Microeconomics, the Bertrand Competition Model, and Web3 Profitability
Microeconomics provides insights into the behavior of individual firms and consumers within a market. Using one of its foundational models, the Bertrand competition model, we can gain a deeper understanding of the challenges faced by web3 protocols.
📈 TLDR
In the Bertrand model, firms compete primarily on price. When products are similar and consumers can easily switch between them, even a slight price advantage can capture significant market share. In the web3 world, many protocols offer similar services, leading to intense price competition in the form of lower fees or higher yields. Such strategies, while popular, often prove unsustainable, diminishing the overall profitability across the web3 ecosystem. Protocols therefore should focus on providing value by either innovating or collaborating, instead of competing each other, which is a zero-sum game that could cause more harm than good to all key stakeholders in the long run.
Bertrand Competition Model
📚 Assumptions of the Bertrand Model
- Firms compete on price.
- Products are perceived as identical by consumers.
- Firms can meet any demand level at the set price.
- Consumers possess complete knowledge of all firms’ prices and will opt for the lowest.
⚖️Bertrand Equilibrium
In the Bertrand model, given the assumptions listed, there’s a unique outcome known as the Bertrand equilibrium. At this equilibrium:
- Price Competition: Firms will engage in fierce price competition. Since products are identical and consumers will always choose the firm with the lowest price, even a minuscule price reduction can allow a firm to capture the entire market.
- Race to the Bottom: This intense competition drives prices down. In an idealized scenario with two firms and zero production costs, prices will be driven down to the level of marginal cost. Essentially, firms will price their products at the cost of production, leaving them with zero economic profit.
That’s all the microeconomics knowledge you need for now! Up next, we will look into the implications for web3 protocols and ecosystem.
In Parallel with Web3
🌐 Oversupply & Homogeneity
The web3 space has seen an influx of protocols offering similar services. This oversupply, combined with a lack of differentiation, not only leads to aggressive price competition but also sets the stage for other challenges like unsustainable user attraction and vampirism. Case in point: In a span of a year, we have 6 Layer-2 platforms.
Notice the number of protocols providing similar service on some of these almost homogenous L2 platforms:
🤖 Unsustainable User Attraction & Demand Stimulation
Driven by the homogeneity in the market, some protocols resort to high yields or airdrops as a short-term strategy to stimulate demand. However, this often attracts speculation, mercenaries or bots, leading to volatile demand and an inaccurate product performance indicator. This can mask underlying flaws or weaknesses in the product, which ultimately leads to the product’s obsolescence. With an oversupply of competitors and a lack in fresh demand, it is difficult for protocols to increase their revenue and profitability. This has led to many protocols relying on token launches, which might ultimately cause more harm than good to investors.
🩸 Vampirism & Market Share Dynamics
The oversaturated and undifferentiated market also gives rise to “vampirism”, where protocols siphon users from rivals. This aggressive strategy can lead to situations where one protocol’s gain in users or liquidity is directly offset by another’s loss, creating a competitive environment where overall growth is stifled, since competitors now have to reduce fees or increase yields in other to stay afloat in the space. This zero-sum game means that no single entity truly benefits in the long run.
📉 The Race to Zero
In the Bertrand competition, when firms compete solely on price and products are indistinguishable, prices tend to fall. In web3, this manifests as protocols undercutting each other’s fees or offering unsustainable yields to attract users. Over time, this can drive fees so low that they barely cover operational costs, making it challenging for protocols to maintain profitability or invest in innovation.
🍣 Case Study: SushiSwap vs. Uniswap
In August 2020, SushiSwap, a fork of Uniswap, attempted to siphon liquidity from Uniswap by offering enhanced incentives to liquidity providers. This strategy, reminiscent of the Bertrand competition, saw SushiSwap diverting a significant portion of Uniswap’s liquidity. Uniswap responded by introducing its own governance token, UNI, to re-engage its community. This saga showcases the intense competition, unsustainable user attraction methods, and the challenges of differentiation in the DeFi space.
🚀 Solutions: Innovate or Collaborate
In the fast-paced web3 realm, innovation trumps imitation. Chasing the allure of being the “next X killer” can be a pitfall. Historically, first movers in web3 have seen more lasting success. How many protocols have claimed to be “Ethereum killers” but were killed themselves? First movers typically have moats with amplified network effects, driven by strong economic flywheel with their tokens. Therefore, competing with leading and strong protocols could be a waste of time and money. If there is a lack of innovation, we should instead adopt a collaborative mindset — which could be significantly more beneficial to the overall ecosystem and its users.
🚀 The Silver Lining, Differentiation & Innovation:
To navigate the challenges of intense price competition, protocols must innovate and differentiate themselves. By focusing on solving real-world problems that have a strong product-market fit, protocols can offer genuine value. Tokenizing off-chain assets, for instance, has a strong product market fit that solves many of the existing problems faced by large illiquid markets, which holds the potential to elevate the entire web3 industry, offering new opportunities and bringing in a broader user base.
In conclusion, the principles of microeconomics and the Bertrand model reveal the intricate dynamics of competition, demand, and supply in the web3 space. These dynamics play a pivotal role in determining the profitability of web3 protocols. For a sustainable and profitable future, the emphasis should be on genuine innovation, differentiation, and addressing real-world needs.
