For such token network effects to work, tokenholders have to have a reasonable expectation that their stake in the network could accrue value. Thus, blockchain protocols may want to take fees earlier than their more traditional counterparts. And quasi-conversely, shared ownership — via governance — can provide a buffer against the extractively high fees we see in web2 businesses.
There may be legal and even operational reasons to turn on the fee switch, but from an economic perspective, the logic is straightforward: A protocol should turn on a fee switch when its network is strong enough that the fee will not divert so many users to other protocols (or out of the market entirely) as to substantially reduce the value of the network.
Easy enough to say, but what are some reasons this could be true? When can a protocol lose participants but not lose value? If the protocol provides a useful service compounded by network effects and embeddedness, no competitor with the same cost structure will be able to provide that same service at a lower cost in equilibrium. Put simply: When a protocol is both useful and widely used, others facing the same cost structure simply can’t offer the same product or service more cheaply while still being sustainable.
Protocols can also reason through a price experiment: How many users will raising fees drive away? In industrial organization analysis, this is known as the diversion ratio. To get a back-of-the envelope idea of your diversion ratio, you might be able to look for “natural experiments” induced by exogenous shocks to the effective cost that users pay for your service — that is, when something outside your control makes your service more expensive to users. Take for example changes in gas fees: How much does demand for your app fall when gas fees spike? Similarly, protocols may be able to estimate the diversion ratio from fluctuations in token price. This analysis is only directional — and it’s important to take sensitivities into account — but it is certainly better than nothing, or guessing, or never taking fees at all.
Finally (or perhaps primarily), you can also reason about price from first principles: How much value are people getting from the service? For an extreme example: If a customer is getting $1m in value, then the protocol can probably afford to add a $5 fee.
***
If you follow the analysis here and run some experiments, you can determine when it’s the right time to flip the switch. And for a quick mnemonic for the logic, here’s the essence in haiku:
Value-add achieved,
complementing network strength,
the fee switch turns on.
***
Acknowledgments: Many thanks to Tim Sullivan, Sonal Chokshi, Robert Hackett, Tim Roughgarden, Kate Dellolio, Miles Jennings, Eddy Lazzarin, Ross Shuel, Shai Bernstein, Michael Crystal, and Liang Wu.
***
Scott Duke Kominers is the Sarofim-Rock Professor of Business Administration at Harvard Business School, a Faculty Affiliate of the Harvard Department of Economics, and a Research Partner at a16z crypto. He also advises a number of companies on web3 strategy, as well as marketplace and incentive design; for further disclosures, see his website. He’s also the coauthor of The Everything Token: How NFTs and Web3 Will Transform the Way We Buy, Sell, and Create.
***
The views expressed here are those of the individual AH Capital Management, L.L.C. (“a16z”) personnel quoted and are not the views of a16z or its affiliates. Certain information contained in here has been obtained from third-party sources, including from portfolio companies of funds managed by a16z. While taken from sources believed to be reliable, a16z has not independently verified such information and makes no representations about the current or enduring accuracy of the information or its appropriateness for a given situation. In addition, this content may include third-party advertisements; a16z has not reviewed such advertisements and does not endorse any advertising content contained therein.
This content is provided for informational purposes only, and should not be relied upon as legal, business, investment, or tax advice. You should consult your own advisers as to those matters. References to any securities or digital assets are for illustrative purposes only, and do not constitute an investment recommendation or offer to provide investment advisory services. Furthermore, this content is not directed at nor intended for use by any investors or prospective investors, and may not under any circumstances be relied upon when making a decision to invest in any fund managed by a16z. (An offering to invest in an a16z fund will be made only by the private placement memorandum, subscription agreement, and other relevant documentation of any such fund and should be read in their entirety.) Any investments or portfolio companies mentioned, referred to, or described are not representative of all investments in vehicles managed by a16z, and there can be no assurance that the investments will be profitable or that other investments made in the future will have similar characteristics or results. A list of investments made by funds managed by Andreessen Horowitz (excluding investments for which the issuer has not provided permission for a16z to disclose publicly as well as unannounced investments in publicly traded digital assets) is available at https://a16z.com/investments/.
The content speaks only as of the date indicated. Any projections, estimates, forecasts, targets, prospects, and/or opinions expressed in these materials are subject to change without notice and may differ or be contrary to opinions expressed by others. Please see https://a16z.com/disclosures for additional important information.
