of using a car can be rewarded with a token. Examples are Walking Coin or Changers. People can also be incentivized for producing or consuming renewable energies. Examples of such tokens include Solar Coin, Electric Chain, Sun Exchange. Users could be incentivized with a token every time they prove that they have used less energy by using energy efficient devices, turning the lights off, etc. Users basically earn money for reducing their carbon footprint: Energi Mine, Electron. Alternatively, one could be incentivized for undertaking actions to help natural resources like for example planting trees, cleaning a beach, reduction of food waste, recycling of goods like Proof-of-Tree-Planted, or Proof-of-Bottles-Recycled: Plastic Bank, Earth Dollar, Bit Seeds, Eco Coin, Earth Token, Recycle To Coi.
Tokenized rewards of such incentive systems can be fungible (tradeable for other tokens) or non-fungible (identity-based reputation tokens). In some cases fungibility can be limited, representing a value that can only be exchanged for products and services within the community, therefore never leaving the internal system and being exchanged for fiat money, but being useful in the internal community. The monetary policy and other token governance rules can be simply embedded thus regulated by a smart contract on the Ethereum or similar Blockchains.
As opposed to tokens that represent an asset or an access right, purpose-driven tokens are a new value creation phenomena that will likely need much of research & development and a long phase of trial and error in the market until we can better understand the potential of tokenizing contributions to a public good. The study of economics, public choice theory, the theory of public goods and behavioral sciences will be essential to understanding and engineering purpose driven tokens.
This is a chapter from my upcoming book titled “Token Economy” which will be published in by O’Reilly in September 2019 (German Version). Date and publisher of English Version will be disclosed soon. More info & newsletter sign-up here. If you would like to give me feedback, pls comment below or send an email to firstname.lastname@example.org.
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About the Author
Shermin Voshmgir is the Author of the Book “Token Economy“. She is the director of the Research Institute for Cryptoconomics at the Vienna University of Economics, and the founder of BlockchainHub Berlin. In the past, she was a curator of TheDAO, and advisor to various startups like Jolocom, Wunder and the Estonian E-residency program. In addition to her studies at the Vienna University of Economics, she studied film and drama in Madrid. Her past work experience ranges from Internet startups, research & art. She is Austrian, with Iranian roots, and lives between Vienna and Berlin.