Welcome back to your 3rd lesson in Web 3! 

In the last few pieces we covered decentralization and blockchain technology. Both are philosophically and technically fundamental to understanding Web 3, and both play key roles in our next lesson: Tokenomics. 

Tokenomics refers to digital economies, enabled by the use of a token such as a cryptocurrency. Tokenomics focuses on the study, design and implementation of economics in the crypto space. We’ll give more details later in this post, but that’s the overarching point. 

In this post we’ll cover the what/why/how of Tokenomics and its relation to standard economics. As we’ve seen lately, more and more people are starting to invest in crypto, yet the designed economic principles powering these crypto projects is lesser known. We’ll spare you the technical details, but it’s worth knowing the overall gist of how token economies help power Web 3. 

Basic Economics

To understand Tokenomics, one has to understand basic, fundamental principles of economics. Don’t worry. We won’t bore you with graphs, charts or mathematical functions. We’re only covering the basics. And for this case, we’re concerned with microeconomics, which is arguably the only subject in economics worth studying. 

To keep things short, we’ll briefly discuss four main principles in economics: supply/demand, scarcity, costs/benefits, and incentives. These basic concepts give insight into how and why humans make certain decisions in an economy. 

Supply and Demand: 

• The price/quantity of a given good is determined by the quantity (the supply) of that good, and the willingness to buy (the demand) of that good. 

• Demand: when the price of a good/service is high, demand is low. When the price of a good/service is low, demand is high. 

• Supply: the higher the price of a good/service, the supply increases. When the price of a good/service is low, the supply is low too. 

Scarcity:

• When the demand for a specific resource exceeds the supply that is available 

• People then decide how to allocate resources to satisfy their basic needs 

Costs and Benefits 

• Costs and benefits point to rational expectations and choices 

• People make decisions that have greater benefits at a low cost 

Incentives 

• The reasons people work toward specific outcomes 

Economics vs Tokenomics 

Tokenomics takes economic principles (incentives, scarcity, supply, demand, etc) and applies them to crypto projects being built on various blockchains. But in the Web 3 space, the applications of these principles take a different form. Let’s take a look. 

ICO vs IPO

IPO stands for initial public offering. When companies first form, all of the equity and shareholders are private. Sometime down the line, companies will require more investing. So they go public and allow regular people to invest in the company and become shareholders.  

Crypto projects have the same process, except it’s with cryptocurrencies. ICO stands for initial coin offering. Similar to IPOs, crypto companies announce ICOs when they need to fundraise to launch a new coin, app or software. Crypto companies allow investors to invest in their coin, in hopes that the coin will rise in value.  

Physical Assets vs Digital Assets

Physical assets are real items of value that generate revenue for companies. For example, if you owned a restaurant, physical assets would include: chairs, refrigerator, tables, food, etc. Without these, a restaurant would be destined for failure. 

Digital assets are the same, except in digital format. Any kind of digital file, such as images, video, audio, PDF, graphics, spreadsheets, etc, are considered digital assets because they hold valuable information and content that generates value. 

Financial Assets vs Crypto Assets 

Investing principles are similar in crypto and in traditional investing. Stocks, bonds, ETFs, IRAs, index funds, etc, are all common ways for people to invest and generate wealth. But now, with crypto slowly emerging, people are gradually transferring their hard earned dollars into Bitcoin, Ethereum and other cryptocurrencies.  

Stock market specifics are out of scope for this piece but for sake of comparison let’s compare traditional financial structures to the next generation’s structure of crypto.

Investors dig more into a company, research its team, and gain insight on its product or service. Many factors play a role in evaluating investment opportunities. Due diligence and research help minimize the chance that investment capital doesn’t go to waste.  

Investing in crypto is very similar. Crypto companies have an objective, a blockchain and a coin to go with it. Their coins have marketcaps, coin prices (similar to share prices) and charts that give a history of its activity. With on chain activity, users can use websites like Blockchain Explorer to see a history of all transactions on a specific blockchain. Blockchain’s transparency and open source protocol allows users to get more information to make better investing decisions. 

Cryptocurrencies: Coins and Tokens 

In the mainstream, the terms coin and token are used interchangeably. At first glance, this may not seem a big deal. But a distinction must be made in order to fully understand cryptocurrencies. Whether you’re a newbie deepening your research, or a potential investor looking to diversify your portfolio, understanding the difference between tokens and coins will help you learn and make better decisions.  

Before reading further, note that both tokens and coins are forms of crypto tokens but are used in different instances. Tokens can be used for functions other than monetary uses such as protocol governance or video game unlockables. As you’ll find out by the end of this piece, coins and tokens offer unique abilities when it comes to governance and finance.

Coins

Cryptocurrency coins have native, independent blockchains (Layer 1). Coins are primarily utilized for payments or transactions that are exclusive to its native blockchain. The best example is Bitcoin. Bitcoin has its own independent blockchain, where it conducts payments and transactions with its native cryptocurrency: bitcoin. 

Another example is Ethereum, which has its own native coin Ether (ETH). Users on Ethereum can buy, sell or store ETH using Ethereum’s blockchain. Virtually every crypto project has its own coin that lets the network run. 

Coins are also mined. Miners from all over spend exorbitant amounts of money to mine bitcoin, yet there is a limited supply of how many can be mined. The projected limited supply of bitcoin is 21 million. Currently, 18 million or so have been mined already. Since there’s a limited supply, the demand for bitcoin soars. Especially as more of the world starts to see its value. 

Tokens 

Cryptocurrency tokens are units of value that are built on top of existing blockchain protocols (Layer 2) to foster innovation, incentives, and interaction between users in the network. For example, Ethereum has a token called ERC-20, which powers DApps on Ethereum’s blockchain. While tokens can be used for payments, they have a wider purpose and functionality, like security and utility: 

• Security tokens: security tokens represent shares in a company, except its digital and on the blockchain 

• Asset tokens: tokens that are backed by real world assets like gold or real estate 

• Stablecoins: tokens that represent stable currencies, such as USD or Euro 

• Non-fungible tokens (NFTs): unique items such as art, digital collectibles, video game items, virtual real estate etc 

Tokenomics and Crypto Network Traits

The study of Tokenomics aligns with the traits of crypto networks. These traits include distribution, monetary policy, staking, and governance. Each trait implements Tokenomics into a valid process that empowers every user in the network. 

Distribution 

• Distribution allows everyone in the network to participate and have access to tokens. 
• Prevents a specific person(s) from having access to all tokens in a network. 

Monetary Policy

• Monetary policies prevent inflation and bring stability to tokens and other cryptocurrencies.
• Stabilizing the price of tokens brings an equilibrium and acts as a hedge against the volatility of the crypto market. 
• Stablecoins are tokens that are pegged fiat currencies such as the dollar, meaning that the coin and fiat currency stay neck-and-neck in value.

Staking 

• Staking allows users with an amount of tokens to validate nodes and be a part of the consensus mechanism. 
• Staking prevents “sybil” attacks, which is when a user in a network pretends to multiple users at once (like creating multiple accounts on social media).  

Governance

• Users in networks have decision-making power and voting rights, granted by governance tokens.
• Governance tokens are awarded as ways to vote and participate in a network.

New kinds of incentives are created through tokenomics. With these incentives, users are equipped with new abilities and contribute to a digital economy. Distribution of tokens, monetary policy on inflation, staking, and governance equip users to interact and thrive in a digital, financial ecosystem. And compared to traditional economics, tokenomics empowers its users and provides them with permissionless leverage. 

Looking Onward 

Tokenomics is a nascent study that still requires more exploration. Since crypto is a brand new industry and an innovative form of technology, tokenomics is evolving every day. But hopefully you get a better idea of how economic principles translate to tokenomics. The principles are the same, but just in a new space. 

Lookout for our next piece where we uncover Web 1 and Web 2! Until then, keep seeking.