Volume 2023, Number April (2023), Pages 1-13
Ubiquity Symposium: Digital Economy: The Economics of the Digital Economy
Ted G. Lewis
The digital economy is characterized by so-called infinite shelf space, zero marginal cost, increasing returns, and friction-free transactions. These and other factors have made crypto currencies an attractive alternative to fiat currency. This essay focuses on the larger implications of cryptocurrency and its role in the economy of the digital economy. While cryptocurrencies appear to be ideal for the digital era, they also have some serious limitations such as vulnerabilities to selfish mining and lack of consumer protections.
The rise of products based on bits versus atoms (software, mainly), use of computers to process money and services in the form of information, ease of buying and selling, and rapid delivery of atoms, is sometimes called the "digital economy." What's new is the use of computers to communicate, inventory, sign, authenticate, and pay, etc. But the economy of the digital economy is something deeper. It is (at least) the following:
- Infinite shelf space. The ability to make an unbounded number of copies of a video, application software, digital book, or cryptocurrency virtual "coin."
- Zero marginal cost. The cost of one additional copy of the above tends toward zero as more copies are made, thus lowering the cost of products.
- Increasing returns. As the abundance of a product increases, the retail value of the product also increases rather than decreases.
- Friction-free transactions. As a byproduct of the above, and because consumers demand it, transactions are made as easy as pushing a button.
In the following essay, I focus on the larger implications of cryptocurrency and its role in the economy of the digital economy. I claim properties of cryptocurrencies such as Bitcoin and Ethereum are problematic for the digital economy. While cryptocurrencies appear to be ideal for the digital era, they also have some serious limitations per the list, above.
Generally speaking, the consequences of the digital economy are changes in social-economic behavior that reach beyond computerization and lightspeed communications. It changes the rules of economics. While Keynesian rules may still prevail, the digital economy exhibits some aspects of Say's Law of "supply creates its own demand," as John Maynard Keynes expressed it.1 "If you build it, they will come" ignores the law of supply and demand.
Examples of the "supply stimulates demand" are abundant in today's hi-tech marketplace. The iPhone created a market for a communication device without an existing market. There was no market for a consumer-based GPS navigation system before they began to appear, and Elon Musk had no idea of the TAM—total available market—for electric cars prior to the first Tesla car. Bitcoin began to proliferate because of a disgruntled innovator rather than the existence of a well-defined market. Nobody knew they wanted Bitcoin until it existed.
The question is, "Does the introduction of cryptocurrencies without a prior TAM follow the same path?" That is, does digital money automatically follow from the rise of a digital economy? It would seem so, but I argue cryptocurrencies lack some important characteristics of a replacement for money in the digital economy. They still have one foot in the traditional non-digital economy that disqualifies them as being entirely part of the digital economy. If cryptocurrencies really are fit for the digital economy, they must adjust to the prevailing characteristics of the digital economy. Cryptocurrencies must adapt.
Economics and Biology
Georgy Gause (1910–1986) was a Soviet scientist who first observed the fight for survival between two species of Paramecium—P.aurelia and P.caudatum. When given equal amounts of water and food, and under identical conditions, Gause observed only one would survive over time. Eventually, one species gained a slight competitive edge over the other, which increased slowly over time, until one crowds out the other.
Garrett Hardin, the famous ecologist called this the competitive exclusion principle, because, given identical and constant conditions, two competitors in the same space will eventually narrow down to one . One will dominate the other. Hardin illustrates this with a simple compound interest thought experiment. Suppose two investors invest the same amount of money, say $1, in two separate accounts, but at different interest rates. One receives 2.00% and the other 2.01% annual return. A simple calculation shows the combined accounts reach a total of $2 million after 696 years, with one achieving 48.3% of the total and the other achieving 51.7%. If this continues for a very long time, the stronger species will achieve 99.9% versus 0.1% of the total. While the competitive exclusion principle may be slow to develop, it leads to dominance, nonetheless.
Gause's competitive exclusion principle illustrates the "winner take all" effect of the digital economy. Sometimes called the "network effect" and sometimes called "increasing returns," the effect has the same outcome—formation of a monopoly, or at least a duopoly. This effect has been known since the monopolistic rise of AT&T from 1913 to 1996, so why is it more important now? The answer is the digital economy grows faster and sharper (in the sense of monopoly formation) than monopolies in previous eras, mainly because products based on bits rather than atoms exhibit extremes of "infinite shelf space, and zero marginal cost." As products become more virtual, they also become more likely to dominate as Gause's law predicts. This is best illustrated by the rise of Bitcoin and its many competitors. According to Gause, one of the many cryptocurrencies in existence today will dominate the digital economy by gaining dominant market share. Others, including fiat currencies backed by governments, will decline, or vanish as cryptocurrencies take over. Or will the competitive exclusion principle fail in this case?
To Infinity and Beyond
The financial collapse of 2008–2009 was traumatic for many people born after WWII. They had never lived through economic hard times like the 1970s or the disastrous Great Depression. So, when the U.S. stock market bottomed out in the spring of 2009, many people lost confidence in "the system." In particular, they lost confidence in the banking system, which was largely blamed.
One of these critics was Hal Finney (1956–2014), the first employee of Phil Zimmerman's (1954) PGP Company.2 Finney was deeply involved in the NSA challenge to PGP from 1992 to 1996, when the government ceased its investigation. He was also a defender of privacy and a critic of "the system" that failed miserably in 2008–2009.
In Finney's mind cryptographic technology "made Big Brother obsolete" . He worried about governments and corporations spying on people, which made him ideal for Zimmerman's new company. He became fascinated by the concept of digital money—money that could not be tracked by banks or governments. This led him to become involved in a number of experiments with proof-of-work (PoW) algorithms—one of the foundation technologies of what would become Bitcoin. His PoW algorithm took the Diffie-Hellman-Merkle and RSA ideas of public-private key exchange a step ahead, increasing security even further, and shielding financial transactions from prying government eyes. Finney purchased the first bitcoin offered in 2009, which led some to believe he was the mysterious Satoshi Nakamoto.
Unfortunately, Finney died at an early age and was cryo-preserved by the Alcor Life Extension Foundation. Max More, CEO and President of Alcor, said upon Finney's demise, "I look forward to speaking to you again sometime in the future and to throwing a party in honor of your revival" . His PoW concept would live on, however, as the cornerstone of the Bitcoin blockchain algorithm.
The idea of a cryptocurrency—encrypted bits representing money—began to gain momentum following the PGP-NSA challenge. It gained even more momentum after the banking system failed in 2009. Nick Szabo, a cryptographer known for contributing another key innovation to Bitcoin and its descendants, invented bit gold. Although it was never implemented, bit gold incorporated two clever innovations: smart contracts and practical digital currency based on cryptography. A smart contract is simply a computer program that tells a computer what to do when certain contractual agreements have been satisfied. For example, a smart contract might specify an invoice be paid upon receipt of a product, or the title to property be transferred upon payment in full.
Szabo also had a PoW concept similar to Finney's. In the bit gold system, a public-private key assignment is made only after a difficult puzzle is solved. That is, solving a puzzle proves the validity of an online financial transaction, and gives a PoW. Users of bit gold had to earn the trust of the system by performing a difficult PoW algorithm.
Szabo also understood the importance of peer-to-peer (p2p) authentication versus central authorities. In a peer-to-peer system, data is copied to many nodes or users of the system to prevent fraud. There is no central authority and transactions are validated by majority vote, but only after every user has attempted to solve a puzzle or do PoW. Users have to earn the trust of all other users of the system. The virtue of peer-to-peer is that it takes power away from a central authority like a government or bank and distributes it to the users. "I was trying to mimic as closely as possible in cyberspace the security and trust characteristics of gold, and chief among those is that it doesn't depend on a trusted central authority," said Szabo.
One of the central problems of digital money is that it is stored as bits in a computer memory that can be easily copied. For example, a copy of a digital coin in a digital wallet remains there after the bits are transferred to someone else. How does a cryptocurrency system prevent the bits from being used again and again? This is the double-spend problem that Szabo and others were trying to solve as the financial crisis of 2008–2009 was in full swing. Assigning a value to bits that can be copied seems like money for nothing. How does it work?
In 2008 the mysterious Satoshi Nakamoto published a paper that proposed a cryptocurrency called Bitcoin, which had all of the characteristics of Finney's PoW and Szabo's public-private key distribution over a peer-to-peer network . Bitcoin became radically popular because it bypassed governments and banks, and it was secure. Nakamoto combined public-private key distribution, PoW, peer-to-peer voting, and a method of preventing double spending into one comprehensive algorithm that became known as Bitcoin.
Satoshi Nakamoto may have been Hal Finney or perhaps Szabo and Finney combined. We may never know for sure. Finney is deceased and Szabo denies he is anyone other than himself. Nakamoto may be several people who put together the pieces created by Finney and Szabo to create the wildly popular bitcoin, and even more innovative blockchain. He, she, or they declared in April 2011, "I have moved on to other things." Satoshi Nakamoto has not been heard of since. An article in The Economist says, "Mr. Nakamoto's disappearance is at least as brilliant as the technology he created in 2008."
In 2019 Craig Wright, an Australian businessman claimed to be Nakamoto, but by 2020 his claim was not substantiated. At the time of this writing, the real Nakamoto remains a mystery, while Bitcoin has become internationally famous.
Bitcoin is "money" in the form of bits protected by encryption and backed by a peer-to-peer network. It is called crypto, because the bits are secured by cryptographic methods similar to the public-private key exchange used in e-commerce. Bitcoins are mined by the peer-to-peer network as a byproduct of verification of transactions. But mining does not come free. Bitcoin miners get paid in Bitcoins for successfully verifying transactions and maintaining a list of transactions called a blockchain. The distributed blockchain contains all transactions since the beginning of "Bitcoin time."
But there is more. In his (or her) original paper, Nakamoto defines Bitcoin as more than digital money. Nakamoto says, "an electronic coin [is] a chain of digital signatures." This is an interesting definition because it claims money is more than a token—it is also wrapped up with the unique history of transactions on the token—how the token has been spent and transferred. In other words, the value of anything is defined in terms of transactions on that something as long as the transactions have not been tampered with and there is a complete record of all transactions—the blockchain.
Consider, for example, the title to property such as a house. The title itself has no intrinsic value—not even the atoms in the paper it is written on has any value. Rather, the title represents a certain property that is valuable or not, depending on previous transactions. It is a token. When property changes hands, a title company holds the title in escrow while a search is made to identify any liens on the property. If the property has changed hands a number of times, been mortgaged, or been involved in legal disputes, the title leaves a trail of transactions in its wake. This trail is called a chain, and while the title is an integral part of the chain, it is the title's historical record that matters. In the context of digital titles and electronic transactions, an electronic title is a chain of transactions authenticated by digital signatures.
Nakamoto's definition makes sense, especially if the title company is replaced by a computer system and the transactions are all electronic. A title, like a coin, is a collection of bits defining ownership and an historical record of all transactions on the title. The problem with digital money is that it can be double spent because the bits can be copied without destroying the original. Instead of destroying the bits representing money, why not simply record all of its transactions? The value of a Bitcoin becomes the net-net result of all transactions against it.
A bitcoin in an electronic wallet is a kind of digital certificate containing encrypted owner information. The certificate points to a blockchain shared across a p2p network. In fact, the address of the wallet containing the certificate is its hashcode ala the blockchain.
Bitcoins are based on customized public-private key transactions like any other public-private key exchange process. They are cashed-in using the owner's private key and purchased using a consumer's public key. To transfer a bitcoin to Alice, Bob signs it with his private key and uses Alice's public key and an electronic Bitcoin exchange to authorize Alice to transfer the bitcoin to her wallet. Alice adds the transferred bitcoin to her wallet, but the transaction and updated value remains on the blockchain to avoid the double-spend problem.
Competitive Exclusion Again
In place of banks and financial institutions regulated by governments, the Bitcoin system uses a public peer-to-peer (p2p) network for storing transactions, miners who get paid to prove the validity of bitcoins and bitcoin transactions, and consumer electronic wallets where bitcoin tokens are stored by their owners. The use of p2p networks for sharing information without a central authority traces back to Napster and Gnutella, late-1990s music sharing networks, where digitized music is stored on consumer's personal computers, and downloaded to other consumers from wherever the music is stored. Unfortunately, p2p networks are subject to the competitive exclusion principle .
The idea of cooperating p2p distributed systems goes back to the origins of computer networks, but perhaps the first scholarly study of the problem of a database spread across several computing nodes is due to Lamport et al. and the Byzantine General's Problem . In simple terms, the problem is to maintain a synchronized and secure database of transactions even though the records are distributed across more than one node of the p2p network.3
The Byzantine General's Problem is complicated due to the potential unreliability of transactions (fraud), the lack of a central clock for processing transactions in order of arrival, and the possibility of tampering. How do we know which General is telling the truth and which one is lying?
P2p networks avoid a central command and control structure by spreading copies of the chain of transactions across many machines. Nakamoto was primarily driven by the desire to eliminate the intermediary—banks, governments, escrow companies, etc. Intermediaries cannot be trusted, they add cost, and they can reverse transactions. According to Nakamoto, "What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party." Nakamoto apparently borrowed Finney's PoW idea and combined it with the Napster p2p idea in a textbook example of recombinant innovation. But replacing trusted third parties raises a new set of questions:
- Can trust be distributed?
- Can transactions be made tamper-proof?
- Can person-to-person exchanges avoid double spending?
Nakamoto proposed a p2p network of ledgers called nodes, as a replacement for intermediaries, a public-private key hash code to prevent tampering, and a clever PoW algorithm and confirmation step to prevent double spending. A hash code is any code that scrambles its input like a random number generator. In addition, the random number generator must produce a hash that is always a certain length regardless of the length of the input. Finding a hash that is less than a certain fixed value is called PoW and is key to understanding how bitcoins are mined. Mining is the process of creating new bitcoins while at the same time limiting the number of coins in the world to 21 million.
The blockchain is a ratchet because it links the contents of block #n-1 and its hash code with the next block, #n, which in turn does the same to block #n and stores its hash in block #n+1, etc. A change in any block requires recalculating the hashes of the entire chain over again. This is the clever part of Bitcoin and also its potential downfall. Recalculation takes time to perform thus fending off fraud, but it also slows down transactions. Bitcoin takes approximately 10 minutes to clear, which is far too slow for transactions on a massive scale. In addition, PoW consumes approximately 700 kWh of energy, compared with competitors like Ethereum, which consumes 60 kWh of energy per blockchain operation. The energy consumed by cryptocurrencies like Ethereum and Bitcoin are major drawbacks of scaling transactions in the digital economy.
Blockchain processing is very slow and energy intensive. It is estimated that upwards of 5% of all electric power is dedicated to Bitcoin mining because of PoW . The time it takes to do PoW and energy consumption concerns have slowed the growth of Bitcoin and inspired alternatives. As of 2020 there were hundreds of cryptocurrencies using different approaches to overcome the limitation of Bitcoin. For example, Ethereum uses Proof-of-Stake (PoS) instead of PoW to validate transactions. PoS still takes one second and involves a certain fraction of peers—each of which consumes power and time. But Ethereum is more scalable, which means it is more likely to take advantage of the competitive exclusion principle to dominate in the long run.
There are other problems with Bitcoin. Ittay Eyal and Emin Gün Sirer of Cornell University showed how to defraud the blockchain through selfish mining . Selfish miners form a conspiracy by sharing the rewards of successful PoW. They all work on the PoW and share the reward equally among the members of the conspiracy pool. Initially intended to smooth out the uneven time delays between rewards, this approach multiplies the power of miners by the number of conspirators.
Eyal et al., say, "The key idea behind this strategy, called Selfish Mining, is for a pool to keep its discovered blocks private, thereby intentionally forking the chain. The honest nodes continue to mine on the public chain, while the pool mines on its own private branch. If the pool discovers more blocks, it develops a longer lead on the public chain, and continues to keep these new blocks private. When the public branch approaches the pool's private branch in length, the selfish miners reveal blocks from their private chain to the public." And the longest (fraudulent) fork is the winner.
The selfish minor conspiracy is a kind of feedback mechanism—it incentivizes honest miners to join the conspiracy. As more miners join, more minors are attracted and want to join. This preferential attachment eventually tips the computational power in favor of the selfish miners. The p2p network collapses because the conspirators become the majority.
Continuing with Eyal et al., "We show that, above a certain threshold size, the revenue of a selfish pool rises super linearly with pool size above its revenue with the honest strategy. Once a selfish mining pool reaches the threshold, rational miners will preferentially join selfish miners to reap the higher revenues compared to other pools. Such a selfish mining pool can quickly grow towards a majority. If the pool tips the majority threshold, it can switch to a modified protocol that ignores blocks generated outside the pool, to become the only creator of blocks and reap all the mining revenue. A majority pool wishing to remain covert may remain a benign monopolist, accepting blocks from third-parties on occasion to provide the illusion of decentralization, while retaining the ability to reap full revenue when needed, as well as the ability to launch double-expenditure attacks against merchants. Either way, the decentralized nature of the currency will have collapsed, and a single entity, the selfish pool manager, will control the system." This is Gause's competitive exclusion principle in action.
To be fair, Ethereum has an answer to this selfish pool manager problem. It uses the conspiracy to its advantage because a majority of stakeholders validate transactions. To make sure they don't cheat, the majority is selected at random from the set of stakeholders each time a block is added to the chain. Dogecoin goes even further. It selects one random stakeholder every time but allows all others to check the work of the chosen one.
Governments must respond to the challenge presented by cryptocurrencies because after all, they are the ones that lose control if crypto becomes dominant. Countries like China recognize the threat, but countries like El Salvador see crypto as an opportunity. "Virtual currency-related business activities are illegal financial activities," the People's Bank of China said in 2021, warning it "seriously endangers the safety of people's assets." More likely, bitcoin endangers the value of the Yuan.
El Salvador plans to build a Bitcoin city at the base of a volcano, with the cryptocurrency used to fund the project, its president announced in 2021. The volcano metaphor may be appropriate as bitcoin is prone to eruptions and periods of calm. This represents an opportunity for El Salvador to stabilize its currency, and in doing so, its small economy (estimated at $26 billion).
What is at stake is the control of a country's currency. For countries like the U.S., Germany, and China, the threat is existential. For countries like El Salvador the threat is an opportunity with little at risk because their currency is insignificant relative to the global economy.
The total market cap of cryptocurrencies as of 2022, exceeded $3 trillion (about the same as Apple Inc.) and is rising, compared to the US GDP of $22 trillion. It is notable that the value of crypto is relative to the dollar, which is the largest fiat currency in the world. How else might crypto be valued?
Will Gause's competitive exclusion principle propel crypto to dominance? Only time will tell.
Does Bitcoin/Blockchain Equal the Digital Economy?
Returning to the four signatures, it is possible to determine if cryptocurrencies match the socio-economic realities of an economy based on digital economics:
- Infinite shelf space. Bitcoin and Ethereum are bounded. Bitcoin is limited to a maximum of 21 million coins, and Ethereum is limited to a certain increase per year, because of fear of inflation just like government-backed currency. In fact, some people believe Bitcoin was limited by 21 million coins because at the time Satoshi Nakamoto invented it, the total value of fiat currencies was $21 trillion. Since there are 1,000 Satoshis per bitcoin, supposedly Nakamoto equated 21 trillion Satoshis with 21 trillion dollars outstanding at the time. So, cryptocurrencies do not avoid the problem of governments printing/inflating money as Nakamoto promised. Bitcoin and Ethereum are bound by atoms just as much as gold or the U.S. dollar. (The value of a bitcoin is whatever people will pay for it).
- Zero marginal cost. This is definitely not true of cryptocurrencies because the cost of producing a cryptocurrency coin is going up, not down. This is due to the use of miners that must get paid, and the energy they consume. Cryptocurrencies require expensive computing and communicating equipment whereas a credit card made of atoms is free.
- Increasing returns. If too many bitcoins are produced too fast, they decrease in value just like the dollar. In fact, Bitcoin has a history of wild fluctuations. Inflation sets in, or world events intervene—just like fiat currency. If products traded in bitcoin alone, perhaps the demand for bitcoin would increase with the number of bitcoins. But bitcoin can be exchanged for dollars and the reverse, so there is no need for them, other than fear of government mishandling of fiat currencies.
- Friction-free transactions. Cryptocurrencies generally fail this test because transaction processing is too slow, too costly, and the consumer experience is poor. One needs a digital wallet, a password, and a safe place to store the physical device containing the cryptocurrency to participate. Compared to an encrypted credit card or Apple Pay or Google Pay near-field communication device, cryptocurrency is anti-friction-free.
Where does the competitive exclusion principle fit in? Coinbase Global, a company that makes a market in cryptocurrencies, is the leading cryptocurrency exchange platform and is rapidly becoming the dominant exchange with 56 million users and 11% market share . While it may not dominate forever, Coinbase is leveraging its advantage—just as Gause's competitive exclusion principle predicts. But the market cap of all cryptocurrencies is by far less than fiat currencies. It remains to be seen if they will benefit from the exclusion principle. So far, they have not.
Lewis, T. G., The Friction-Free Economy. HarperCollins, 1997.
 Hardin, G. The Competitive Exclusion Principle. Science 131, 3409 (1960), 1292–7.
 Popper, N. Hal Finney, Cryptographer and Bitcoin Pioneer, Dies at 58. The New York Times. August 30, 2014.
 Nakamoto, S. Bitcoin: A Peer-to-Peer Electronic Cash System. October 31, 2008.
 Lewis, T. G. P2P Networks are Inherently Unstable. Ubiquity 2018, June (2018), 1–10. https://doi.org/10.1145/3223880
 Lamport, L., Shostak, R., and Pease, M. The Byzantine Generals Problem. ACM Transactions on Programming Languages and Systems 4, 3 (1982), 382–401.
 Stoll, C., Klaasen, L., and Gallersdorfer, U. The Carbon Footprint of Bitcoin. Joule 3, 7 (2019), 1647–1661.
 Eyal, I., and Sirer, E. G. Majority is not enough: Bitcoin mining is vulnerable. arXiv. 2013.
 Dean, B. Coinbase Usage and Trading Statistics (2022). Backlinko. Updated April 15, 2021.
Ted G. Lewis is the 2021 Oregon State Hall of Famer, author, and computer scientist with expertise in applied complexity theory, homeland security, infrastructure systems, and computer security. He has served in both government, industry, and academe over a long career, including, Executive Director and Professor of Computer Science, Center for Homeland Defense and Security, Naval Postgraduate School, Monterey, CA. 93943 CA., Senior Vice President of Eastman Kodak, President and CEO of DaimlerChrysler Research and Technology, North America, Inc., and Professor of Computer Science at Oregon State University, Corvallis, OR. In addition, he has served as the Editor-in-Chief of a number of periodicals: IEEE Computer Magazine, IEEE Software Magazine, as a member of the IEEE Computer Society Board of Governors and is currently Advisory Board Member of ACM Ubiquity and Cosmos+Taxis Journal (The Sociology of Hayek). He has published more than 35 books and over 100 journal and periodical publication, most recently including The Signal: The History of Signal Processing and How We Communicate, Book of Extremes: The Complexity of Everyday Things, Bak's Sand Pile: Strategies for a Catastrophic World, Network Science: Theory and Practice, and Critical Infrastructure Protection in Homeland Security: Defending a Networked Nation. Lewis has authored or co-authored numerous scholarly articles in cross-disciplinary journals such as Cognitive Systems Research, Homeland Security Affairs Journal, Journal of Risk Finance, Journal of Information Warfare, and IEEE Parallel & Distributed Technology. Lewis resides with his wife and dogs, in Monterey, California.
1In classical economics, Say's law, or the law of markets, is the claim that the production of a product creates demand for another product by providing something of value that can be exchanged for that other product. So, production is the source of demand.
2Philip R. Zimmermann is the creator of Pretty Good Privacy (PGP). For that, he was the target of a three-year criminal investigation, because the government held that U.S. export restrictions for cryptographic software were violated when PGP spread all around the world following its 1991 publication as freeware. Despite the lack of funding, the lack of any paid staff, the lack of a company to stand behind it, and despite government persecution, PGP nonetheless became the most widely used email encryption software in the world. After the government dropped its case in early 1996, Zimmermann founded PGP Inc.
3Wikipedia says the Byzantine General's problem is "a situation in which, in order to avoid catastrophic failure of the system, then system's actors must agree on a concerted strategy, but some of the actors are unreliable."
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