Framing the Problem: Scalability and Economics
Framing the Problem: Scalability and Economics
“If I had an hour to solve a problem I'd spend 55 minutes thinking about the problem and five minutes thinking about solutions.” ― Albert Einstein
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Oftentimes, our solutions are derived based on how we perceive and understand the problem.
In last week’s editorial on Linera Protocol, we discussed the Web3 scalability -the problem statement and the solution developed by Linera - from a technical/ engineering point of view.
Since then, we have received a few follow-up questions as to why new blockchain designs matter: Higher transactions per second? Lower network latency? How does that impact end users?
Web3 scalability is as much an engineering and technical problem as it is an economics and market design problem.
Before we get started in this section, here is a recommended technical overview of blockchains.
Market: What are we trading?
“Blockspace is the commodity that powers the heartbeats of all cryptocurrency networks” as mentioned in this article.
In a nutshell, in every blockchain, users, traders, and dApps compete to have their transactions included by validators/miners via gas fee. The higher the gas fee you are willing to pay, the more likely your transaction will be included in the next block, given that there is blockspace scarcity.
Naturally, this leads to deeper thinking around auction design to determine who wins the bidding process. (You can read more here)
Economic framing of the scalability problem
As you can see, because this is an auction market, there is the demand side (transactions competing to be included in the next block) and the supply side (validators and miners competing to process such blocks).
In the above chart, the price p or the equilibrium price is where the demand and supply sides agree on the transaction. Simply put, that becomes the gas fee (i.e., the price) you have to pay to be included in the next block.
As many would know, that price can get quite high, especially with new digital asset classes and new business models emerging (such as NFT airdrops).
For context, users spent $9.9 billion in transaction fees in 2021. Source
This brings us to explore and understand what scaling solutions mean in terms of supply and demand.
There are two popular contemporary directions in scaling blockchain: on-chain versus off-chain solutions.
Supply-side: On-chain solutions
“On-chain scaling refers to any direct modification made to a blockchain, like data sharding and execution sharding in the incoming version of Ethereum 2.0. Another type of on-chain scaling would be a sidechain with a two-way bridge to Ethereum, like Polygon.” Source
Put another way, on-chain scaling solutions can be thought of as increasing the supply of blockspace processing.
Various solutions as of late have been proposed and implemented, such as:
A more efficient consensus mechanism to reduce block (example) and paralellism to increase throughput (example)
Modularizing the architecture stack to improve throughput (Read more here)
In short, by increasing the supply, we can theoretically reduce the price paid and increase the quantity supplied to the market (throughput).
Demand-side: Off-chain solutions
“Off-chain scaling refers to any innovation outside of a blockchain, i.e., execution of transaction bytecode happens externally instead of on Ethereum. These solutions are called L2 because layer 2 works above layer 1 (Ethereum) to optimize and speed up processing. Arbitrum and Optimism Ethereum are two well-known examples of L2 scaling solutions.” (Source)
One way to think about off-chain solutions is that it reduces demand.
Take, for example, roll-ups; saving the transaction's final state or the Merkle root (example here) effectively compresses the data needed to be processed on-chain, thus reducing the need for blockspace.
Put simply, since the demand decreased, we are shifting the demand curve inward and can theoretically reduce the price.
Final Thoughts
To enable the next generation of web3 transactional activities and business models, scaling solutions and technical designs aren’t just an engineering endeavor but also an economic one.
As this article is a very simplistic understanding of blockspace market dynamics, further knowledge is needed to explore whether other economic concepts take hold, including superior goods, inferior goods, and veblen goods. Additionally, beyond supply and demand, it’d be interesting to see a sensitivity analysis similar to Laffer Curve and how base fees collected (EIP-1559, see below) can influence the overall transactional volume.
Also, the evolving dynamics between the demand side (i.e., hopes to pay a lower gas fee) and the supply side (i.e., hopes to charge a higher fee) players through the advancement of both on-chain and off-chain technologies will be interesting to watch.
Lastly, what’s really interesting about web3 infrastructure is that there are submarkets, such as the market between sequencers and verifiers with an optimistic roll-up. (See Paradigm’s article above)
Further learning
Tim Roughgarden: An Economic Analysis of EIP-1559; Q&A with Vitalik Buterin
Game Theory Applied to Mining Pools, Token Offering, Dao, and Consensus Protocols
AMA
Much thanks to Andrew and Adi from Goodwin, a premier law firm in the Bay Area, for joining us to talk about different financing structures and terms to understand and watch out for.
You may view the recording here. You can also read more here from A16z.
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