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Worldview of Bystack (II): The Island Effect in Blockchain

This article is translated from “Bystack世界观(二):区块链岛屿法则” written by Chang Jia, founder of Bytom, a Chinese star blockchain project aiming to connect the atomic world and the crypto world.

In fact, every technological revolution will eventually take the form of changing social organizations. In the 1990s, due to the Internet technology revolution, many people believed the Internet would break down the organizational structure of firms by allowing people to communicate and cooperate on a large and open network.

After that, firms, nevertheless, still exist.

As blockchain revolution is sweeping the world, some blockchain experts also have the same question like Coase, “will blockchain make firms disappear?”

In his paper The Nature of the Firm (1937), Ronald Coase asked “why do firms exist? why do people band together in one enterprise rather than work separately, each selling his services to the other in the arms-length marketplace? ”

Coase says the reason is transaction costs. This British economist argues that in the presence of these transaction costs, firms will get bigger as long as they benefit from getting something done in-house, without the transaction costs associated with outsourcing to negotiate, sign and execute contracts. The company will keep growing and shrinking until the “cost of solving something internally” equals the “cost of outsourcing it in the marketplace”

The lower the transaction costs become, the more efficient the market will be, and more small firms will come up. This is the wave of decentralization in blockchain thinking.

Michael Munger, an economist at Duke University, goes further and breaks down these transaction costs into three types: (1) cost of measure, how difficult it is to find and measure the value of an asset or the quality of a service; (2) cost of transfer, how difficult it is to reach agreement on contracts for goods, assets or services; (3) cost of trust, whether your counterparty is trustworthy.

Think about it. In the past, many firms had their own servers and developed their own mail systems, enterprise management systems and customer systems. Later, cloud computing came into being and enterprise services emerged. Cloud computing not only reduces the cost of measure – servers and bandwidth resources could be charged by seconds, but also reduces the cost of transfer since clients only need to purchase online instead of signing cumbersome contracts offline and physical delivery of servers is spared. The transaction cost of buying these services is much lower than that of developing and maintaining your own systems. As thus, cloud computing becomes popular, such enterprise services help shrunk corresponding business departments of demander companies.

Compared to the internet, blockchain technology has the following advantages in reducing transaction costs,

  1. Severability. The value of an asset can be measured precisely, and it can be split almost indefinitely into any economically viable unit. The problem with the cost of measure is solved.
  2. Fungibility. Blockchain can convert non-interchangeable atomic assets into interchangeable bit assets, which would greatly save the cost of transfer. Take smart contracts for automobile trading for example, suppose that Nick Szabo’s vision was realized, every car has a unique built-in asset ID and car sale and rental would be conducted via smart contract. In this context, no physical delivery is needed in the process of car trading or renting, the transfer of car ownership and use right would be completed after onchain signature is done. The problem with the cost of transfer is thus solved.
  3. Trustworthiness. Real onchain transactions are featured by self-proof, exclusivity and unidirectionality, among which unidirectionality is the most important. On the one hand, based on the competitive consensus of computing, traders can absolutely believe that the transaction behavior is irrevocable; on the other hand, after introducing coin days destroyed into credit evaluation, it can solve the problem of faking good ratings that is difficult to eliminate in Internet payment. We can trust every anonymous address, as long as the corresponding transaction and credit rating on the address is reliable. If an address is creditworthy, it is statistically a trusted counterparty. The last problem has also been solved.

So, will firms exist in the future?

There’re actually two types of firms. The first type sells goods, and the other sells services. For the former, due to the scale effect, the marginal cost of production decreases with the size of the company, while the transaction cost is on the contrary. If an agent can achieve the same sales performance, it is better to outsource sales to the agent, and if the logistics provider does better, why not directly cooperate with it in logistics. This will cause the company to shrink. The superposition effect of production cost and transaction cost will balance the size of the company at a certain point (Figure 1).

Figure 1

And for the second type of firms, such as advertising, design, consulting firms, their sales service is very difficult to standardize, unable to replicate, and has a variety of personalized customer demand. Every new project means the repeated labor input while reusable workload is almost zero, in this context, their expansion cannot bring service costs to decline, but may lead to additional management cost, that is, the service cost increases along with the scale of the firm. On the contrary, since transaction itself is a service, companies committed to reducing transaction costs in various industries will reduce the size of the companies they serve, but stimulate the expansion of their own size. Under this backdrop, transaction costs decrease with the size of the company. Similarly, the superposition effect of production cost and transaction cost will balance the size of the company at a certain point (Figure 2), a mirror relationship with the first type of company (Table 1).

Figure 2

Table 1

Therefore, the relationship Coase found between firm size and transaction costs are universal, but it has its limits. His empirical conclusions, drawn in 1933 from a study of traditional manufacturing companies such as Ford of the United States, in fact neglect two points.

First, there’s no distinction between production-oriented and service-oriented companies. In his era, companies like Google and Alibaba that provide services through Internet technologies have not emerged, so the relationship between service companies and transaction costs was not included in his study.

Second, there’s no distinction between internal and external perspectives. Sites like Alibaba Cloud, which solves the demand for cloud computing services, significantly reduce the transaction costs of this field. View from the demand side, it no longer needs to establish a dedicated server operation teams but only needs contracted services outside the firm, so from the internal perspective, of course, the size of the company is reduced. While from an external perspective, as the provider of the transaction, it will expand to a staggering scale due to the reduction of transaction costs.

A street interview is quite classical. It asked people to estimate the size of ByteDance (a Chinese internet giant), and almost everyone vastly underestimated its scale. Perhaps most people presume that internet companies do not need many people. That’s because they ignore the fact that such service companies striving to reduce transaction costs can grow savagely as the marginal cost of transactions decreases. Blockchain will obviously further strengthen that.

This can also be explained logically. In the blockchain sector, the marginal cost of trading is decreasing. It takes time to build up the credit of a new address, its credit grows along with the volume of trades grows. Credit is like ants’ pheromone, and the higher the credit is, the more ants (potential traders) will be attracted to this route and the marginal cost of transaction will correspondingly decrease. From the perspective of fees, the marginal cost of transactions is also decreasing, because the transaction fees on blockchain (miners’ fees) are not charged by amount, but by byte. In contrast, most transactions in reality are charged by amount. As a result, traders can package many small transactions (perhaps through the lightning network, side chains, or offchain channels) into one large transaction, which of course will significantly reduce the marginal cost of transaction.

Blockchain could significantly reduce transaction costs and give new meaning to “Coase question”. So I propose a bold conjecture – “blockchain island effect”: with the popularization of blockchain technology, traditional manufacturing companies will become smaller and service companies will get bigger (Figure 3).

Figure 3

Since traditional production-oriented companies are still behemoth in our time, service-oriented companies are relatively much smaller. As the pioneers of service companies, Alibaba and Tencent ranks 462 and 478 in the Fortune Global 500, if the traditional production companies are likened to large mammals in the ecological industry, then service companies in the Internet and blockchain sectors are like small mammals, the “blockchain island effect” then is almost the same with the island rule in biology, namely, large companies will become smaller and small companies get larger. It takes thousands of years to evolve into the island rule in biology realm, while the island rule in blockchain perhaps only takes a decade to be observed. It remains to be seen whether it will actually happen in the future.

The island rule or the island effect, also known as Foster’s rule, is an ecogeographical rule in evolutionary biology stating that members of a species get smaller or bigger depending on the resources available in the environment. 


    3 years ago BYTOM BLOCKCHAIN

    Worldview of Bystack (II): The Island Effect in Blockchain
    In fact, every technological revolution will eventually take the form of changing social organizations.