Encompassing All the Pieces of the Bitcoin Network and Economic Ecosystem
Cryptocurrency has exploded onto the scene, and has rapidly come to resonate with a growing number of people becoming enthused with it as a means of value and transaction. So why exactly is it proving so popular among people?
Through this insightful article, we hope to illustrate some of the motivating factors behind people who choose to become pioneers within the cryptocurrency world, while also looking into the economic rationale behind doing so, all of which has allowed Bitcoin to become the one we know now.
Economic Rationality – So What is it Exactly?
The workings of Bitcoin from theory to practice is what truly sets it apart from other mediums of payments, with the cryptography comes into the Bitcoin network. But another aspect to that comes into view as important is economic rationality, it allows for the network to run smoothly, and yet it gets very little credit.
So where does this concept come from? Economic Rationality makes its first appearance in our collective economic language in the 1700s, back during the time when economists were beginning to use the Expected Utility Hypothesis, which was showcased by Daniel Bernoulli as an attempt to answer the St Petersburg Paradox.
The Expected Utility Hypothesis had a number of layers added to it thanks to both John Von Neumann and Oskar Morgenstern in the “Theory of Games and Economic Behaviour,” which was published back in 1944.
The EUT seeks to map out and give a more thorough definition of how people will behave when they are confronted with conditions of uncertainty. Within the Expected Utility Theory, when people are compelled by uncertain circumstances to make a decision, it is likely that this will result in a decision which yields the highest expected utility. So what does it mean? Utility refers to the number of products of probability and the utility they have above possible outcomes.
Put in a more straightforward way, people cannot be certain of the kind of results from their choice, inevitably, the decision will be made based on the underlying factor of what will benefit them the most. It has to be considered that there are a number of other factors that we need to take into consideration when the decision is made.
This can include the kind of aversion to risk that the individual has, as well as how much utility it has for other bodies either directly or indirectly involved. Being able to tick as many of these boxes as possible will make the individual's decision the best one, making them happiest.
This theory managed to gain a great deal of traction as it became recognized as a durable hypothesis, being one that maps out cohesively the rapid decision making process involved within people. The net positive of Expected Utility Theory is that it proved to be the foundation for the origins for economic rationality, and allows for the thorough definition of the concept of effective decision-making. The underlying theory is one that's generally agreed on by economists, they tend to differ on the basis of what a rational decision is.
In conclusion, the Expected Utility Theory has come to represent a cornerstone and basis for a large number of economic models and systems, including policies, but it has its fair share of flaws.
With the 20th century progressed further, this Utility Theory began to show cracks and limitations as the demands and strains of the period became glaringly apparent. An example of this being that the theory only stood true when it came to the options available to the individual. This allows for an outcome that was easy to see and immediately understand, it however is thwarted were the opposite choice to be made.
Theoretically, the theory itself works well, but when it is applied in the real world, it tends to become a little more blurred than theorists would like. As a result of this, a new theory was needed in order to more accurately assess the process of decision making within people that are often confronted with difficult and complex situations.
In the 1950s, for example, the concept and theory of Bounded Rationality was introduced by Herbert Simon. Bounded Rationality states that human beings are often reliable when it comes to making rational choices, within the economic sphere, this involves those choices that present the best investment or most profitable. It's with this in mind that it must be stated that people can only make as informed a decision as the information around them is.
During the 1970s, within a research paper published by Daniel Kahneman and Amos Tversky challenged the notion that the decision making process includes irrational behavior in people was consistent. The economists theorized that this irrationality is, in fact, relatively common and not random. As a result of this, Kahneman, and Tversky constructed what we now call the Prospect Theory. Prospect Theory refers to the biases which can occur in human behavior and decision making, this includes features like loss aversion, which can cause irrational behavior.
This theory represents a remarkable change in the economic world, which sees a transformation, changing course to emphasize the power of hard evidence in changing the opinion of humans confronted by it. In summary, more rational decisions are made when the person has access to more substantial evidence.
We find that these theories intersect in a substantial way – and that is that they each demonstrate that the more rational decisions take place when choices and outcomes are more easily quantifiable.
So Where Does Economic Rationality Fit in With the Bitcoin Network
Bitcoin, from its network to the way it conducts transactions is pretty ingenious. The way it applies game theory, a proof of work consensus mechanism, including distributed ledgers to Cryptography, Bitcoin stands out due to the fact that it has, coded into its function, economic incentives for its users.
This is a feature that was made completely clear by Satoshi Nakamoto when he published and further elaborated on the function of Bitcoin in his White Paper. Nakamoto sought to ensure that these same incentives were optimized, making them easy to identify and quantifiable. Pairing up to Economic Rationality quite well.
Bitcoin and its network provides an already finite supply of its digital currency. The quantity is meticulously plotted out, as are the times when these same tokens will be made available to users on the network, and if users wanted to obtain information, it is readily available for its users. The functionality of this network means that its tokens will gradually stop being issued to its users. This is where the second intrinsic incentive comes into play – the transaction fee – which will become increasingly important.
Those users that take part in the Bitcoin network in order to secure it will be able to capitalise on fees paid by individuals that want to complete transactions on the network. This, in concert with the very clear representation of this information, is crucial when taking into consideration the rationale of people, and illustrates the reason why cryptocurrencies are an increasingly popular thing.
When we consider these elements of Bitcoin, we can see that it hinges completely on bounded rationality. Bitcoin has a dependence on human beings in order to give it power, give it its value, and keep it operational. The design the network boasts is intelligent, but the reality is that cryptocurrencies are loaned their value thanks to the people that use it.
The future of cryptocurrency hinges upon the continued rationality that the market enjoys. As was previously spoken about, however, humans are inevitably susceptible to irrationality and, as a result, irrational behavior in decision making. It's because of this that, even when there is a better, more profitable choice set out, people will make an irrational decision which will leave them worse off.
So this brings up the question of how rational the market is with regards to something so well designed as Bitcoin? Will the presence of substantial facts allow for investors in it to make the best choice? Or lead it to more irrational approaches? We won't know just yet.