Hello everyone, in this lesson we will pick up where we left off and unpack some of the cryptoeconomic properties that make currencies like bitcoin valuable.
The term cryptoeconomics causes a lot of confusion people are unclear on what its supposed to mean.
The word itself can be misleading as it suggests that there is a parallel crypto version of the whole economics.
This is wrong.
In simple terms cryptoeconomics is the use of incentives and cryptography to design new kinds of systems, applications and networks.
Cryptoeconomics is specifically about building things.
Cryptoeconomics is not a sub-field of economics, but rather an area of applied cryptography that takes economic incentives and economic theory into account.
Bitcoin, Ethereum, Zcash and all other public blockchains are products of cryptoeconomics.
To understand why the coins on these blockchains have value, we first need to understand what money really is and what makes it valuable.
In the most basic sense, money facilitates trade.
In earlier societies, money could be a bag of flour, a fur hide or even a goat.
It could be anything as long as the person receiving it deemed it valuable enough to provide a good or service for it in return.
For hundreds of years, people traded goods and services directly. And money as we understand it today didn’t exist.
Let’s say I have a farm, with an excess supply of wheat. I could offer a bag of wheat to the local shoemaker for a pair of shoes.
For this transaction to happen, I need to want shoes and the shoemaker needs to want wheat.
But what if the shoemaker doesn’t want wheat? Or, I had a bad harvest and I don’t have enough wheat to spare.
If I don’t have something the shoemaker wants, I can’t use his services.
This was a real problem.
Different people needed different things at different times.
So, no one could guarantee that they had the required items to make a successful trade.
Even for the most basic amenities they needed to survive like food or warm clothing.
People needed something that was valuable to everyone all the time. So instead, they started trading coins with each other that acted as placeholders for value.
And what made these coins special was that everyone agreed they had the same value.
This gave people the guarantee they needed.
They could always trade coins for any good or service, which made them want to collect more and more coins because the more coins you had, the more things you could trade them for.
Fast forward a few hundred years, and you can see the basic premise of money hasn’t changed much.
We all agree what the pound is worth, and each of us has a certain number of pounds, which we use to get goods and services. We also provide goods and services to get more dollars.
The only thing that makes our dollars valuable is that we know we can use them to get things. That and the fact that we can’t just magically produce them whenever we want.
So, for money to have value, everyone needs to agree to give it value and it has to be scarce.
So how does Bitcoin achieve this?
Bitcoin’s promise of a decentralised currency is very valuable.
It functions like digital cash.
It has all the convenience and speed of digitally transferring money without having to rely on a third party like a bank.
These properties, as well as the security in a network that ensures they can be fulfilled, makes bitcoin something people want to assign value to.
With bitcoin, you can send money across the world in minutes without having to worry about exchanging currencies, or going through intermediary banks.
You also know that your bitcoins have value on an international level. So you’re not tied to your bank or your particular country per se.
Some of the biggest markets for bitcoins are in countries like Greece or Venezuela, where their national currency value is very unstable.
With bitcoin, people in these countries know that their assets won’t suddenly become worthless when their national economy takes a hit.
This is an offer people find very appealing because it goes a step further to give your assets value on the international market, and facilitates trade directly on a global scale.
The biggest problem digital cash companies faced was that people could duplicate their coins the same way you can duplicate a photo on your computer.
And once they had multiple copies of their cash coins, they could pay the same coin to many people as many times as they wanted.
So basically, everyone could have an infinite supply of the digital coin, which ultimately made it worthless. People stopped agreeing to offer each other goods or services in exchange for the coins, because they could just make the coins for themselves.
This issue is formally known as the double spend problem, and what made bitcoin special is that it offered a sloutuion to it, which many had thought was impossible.
For bitcoin to function as money, people needed to trust that transaction records were valid and unalterable. And that people couldn’t double spend their coins. For bitcoin to function as cash, there had to be no middleman between transacting parties.
So, how did bitcoin get everyone to behave without a third party enforcing rules or settling disputes? By using incentives. Instead of just expecting people to follow the rules based on an honour system, the blockchain code rewards people who follow the rules while making it economically infeasible to cheat.
So, if each person acted as selfishly as possible, and did what was best for him or herself, the system would thrive.
In this way, Satoshi created digital scarcity, which gave bitcoin a sense of value that previous digital cash systems couldn’t achieve. He also ensured against inflation by setting up some rules around when and how bitcoins would enter the market.
He did this by capping the total number of bitcoins to 21 million this means that there will only ever be 21 million bitcoins in circulation. Once this number is reached, no more new bitcoins can be produced.
He also controlled the flow of new bitcoins to the market, to ensure that they don’t flood the market and decrease the value of the coin. In fact, the only way to create bitcoins on the network is by mining new blocks.
We’ll get into a lot more detail about how mining works in our cryptography section, which is coming up next.
But for now, you should know that every time a block gets mined, 12.5 new bitcoins are released into the network. This number used to be 25, four years ago. But has halved since, to reduce the number of bitcoins entering the market. It will half again in four years and continue halving every four years until there are 21 million bitcoins. In the network.
By doing this, Satoshi has made a bitcoin a scarce commodity with inherent value like gold.
- Now that you have an overall understanding of how bitcoin works and what makes it valuable, you’re ready to dive into how cryptography is used to implement economic incentives on the blockchain.
- In our previous lesson, we dived into data structures on the blockchain, as well as how hashing and digital signatures work together to make transactions on the blockchain immutable.
- Next, we will look at how consensus is achieved on the blockchain. And mining.
Thanks for reading.
Thank you to Niloo Reavaei