Network Economics: How Blockchains will catalyze business partnerships & make them a critical success factor?
In a previous article, I wrote about the opportunity that Blockchains provide to understand macro-economic effects from first principles of micro-economics & game theory. In this article, I want to explore how Blockchains will transform the tools that enable the emergence of a macro-economy from micro-economy. Here is an outline of the article:
- In today’s highly inter-connected world, economic value gets created by firms collaborating with each other. This results in the creation of economic (business) networks.
- Real world economic networks are complex. They do not fall cleanly into centralized or decentralized categorization— yet, the centrality of a firm in an economic network is often a proxy for its power.
- Firms use a variety of tools to maintain the complex network of relationships they form with partners, suppliers etc. Contracts are one such tool.
- With Smart Contracts & Token Economics, Blockchains provide a way to redesign contracts, incentives & hence economic networks.
Economic Value & Networks
Economic value gets created by firms collaborating with each other. This results in the creation of economic (business) networks. The most obvious example of such business networks are supply chains. Actually, the name supply chain is a misnomer since real world suppliers, contracts, vendors form a network.
The figure on the left shows a sub-network in Toyota’s supply network. Each node represents a company and an edge between two nodes represents a supply-procure relationship. The whole supply network consists of over 2000 companies and the network structure is significantly more complex than the sub-network shown here.
Setting up & managing supply networks is non-trivial — to say the least — and one of the primary tools used to manage them are contracts.
Another example of a business network among firms are coalition loyalty point programs. Coalition Loyalty Points allow multiple firms to share a customer base — for customers, loyalty points earned at one firm can be redeemed at another firm.
The figure on the left shows a loyalty point networks. Nodes represent firms and an edge between two nodes indicates that they mutually allow exchange of points. Interestingly, the graph shows three clear partitions: the one on the left are airlines, in the middle credit card companies, and one on the right hotel chains. There seems to be no edges within partitions and across partitions the graph appears to be almost complete. Nodes within a partition
seem to be competitors, and have no partnerships, whereas nodes across partitions seem to be complementary.
Similar to supply networks, setting up & managing loyalty point exchange programs requires negotiating complex contracts between firms.
Yet another example of economic networks is the financial network which interconnects the international banking systems. Over the last few decades, the network has become denser and more interconnected. These financial networks are also held together by a combination of contracts, standards, processes & technology.
Complex (Economic) Networks
As the examples above show, real world economic networks are complex — a reflection of how markets work.
Economic evolution, like biological evolution, is messy.
The field of network science has found ways to describe and model network complexity. One measure to describe nodes in complex networks is centrality. There are many ways to define the centrality of a node in a network: degree centrality (the number of nodes a node is connected to), betweenness centrality (the number of shortest paths that pass through a node), eigenvector centrality (a measure of the influence of a node in the overall network).
Irrespective of the exact definition used however, the intuition is essentially the same — nodes which are central in the network command disproportionate power. In social networks, this power may manifest itself as social influence e.g. individuals with lots of followers. In economic networks, it manifests itself as monopolization or aggregation. And it is in this context that the importance of decentralization (dis-intermediation) begins to make sense.
Decentralization is one of the most talked about value proposition of Blockchains. Vitalik went into quite some depth detailing out the different types of decentralization and their implications. One of the points that he made is that traditional corporations are politically centralized (one CEO), architecturally centralized (one head office) and logically centralized.
True as this statement may be, there is an alternate interpretation of economic centrality that is perhaps more relevant today: centrality in economic networks. Take for example the aggregator platforms of today: Amazon, Uber, Airbnb provide a platform for sellers and buyers to interact. To be sure, these intermediaries do provide economic value. The question though is: do these intermediaries derive disproportionate economic benefit due to their central position?
Beyond ICOs and coin prices, the real potential of Blockchains is that it may be possible to build decentralized marketplaces and economies where the services traditionally provided by intermediaries may be provided by a combination of smart contracts and individual behavior incentivized using tokens.
This is a fundamentally new economic paradigm and is likely to have far reaching implications.
Managing Economic Networks
Implicit in the idea of economic networks is the idea of the boundary of a firm. Nodes in a network represent firms: a node is an independent entity (has a boundary) and edges represent the relationship between the firms. Perhaps the most fundamental question we can ask about economic networks is why do they exist? Why do firms exist and why do the relationships between them exist?
In 1937, Ronald Coase proposed a theory of the firm. He offered the explanation that: people begin to organize their production in firms when the transaction cost of coordinating production through the market exchange, given imperfect information, is greater than within the firm.
A transaction cost is a cost in making any economic trade when participating in a market. Transaction costs can be divided into three broad categories:
a) Search and information costs are costs such as in determining that the required good is available on the market, which has the lowest price, etc.
b) Bargaining costs are the costs required to come to an acceptable agreement with the other party, drawing up an appropriate contract and so on.
c) Policing and enforcement costs are the costs of making sure the other party sticks to the terms of the contract, and taking appropriate action (often through the legal system) if this turns out not to be the case.
The last two points also capture the incomplete contracting paradigm which argues that if contracts cannot specify what is to be done given every possible contingency, then firm boundaries matter.
Contracts are a key tool in managing economic networks. The three networks that we have seen are very different from each other — both in terms of their structure and the dynamics of interactions that takes place over them. And yet contracts play a critical role in all these networks.
Smart Contracts
One way to think about contracts is as a tool which connects two firms together in an economic relationship. As business networks become more complex however, managing the complexity with contracts is hard. Contracts require negotiations, specification and enforcement — each one of which is a manually intensive process. The idea of Smart Contracts in Blockchains raises a fundamental question:
How far can Smart Contracts reduce the incomplete contracting problem? How will this impact the evolution of economic networks?
From a Computer Science perspective, a Smart Contract is a piece of software which (i) is guaranteed to execute once deployed and (ii) the result of whose execution are stored in an immutable, shared ledger.
From a micro-economics view point, Smart Contracts are an opportunity to revisit the incomplete contracting challenge. The two key value propositions of smart contracts are that
a) They make contract specification precise — since smart contracts are programmed in deterministic programming languages, there is very little ambiguity in what the contract will do under a given set of actions taken by agents who signed the contract.
b) They guarantee the execution of the contract code — this has the potential of automating contract enforcement.
Combined together these two features of smart contracts imply that inter-firms contracts will likely become cheaper to deploy and yet more effective.
Smart Contracts can thus potentially lead to more automated inter-firm collaborations. Effectively, certain contract forms will become standardized making inter-firm collaborations fast, smooth & cost-effective to create organizations spanning the globe. However, challenges remain. One challenge is that by design Smart Contracts are difficult to stop once deployed. Would we require a court of smart contracts? [Thanks to Prof. Alex Tabarrok for this suggestion].
Second, Smart Contracts do not necessarily make contract negotiation easier. There is interesting space for innovation here and at KoineArth, we are exploring the use of AI agents for this. Think about the potential of this: a network of smart contracts could do things with very little human involvement. What are the potential economic implications of this?
A yet another challenge for Smart Contracts is that the execution of smart contracts often requires information about the state of the real world — smart contracts must reach out to entities (known as oracles) which provide this information. However this defeats a fundamental principle of Blockchains by centralizing trust in the oracles. An interesting approach being explored for this challenge is the use of token incentives to create decentralized oracles — this is a variation of a problem studied in Game Theory — incentivizing truth telling when truth is not verifiable. (See a nice tutorial here)
Token Economics
Tokens are a fundamental construct of Blockchains. The ability to create new tokens or currencies (monetary policy) and to distribute and allocate these tokens according to economic incentives (mechanism design) can be a powerful tool in the way economic networks are managed.
The use of tokens by firms to incentivize desirable behavior is not new. Alternative currencies like airline miles & loyalty points are used by enterprises to influence consumer behavior even today. What is new is the scale with which it is possible to do this now.
With the advent of Blockchains, it is imminently possible for firms to use tokens to incentivize desirable behavior in their partners & suppliers. In fact, it is interesting to think about firms creating an enterprise-wide token— this view point makes sense when you realize that 69 of the top 100 economies in the world are actually companies.
One potential advantage of having a firm wide token is that an enterprise -token monetary policy of an enterprise-token can serve as a governance tool. Similar to national monetary policies which are critical in managing national policies of countries, an enterprise-token monetary policy can potentially be used by the CFO as a corporate governance tool. In spirit, this is similar to CFOs do today when managing loyalty points. An enterprise-token though would have more uses in the enterprise and hence its monetary policy would be more involved.
There are some interesting open questions : What would be the socio-political impact of firms creating their own tokens? How would these tokens interact with national currencies? What would be the impact of this on national & international economies? I think it is time to start talking about these …
Summary
Take a step back and think about this — we are talking about the use of both micro-economic tools (contracts) and macro-economic tools (token monetary policies) to manage economic networks. With Smart Contracts & Token Economics, Blockchains provide a way to redesign contracts, incentives & hence economic networks. In today’s highly inter-connected world, where economic value gets created by firms collaborating with each other, how important would this be? How will today’s economic networks evolve? Will economic power get redistributed? Who will be the winners? Is a new economic order about to emerge?
-Praphul Chandra is the founder & chief scientist at KoineArth, a startup working at the intersection of blockchains, mechanism design & machine learning. A thank you to Prof. Alex Tabarrok for his feedback to improve this post.
