• Jun Aoyagi

Industry Competition: The Blockchain versus Centralized Authority

The blockchain is not just for Bitcoin and cryptocurrencies, but various goods and assets are traded through the blockchain system. For example, we can purchase a bottle of wine by using EY’s wine blockchain built on Ethereum. Its primary purpose is to keep track of the quality of wine that is hard to verify for consumers. Indeed, the literature (Malinova and Park, 2017; Aoyagi and Adachi, 2018; Cong and He, 2019) suggests that the blockchain mitigates information frictions between traders, and that is why we use it for trade.

However, purchasing a bottle of wine at a local wine cellar is always an available outside option. Even in Bitcoin trading, transactions at a centralized exchange platform (e.g., coinbase.com) is not “on-chain” because it internalizes all transactions, and only the net amount is recorded on the blockchain. Even without the blockchain, a manager at a wine cellar or an exchange may keep track of information to guarantee the quality of goods (or validity of your trading partner), thereby mitigating information asymmetry. So, the existing trading methods (e.g., banks, auction houses, credit cards, and security brokers) provide us with economically similar service to the blockchain, and this brings about industry competition. Namely, the existing industries must confront with the penetration of the blockchain-based system and modify their strategy appropriately to keep their share and benefit.

My recent article formalizes the competition between a traditional platform run by a centralized record-keeper, called the broker, versus a blockchain-based platform. Both provide trading service to consumers and determine how intensively mitigate traders’ information friction by setting “monitoring intensity.” Importantly, the blockchain does not involve a centralized decision maker, and the traditional theory of competition (such as Cournot, 1838; Bertrand, 1883) may no longer give a pertinent answer. Instead, the blockchain is based on the distributed ledger system, and competitive miners determine the blockchain’s best-response function.

For the broker, the key is the consumers’ price-quality tradeoff, e.g., some people are eager to resolve quality uncertainty by purchasing expensive “reserve” wine at a prestigious wine cellar, while others purchase cheap wine at a local discount store. If a platform increases monitoring intensity, it improves the quality of traded goods, while the general equilibrium price of goods also increases. Consumers with high priority on minimizing the pecuniary cost will migrate to other low-quality trading methods, while those who with strong preference for the quality stay in the broker's platform, appreciating the reduction in quality uncertainty.

Then, the broker faces a tradeoff when reducing information friction. It causes outflow of consumers from brokerage service to the other trading method (i.e., the blockchain) but remaining “loyal” customers evaluate the brokerage service more. The broker can extract high rent from each consumer, but the number of serving consumers declines, making the aggregate rent non-monotonic. Which one of these effects will be dominant? It depends on the blockchain’s strategy.

When the blockchain provides high intensity, the broker voluntarily sets the monitoring intensity lower than the blockchain’s one. Setting higher intensity than the blockchain does not payout, because the blockchain with lower, yet similar intensity would be an “easy-to-switch” outside option for consumers, and they do not evaluate the high-quality brokerage service. Instead, the broker is better off by leaving a certain level of information frictions among consumers and making the equilibrium goods’ price low so that she extracts rent from a large number of consumers with a weak preference for the quality.

The blockchain’s superiority arises since the above reasoning does not work to pin down the blockchain’s strategy. It is competitively determined by the blockchain miners rather than the centralized decision maker. Specifically, even though taking low monitoring intensity is optimal for the blockchain as a platform, it is not achieved as the result of miners’ competition. Even when the broker offers low monitoring intensity, the miners’ competition derives a sufficiently high intensity as the best response whenever the participation cost of miners is not high, or the underlying information asymmetry is not severe. Thus, the advent of the blockchain triggers industry competition, and it is intrinsically asymmetric. This gives rise to the possibility that the blockchain becomes superior to the traditional centralized trading method, answering ongoing questions, such as “Why do we need the blockchain in addition to the existing intermediaries?”

Jun Aoyagi - Department of Economics, UC Berkeley

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