From asdf Dec 19, 2023

Disclaimer: I’m not an Economist by training. I have done as much research as I can while preparing this article, but there might still be fallacies in my arguments. If you find any, please reach out.

One question that I often get when discussing consumer app ideas leveraging crypto is “does this really have to be in web3”? This often leads to an exposition on how building a web2 counterpart would be substantially difficult or simply not work. The intention of this post is to provide a comprehensive analysis on game theory and its applications in web3. Game theory is a more generalized approach and covers governance, token models, decentralization et al. I believe this new framework can be leveraged to build powerful applications. The right incentives can propel the society in a good direction.

Decentralization is misguided

Chris Dixon wrote a short piece on Why Web3 Matters, which I think is a must-read. If I can highlight a fragment:

In web3, ownership and control is decentralized. Users and builders can own pieces of internet services by owning tokens, both non-fungible (NFTs) and fungible… Tokens give users property rights: the ability to own a piece of the internet.

Ownership is a core proposition of web3, but in itself is not the main reason why you can build better applications. In an earlier post on why decentralization matters, Chris Dixon wrote:

The bad news is that it became much harder for startups, creators, and other groups to grow their internet presence without worrying about centralized platforms changing the rules on them, taking away their audiences and profits. This in turn stifled innovation, making the internet less interesting and dynamic.

I would like to take this one step further. Web3 is an attempt at building better Internet applications. Characteristics such as ownership in web3 is evidence that we are striving to regain control of the web. Yet at the same time, I think it is worth asking the question which platforms are particularly problematic? There are two broad categories: social apps (Meta, TikTok, Twitter) and service apps (Amazon, Uber, Airbnb). I suspect the culprit is the former, since social platforms are often the one criticized for causing damage to society. A testimonial of this is the existence of the “web3 social” movement. Its goal is to replicate models that have proven to work in web2 and port them to web3. An audacious task that I commend them for taking up. But why are they specifically targeting social apps? To me, “web3 social” is a naive approach and misses the point.

Let’s use some examples. Consider Tinder. Is Tinder a social app? Yes, but it isn’t like Facebook. Yet Tinder is often criticized for ruining dating and has made a divisive impact on society. Simply building a web3 counterpart would be like beating around the bush. What exactly would be the intention there? Your matches are now NFTs that you can collect, or own your profile? Simply put, introducing web3 features without proper thought would be fruitless endeavor. Here’s the issue though: Tinder is writing the rules of dating and at the same time, it is in their best interest to maximize their revenue. They want users to swipe. It’s a predatory business model and it doesn’t care about the negative impact on society.

The crux of my argument is that web3 allows us to reimagine our existing systems. It allows us to conceptualize a system whereby users are incentivized to govern the application rightly — similar to how miners are incentivized to secure the Bitcoin network. A system where shareholders are not maximizing their revenue by showing advertisements at every step of the way and platforms aren’t simply competing for engagement. A system that our overlords are not constantly trying to buy out because of the power that resides with it. How do we fix this? The core theme of this post is to give the reader a new framework that they can leverage when designing web3 applications.

Games are everywhere

Before Facebook, Zuckerberg created a website called FaceMash. It would take pictures of two Harvard students and ask you to rate them. It was widely successful. Why did it work? Because it created a game where people were ranked based on their photos. It did create ethical problems but it demonstrated the potential for social platforms. Today, we play all sorts of games on online social platforms. We compete for likes, followers and views. This has been an immensely successful approach. TikTok has amassed nearly a billion active users that check the app daily. Imagine pushing an agenda to a billion users instantaneously. No wonder there is so much controversy around it. If you create a compelling game and you are able to assemble an audience, it can lead to all sorts of opportunities.

Paul Graham in his famous essay on “How to Get Startup Ideas” wrote:

When something is described as a toy, that means it has everything an idea needs except being important. It’s cool; users love it; it just doesn’t matter… Microcomputers seemed like toys when Apple and Microsoft started working on them. I’m old enough to remember that era; the usual term for people with their own microcomputers was “hobbyists.” BackRub seemed like an inconsequential science project. The Facebook was just a way for undergrads to stalk one another.

Now let’s analyze the game from an economist’s perspective. Game theory states that every “game” has players (the decision makers), actions (what the players can do) and payoffs (what motivates them, how they “profit” from each result). Game theory tries to understand the strategic actions of two or more “players” in a given situation containing set rules and outcomes. Any time we have a situation with two or more players that involve known payouts or quantifiable consequences, we can use game theory to help determine the most likely outcomes. Nash equilibrium is an outcome reached that, once achieved, means no player can increase payoff by changing decisions unilaterally. To understand game theory better, I strongly recommend the reader to check out this Yale Course.

Let’s apply game theory to Tinder. Game theory analysis requires three components: players, strategies, and payoffs. The players in this case are a man and a woman (for simplicity sake). The players can pick between two strategies: be selective with their matches or spam right swipes. The payoffs depend on both the quality and quantity of matches both genders get. The best possible outcome is that both genders are selective, since that means both match with a person who’s interested in them. If both genders spam matches, then everyone will end up with a bunch of matches they don’t care about, which defeats the point of Tinder. If one gender is selective and the other spams, the person that is selective is happy, because they get a decent amount of matches and feel validated while the others are unhappy because they aren’t getting many matches. We know by looking at the data that men’s match rates are less than 1%. And since most guys are spamming, being selective doesn’t help in getting matches. The end result is that the woman is selective and the man spams. Resulting in a really poor experience. You can read more about Tinder case study here.

Cryptocurrency was born out of Game Theory

Bitcoin whitepaper figured out a solution for a key problem that stood in the way of creating decentralized currency. How do you ensure that all the actors of a decentralized network behave correctly without trusting each other? The approach was to identify the players in the Bitcoin network as either the users of the network or miners that maintain it. Miners were incentivized to secure the network by giving them a reward for doing so (proof of work). It was important to strike the right balance between the reward for mining blocks and computational cost incurred for doing so. Satoshi was able to figure out that if Bitcoin continues to exist, it’ll continue to accumulate value and over time, the reward for miners can be cut in half every 4 years to ensure that only a fixed number of Bitcoin can ever exist. In a nutshell, Bitcoin is a masterpiece of game theory and incentives.

You might be wondering if it has always been about game theory, then why the strong focus on financial infrastructure? What about DeFi and NFTs? I have a theory. We created decentralized money, but we struggled to use it for anything practical. It also doesn’t help that the governments flat out rejected it and considered it a threat against sovereignty. Commercial use of crypto didn’t work. It was too slow, too risky and too volatile. But the community remained devoted to its potential and ended up becoming cult-like. The name of the game was “number go up, number go down”. It became clear that the home of crypto is the Internet itself and it needed something novel. On the Internet, it had to compete with the likes of Stripe and Paypal. The experience was much poorer. Wallets everywhere, money scattered around. But at least there was progress. The experience of clicking “connect with wallet” sparked joy amongst aficionados. The search was on for the “killer app” and we got Uniswap and OpenSea; both decentralized exchanges that served different purposes. It’s time to move past the phase of “connect with wallet”. We have MPC technology now and we can start to introduce more user-friendly experiences. We also have faster processing times and ability to do sponsored transactions. We are almost there where this technology is truly under the covers. I don’t think we should remain fixated on decentralized exchanges, derivatives and other similar products. It’s time to put imagination to work to compete with existing Internet apps (or better yet build truly novel ones).

Towards a better society

While it’s important to not be overly optimistic, I do think it is important to recognize where we might be headed. Designing for the right incentives on the web can be incredibly powerful. Consider Wikipedia. Despite all its problems, Wikipedia has been the source of truth on many occasions. It doesn’t have a great business model; it runs on donation. But nobody has been able to build a better Wikipedia. The word “wiki” is now synonymous with any store of information. This proves that in order to be successful you don’t need to appeal to your capitalistic emperors. You don’t always have to maximize revenue. Sometimes, a better product simply wins because of the virtue that society has determined that it is better. We don’t necessarily need mind-boggling TVLs. Instead we can win by simply building a social good that gets significant adoption and makes a positive impact.

Mechanism design theory is an economic theory that seeks to study the mechanisms by which a particular outcome or result can be achieved. Mechanism design theory allows economists to analyze, compare, and potentially regulate certain mechanisms associated with the achievement of particular outcomes that focuses on how businesses and institutions can achieve desirable social or economic outcomes given the constraints of individuals’ self-interest and incomplete information. I won’t go too much into specifics of mechanism design in this post, but you can understand it better by checking out this Stanford course. Suffice to say that if we want certain outcomes, it is possible to create platforms that can get you there. For instance, do we want a society that is fit and healthy? Do we want a society that is generally happy? Do we want a society with family values? We can build such society. All we need to do is construct incentive models and craft a game that allows us to reach those objectives. A game that is fun to play.

Lastly, I wish I could coin a term for all this. To be fair, as much as I hate the term “GameFi”, I do like how comical it is.