Urban economics explains the evolution of Web3. And vice versa.
Following the deadly attacks of September 11, 2001, lower Manhattan struggled to attract and retain residents. In 2002, New York State and City established the Lower Manhattan Development Corporation (LMDC) to "help plan and coordinate the rebuilding and revitalization" of the area,
Among other things, the LMDC launched a Residential Grant Program to "encourage individuals to remain in, or move to" Lower Manhattan and "fuel [its] resurgence." Overall, the LMDC paid $227 million in grants to more than 39,000 households. This included $6,000 and $12,000 to those willing to sign a 1- or 2-year lease in the area. Some are calling on New York to enact a similar program now in order to bring back residents who left the Financial District during COVID.
To an outsider, this might look like a terrible waste of money. Paying people to live in one of the most coveted areas in the world? But urban economists know that cities become coveted because they are coveted; they become attractive to people because they are full of people. And so, to ensure a city will flourish, it makes economic sense to pay people to kickstart or revive a process by which a critical mass of residents and economic activity attracts even more residents and economic activity.
Even today, some US cities are giving away land for free or paying people to move. In some cases, this creates a positive flywheel, and the incentives can be removed. In other cases, it doesn't, and the whole, erm, pyramid collapses. The same is true for individual buildings. As Konrad Putzier reported earlier this week in the Wall Street Journal earlier this week:
"The recent recovery of U.S. office rents owes much of its success to something landlords hate to discuss: all the freebies, cash gifts and other incentives they have to fork over to tenants.
These sort of payouts have long existed to a degree in the office, retail real-estate and apartment markets, especially in places like New York City and San Francisco. But they have never been so big or so commonplace as they are in urban office markets these days, real-estate brokers say.
Landlords are showering tenants with tens of millions of dollars and months of free rent. They are paying moving expenses and for customized alterations. In exchange for this largess, building owners are able to charge inflated rents that amount to much less than their face value suggests when all the giveaways are factored in."
What landlords are currently doing may seem excessive (and, at times, bordering on fraud), but it has a long and storied history. Landlords take money from investors; they pay that money to incentivize tenants; the tenants pay "nominal rent" that landlords use to convince even more investors to pour in money.
Of course, most large investors are savvy enough to understand what's going on. Still, they have an incentive to play along: the "nominal rent" helps drive the "nominal valuation" that allows the project to secure mortgages from banks. The banks, for their part, package the mortgages into all sorts of securities that they sell to various other investors. So, banks also have a strong incentive not to understand what's really going on but to tick the right boxes and move the "goods" along the financial food chain.
These incentives are also true for individuals within these organizations, who are often paid "by the pound": The real estate people get paid more if the nominal rent is higher, and if the nominal valuation increases, the fund managers get paid more if they raise more money from investors, the mortgage originators get paid more if they process more loans, the securities salespeople get paid more if they make the securities look as attractive as possible and downplay any potential issues. And even those working in government and other regulatory bodies often have an incentive to show they helped "increase home-ownership" or, more recently, "increase office occupancy."
Everyone is just doing their jobs! And the whole process works as long as it works. Sometimes, it truly kickstarts a flywheel that enables all parties to make money and create lasting value. At other times, it collapses, and people lose their shirts. There is usually "no one to blame" when that happens because everyone was just doing their jobs. (and if it happens on a large enough scale — as it did in 2007-2008 — the government steps in and bails out the banks).
My point is that paying people to consume a product or even giving a product for free is often a rational way to kickstart a business. It's a pyramid scheme only if it fails. But it often succeeds (hence "It's not a bubble unless it bursts" from my original piece on this topic).
This type of pyramid marketing works in cities because cities are networks. They create and benefit from positive network effects. In simple terms, this means that every new resident or business in a city makes the city more valuable for all other residents. And the longer this process continues, the more robust the city becomes and the more likely it is to withstand crises (like terrorist attacks, viruses, and technological changes).
Some of the most popular internet companies — Facebook, Airbnb, Uber, and Google — are also networks and benefit from network effects. But they differ from cities in one important way: Their customers are always renters, never owners. In a city, ownership and participation are intertwined. Individuals and companies are not just "users" — they can own the homes and offices they occupy (or rent out).
As a result, the participants in the urban economy can benefit directly from the appreciation of the city's land value. This aligns resident incentives even more tightly with those of the city as a whole. Letting participants own a piece of the "game" creates a more effective pyramid and increases the odds that the whole enterprise will succeed and become sustainable.
But not all urban participants are landlords. And in many cities, most residents and business owners don't own property. Still, enough of them are for the flywheel to work. But the ownership gap in successful cities contributes to income inequality by making landlords richer and making living costs higher for those who don't own. To address this issue, Henry George suggested a Land Value Tax at the end of the 19the Century.
The inequality that results from successful networks is even worse on the internet. The customers of the largest Web 2.0 companies — Facebook, Microsoft, Google, Airbnb, Uber — don't own a piece of the overall network. Ownership and participation in these networks are completely separated.
One of the unique features of Web3 is the combination of participation and ownership. Users buy tokens to access different services and gain rights to access different apps. These tokens confer both participation rights and ownership rights. As the value of the network increases, all token holders benefit.
And just like cities, many Web3 projects give away free tokens to their early and most active customers — "airdropping" them at random into people's wallets or paying people to consume content and play games. And just like with cities, this is often a terrible waste of money or a scam that involves multiple witting and unwitting participants. But in some cases, it kickstarts a flywheel of positive network effects.
Online, the whole thing happens much faster than in cities, and all the incentives and mechanisms are stated explicitly. This increases the number of failed projects and makes it easier to spot the pyramid. It may be ugly and cynical, but it's not necessarily irrational.
Even Bloomberg's Matt Levine is warming up to my theory that pyramid schemes will be the dominant marketing method of the next decade and beyond. As he puts it: "I don't like it! But I am not confident that he's wrong."
The basic idea is that a growing number of businesses will create mechanisms that enable customers to benefit from the businesses' growth. This, in turn, will incentivize customers to promote the business to other potential customers. As a result, early customers could profit by attracting more and more customers — just like in a pyramid scheme.
Pyramids and multi-level marketing schemes are not new. What is new is the critical role such schemes will play in the economy. Companies will have to find ways to compensate and incentivize early adopters to have a chance to succeed. They will have to do so for three main reasons:
- Increased competition: More and more industries are shifting from the economics of scarcity to the economics of abundance. Power shifts from those who control supply to those who control demand — from those who own printing presses, recording studios, and factories to those who command the attention and trust of consumers who can summon whatever they want at the click of a button.
- Higher rewards for winners: In a global market with billions of customers and online marketing channels, geography no longer protects the average from the best. In the past, each little village could sustain its own grocery store, tailor, orchestra, and whatnot. Today, it's possible for a handful of providers to cater to the whole world or to narrow niches across multiple markets. As a result, the distribution of rewards in a growing number of industries and professions follows a power law, similar to The Economics of Superstars that govern sports and entertainment.
- The growing importance of chance events: In a global market where many providers are competing intensively for a handful of massive rewards, consumers are facing too much choice. Picking the best product becomes harder in such a noisy environment. Statistically, expanding the number of options increases the odds that the second (or fifth) best option will prevail. Luck plays a growing role in determining which projects and products achieve initial success. And network effects play a growing role in turning initial success into a massive competitive advantage.
In such an environment, companies need to compete more fiercely, winning is worth more than ever, and the key to victory is increasing the odds of initial success. This dynamic is a subset of what I call The Economics of Abundance (a term others use to describe different things).
In the initial wave of the Economics of Abundance (~2015-2019), we've seen new companies offer free or subsidized products in order to achieve initial success. This included rides, meals, movie tickets, but also information, bandwidth, and messaging tools.
In the second wave of the Economics of Abundance, we will see companies pay customers to consume their products and use tokens to incentivize customers to recruit even more customers — and profit from the business's success and the appreciation in the value of the token.
Interestingly, even cities will have to adopt a more aggressive approach towards marketing. When people can live and work anywhere, the old "pyramid" of free rent and short-term tax breaks might no longer be enough to kickstart or sustain positive network effects. Maybe they should airdrop some tokens — not just to people who already live there, but to people they want to attract.
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