Decentralized Business Model
How reduction in transaction costs influence evolution in digital business models
Internet innovations start with the vision but they get universal adoption once there’s a sustainable business model. Google, Facebook and Twitter are are able to serve billions of users due to invention of online advertisement. Uber and Airbnb grew because of the ability to create two-sided markets. To build scalable and sustainable decentralized Web we need to understand implications of this new business model. In this post I will provide reasons why decentralized application have competitive advantage over some of the existing internet businesses.
In this article we will take a look at traditional Pipeline, modern digital Platform and uprising Decentralized business models from transaction costs point of view. We will compare contribution of magnitude of transaction costs of each business model to the economic value created for the customer and predict market forces that will influence shifts in distribution of these business models in the market. We will start with examining each model’s cost structure in detail.
Pipeline Business
Where
TC — Total Costs
C — cost of production
N p — number of producers
C tx — average transaction cost
Platform Business
Where
TC —Total Costs
C —cost of production
P p — profit generated by the platform
C tx — average transaction cost
Decentralized Model
Where
TC — Total Costs
C — cost of production
C tx — average transaction cost
Transaction Costs
From the equations above we can argue that:
However, the key difference between the business models above is the magnitude of C tx. Typically, transaction costs consist of three elements:
- Search and information costs
- Bargaining costs
- Policing and enforcement costs
Besides, transaction costs depend on asset specificity, which can be divided into four types — Site (location of resources), Physical (manufacturing specialization), Human (knowledge specialization), Time (limited opportunity for a transaction).
We will show that the Platform business model provides significant cost reduction over the Pipeline model in transaction costs of type (1) and (2), then we will see that the Decentralized model in the worst-case scenario can provide an equivalent amount of transaction costs of type (1) and (2) and strictly lower costs of type (3).
Time Specificity
Digital communication technologies radically reduced the speed and therefore costs of information exchange, which in turn forced many industries to transform themselves from vertically integrated to open markets (Pipeline → Platform).
Human Specificity
In both Platform and Decentralized business models reputation acts as a solution for opportunism exhibited by market actors. Platforms made it so that new buyers incur lower transaction costs due to the proven and pre-qualified reputation of market participants (Uber drivers, Upwork freelancers, eBay sellers).
The decentralized business model is different from Platform one in a way that it’s removing the platform as an intermediary and provides at least the same level of verifiable data about the supplier but at a lower cost. The reputation dataset is richer and potentially more trusted because it’s not only based on the on-platform interactions but other sources: from government licenses to direct customer reviews.
Information cost
Search and information costs consist of thing like:
- Collecting and analyzing information
- Verifying credentials
- Legal costs
- Communication costs
In the Pipeline business model, all of these costs are incurred directly by buyer and seller. We can abstract this process in a form of two agents game, wherein in stage 1 both agents decide on their in-advance cost of a transaction. If no party pays the cost, the transaction is not happening. In all other cases, information costs are split between agents or outsourced. In the case of outsourced information costs increase by the profit margin of the external contractor (e.g. law firm).
In the Platform business model majority of information costs are incurred by the platform operator who expects to make a profit by having exclusive market information and generating network effects. To maximize profits, the platform has to compensate own costs while ensuring that transaction happens on the platform by creating lock-in and fighting off-platform interactions.
Bargaining cost
Data standardization and open protocols for data discovery in the Decentralized Model create advantages over the Platform business model due to increased market size for the participants: every supplier will remain publicly discoverable but there are no platform lock-in or platform fees anymore.
However, due to this very reason, the price of bargaining can go up in digitally mediated Platform businesses, as both parties have more information about each other readily available in the open market. The Platform and not business has most of the control over price dynamics. In addition to that, Platform can arbitrarily create information asymmetry to boost its profits.
This leads to a significant positive impact of the Decentralized business model in a form of higher granularity in disclosing their preferences for both supply and demand sides. Instead of committing to share all your usage and preference data with the platform operator in exchange for improved service, customers and sellers are now able to create their own atomic price, quality, and other preferences and share those only when and with whom they see fit.
Enforcement cost
Pipeline businesses largely rely on external (e.g. government) regulation to enforce economic behavior. Such regulation is costly as it is not specific for any particular business and has enormous overhead in a form of costs associated with policing and legal actions. Platform businesses make this more efficient by moving enforcement activity on the platform in a form of custom policies, handmade market dynamics, and a proprietary reputation system. In addition to that, even if no enforcement is necessary both Pipeline and Platform firms still incur compliance costs.
In the Decentralized model, distributed computation platforms (blockchains, smart contracts) open the possibility for programmatic law and automatically enforceable systems. Digitally signed smart contracts have almost no additional overhead and act as an integral part of the deal. When combined with decentralized payment methods such contracts provide not only legal assurance but also financial enforcement (by acting as non-bias escrow) as well as compliance and audit tools (due to the immutable nature of public blockchains). Smart contracts are publicly auditable and therefore both seller and buyer sides can have a high level of assurance that terms of a widely used contract are not over favorable for one side.
Conclusion
To sum everything up, we know that higher transaction costs (search, bargaining, enforcement) lead to most of the economic activity happening within the firm, and lowering transaction costs moves the same activity to the open market. Since lower transaction costs are beneficial for both sellers and buyers in any typical market, natural market forces will facilitate and speed up this vertical disintegration given that technology is mature enough. Decentralized markets represent the next stage of this process and consist of no vertically integrated firms but rather open protocols that do not aim or have the ability to earn profits and multiple competing “front-ends” that act as gateways and share the same underlying end customer-controlled data. Moreover, decentralization leads to a reduction in switching costs due to data portability and reduction in the magnitude of network effects for each individual app or platform yet an increase in network effects for the protocol in large.
