What is Cryptoeconomics? A Guide For Beginners

The term crypto-economy is misleading as implies a comparison to the economy as a whole. Know more in this beginners guide to cryptoeconomics

By Larissa Lopes
Updated on August 12, 2022
What is Cryptoeconomics? A Guide For Beginners

What is Cryptoeconomics? A guide for beginners. The term Cryptoeconomics is derived from two words: cryptography and economics. Unfortunately, people often ignore the “economics” part of the equation, which gives blockchain its distinct powers.

Blockchain is not the first time a decentralized peer-to-peer system has been used to transfer files. Pirate sites have used it for years; however, it was a failure in every sense of the word.

What is Cryptoeconomics?

The combination of incentives and cryptography to build systems, applications and networks are known as the Crypto-Economy. In other words, cryptoeconomics is applied cryptography considers economic incentives and economic theory. Cryptography is used in digital signatures and hash functions on blockchains.

Beginners Guide to Cryptoeconomics: What does this have to do with the economy in general?

The term cryptoeconomy is misleading as it implies a comparison to the economy as a whole. This is one reason why people like Parker ignore the word. Economics studies decision-making, so how individuals and groups respond to incentives.

The development of Bitcoin and also blockchain technology does not require the development of new theories about human choices because humans have not changed. Applying macroeconomic and microeconomic theory to cryptocurrency and token markets is not cryptoeconomics.

Mechanism design, a subject associated with recreation theory, has greater in no unusual place with cryptoeconomics. The game theory looks at a particular strategic interaction (a “game”) and tries to understand the optimal strategy for each player. And what would happen if both players adopted those strategies?

Cryptoeconomics, like engine design, is concerned with creating and designing systems. We use economic theory to construct “rules” or procedures that achieve a specific equilibrium outcome, just as we did in our auction example.

On the other hand, the methods used to establish economic incentives in cryptoeconomics are developed using cryptography and software, and the systems we design are almost invariably distributed or decentralized.

Beginners Guide to Cryptoeconomics: Purpose of Cryptoeconomics

Before the introduction of Bitcoin, widely assumed that establishing a peer-to-peer network capable of reaching consensus without significant vulnerabilities to attacks and failures was unattainable.

The Byzantine Generals Problem is a popular name for this problem. This logical problem shows how important it is to build consensus between different actors in a distributed system. However, some actors can be unreliable, so the problem’s premised on actors not reaching a consensus and the network not working as planned.

Satoshi Nakamoto solved this challenge by introducing an economic incentive to his peer-to-peer network with the introduction of Bitcoin. So, since then, decentralized networks have relied on cryptography to reach a consensus on the current state and history of the network.

Additionally, most networks have built-in financial incentives to encourage network participants to behave in certain ways. Moreover, this combination of cryptographic protocols and economic incentives creates a whole new ecosystem of durable, secure, decentralized networks.

What is the role of Crypto Economics in improving Bitcoin security?

Bitcoin’s security mechanism is based on the notion of majority rule. This means that a 51% attack, in which bad actors take control of most of the network’s computer capacity, can theoretically gain control of the blockchain.

In such a scenario, an attacker could prevent new transactions from receiving confirmations or roll back the transaction entirely. On the other hand, controlling so much hashing power would be prohibitively expensive, requiring larger hardware and lots of power.

And one of the reasons for Bitcoin’s success is the crypto economy. Satoshi Nakamoto used assumptions to support specific incentives for the various groups participating in the network. Moreover, the validity of these assumptions about how network participants respond to various economic stimuli is critical to system security assurance.

Without the robustness of cryptographic technology, there is no secure account unit to compensate miners. Furthermore, without miners, there is no way to verify the integrity of the transaction history of the distributed ledger unless verified by a trusted third party, nullifying one of Bitcoin’s key advantages.

The symbiotic relationship between miners and also the Bitcoin network promotes trust according to cryptoeconomic theory. However, this does not guarantee that the system will survive in the future.

Beginners Guide to Cryptoeconomics: Role of Cryptoeconomics in Bitcoin Mining

The Ethereum community came up with the term “Cryptoeconomics.” But was inspired by the economic incentives of the Bitcoin protocol. Bitcoin mining aims to make contributions to the network more profitable and attractive rather than attacking it.

With the emergence of Ethereum as the first successful general-purpose blockchain protocol. Economic incentives have become more widespread to secure a wide range of behavioral and informational consequences of decentralized systems.

Validated through the mining process, in which miners succeed in a block of transactions that pay for with bitcoin. This monetary incentive encourages miners to act honestly, making the network more reliable and secure.

Without the difficulty of cryptographic technology, there would be no secure unit of account to reward miners. Also, without miners, there is no way to verify the authenticity of a distributed ledger’s transaction history. Unless authenticated by a trusted third party, negating one of Bitcoin’s main advantages.

According to cryptoeconomic theories, the symbiotic interaction between miners and the Bitcoin network promotes trust. However, this does not guarantee that the system will continue to exist in the future.

Beginners Guide to Cryptoeconomics: How does Cryptoeconomics Improve Bitcoin Security?

Bitcoin’s security mechanism is based on the concept of majority rule. This means that her 51% attack, where malicious actors control most of the network’s computing power, could take control of the blockchain.

Cryptoeconomics is one of the reasons why Bitcoin is so successful. Satoshi Nakamoto hypothesized to support specific incentives for different groups participating in the network. Moreover, the accuracy of these assumptions about how network participants will respond to various economic stimuli is critical to ensuring the system’s security.

Bitcoin’s Proof-of-Work (PoW) method and transaction verification employ SHA-256 encryption. One of the main properties of the bitcoin protocol, the transaction blockchain, is responsible for its security.

Blockchain relies on many volunteers signing this cryptographic hash to authenticate transactions on the Bitcoin network. This method ensures that transactions are normally irreversible and the security of Bitcoin data is high.

Beginners Guide to Cryptoeconomics: Cryptoeconomic Application Project

We can layout packages that sit “on top” of a blockchain like Ethereum as soon as we clear up the central trouble of blockchain consensus. The underlying blockchain provides a currency unit for creating incentives and penalties. And a set of tools for creating conditional logic in the form of “smart contract code.”

You can also find cryptoeconomic design in the applications we create with these tools.

For example, cryptoeconomic procedures are necessary for the Augur prediction market to work. Therefore, augur develops an incentive system that rewards users for reporting the “truth” to the app, which it later uses to settle bets on the prediction market, using its native currency REP.

This is a breakthrough that allows the creation of decentralized prediction markets. Gnosis, a prediction market that uses a similar strategy but allows users to define alternative mechanisms for detecting actual outcomes, uses a similar method (commonly called an “oracle”).

The token sale or ICO is also designed using cryptoeconomics. For example, Gnosis used a “dutch auction model” for its token sale, resulting in a fairer distribution.

While this is a separate issue from developing the underlying consensus methods, there are enough parallels to consider both cryptoeconomics.

Building these apps requires a thorough understanding of how incentives influence user behavior. And also, careful design of cost-effective processes can consistently drive a specific outcome. They also require knowledge of the features and limits of the underlying blockchain on which the application is based.

Final thoughts

Cryptoeconomics is an essential factor to consider when building a decentralized network and also is a relatively new idea that has emerged with the introduction of Bitcoin.

In cryptoeconomic models, isolating the different roles helps analyze costs, incentives, and value streams for each participating group. It can also help in considering relative power and identifying potential areas of centralization, both of which are necessary for developing more balanced governance and token distribution schemes.

Cryptoeconomics and applying cryptoeconomic models can be extremely useful in building future networks. Develop more efficient and sustainable future networks by analyzing cryptoeconomic models already tested and tested in real contexts, resulting in a more resilient ecosystem of decentralized economies.