Supply and Demand. Sometimes, it’s a line. Other times, a curve.

TLDR: If behavioural economics is the first principle in economics design, then supply and demand is the second basic principle. There are many ways to design and govern supply and demand. The design is dependent on the purpose and objective of the token.

This episode is going to be real simple and basic. I don’t want to assume that everyone knows everything. There are plenty of things that I don’t know. It’s always best to go back to basics. The future episodes will be more technical and nerdy, so let’s get the basic foundations right before we build complicated structures!

How is behavioural economics and supply and demand the basic principles? It is all about economic engineering! In economics design, instead of using models to describe how the world works, we design the rules that are implemented in the ecosystem. So we get to design and define the supply and demand.

Topics covered this week:

The basics of supply and demand
How to govern supply and demand
How to apply supply and demand in token economics

At the end of the day, we are designing economics systems via rules and mechanisms. As a designer, you have a set objectives that you want the ecosystem to achieve. The challenge here, is how to implement the objectives.

We have behavioural economics to push people towards that shared objective. And we have supply and demand to affect their actions too. Think of it as a two-prong approach: rules for the irrational mind and rules for the rational mind.

Supply Demand 101

In economics, we always talk about supply and demand. They are 2 lines. And usually when they intersect, that is what we call “market equilibrium”. That point where the 2 lines meet is the market price and market quantity.

But what these lines share, is the relationship between both parties. When prices are low, buyers will demand more. When prices are high, buyers will demand less. It is the opposite for sellers. When prices are high, sellers want to sell more. When prices are low, sellers want to sell less.

The buyer’s line shows at what price, how much the buyer wants to buy. The seller’s line shows at what price, how much the seller wants to sell.

When the lines meet, it is the specific price where both buyers and sellers are comfortable with buying and selling at.

For example, when you travel to Southeast Asia and bargain for an item. That is the price both buyers and sellers are willing to trade and exchange the item for money.

There are a few things that affect the buyer’s line and seller’s line.

Buyer’s Line

We also call this a demand curve. The demand curve is different for each person. In the big picture, we combine all the individual demand curves together, to get the demand curve of the entire ecosystem.

These are factors that affect how much the buyer wants to buy, at a specific price. The number of available substitutes, consumer preferences, and the shifts in the price of complementary products affect demand. For example, if the price of video game consoles drops, the demand for games for that console may increase as more people buy the console and want games for it.

Seller’s Line

We call this a supply curve. Similarly, when we have plenty of sellers, we combine all the various curves together and get the supply curve of the entire ecosystem.

These factors are production capacity, production costs such as labor and materials, and the number of competitors directly affect how much supply businesses can create. With supply curve, there are other indirect factors know as ancillary factors. These are material availability, weather and the reliability of supply chains also can affect supply.

Governance: How and Why

Why do we need to govern supply and demand? Because it affects our logical decision making actions. We can govern them in various ways and methods.

Supply

There are different types of supply curve:

Fixed supply: to limit the supply on the resources because it is like that (land), reduce governance intermediaries (central bank)
Diminishing supply: things that are used up and non-replaceable or takes a long time (diamond, minerals). These are hard to attain as they disappear and takes a very long time to create.
Fluctuating supply: depends on something arbitrary and can’t be controlled (eg gas or solar energy)
Diminishing increase in supply: total supply increases with time, but it increases less each period. For example, oil extraction via OPEC and/or other related countries. It is the slow increase in supply until there is none left.

Demand

The demand for a particular product would be different in different situations. We must be clear about the type of demand to create value-add use-cases to boost the demand.

Effective demand: classical demand curve that shows the willingness of someone to pay. The lower the price, the more the willingness to pay.
Latent (potential) demand: demand that is not yet expressed in the marketplace.
Derived demand: proxy demand where something in demand shows the similar demand pattern. For example, increase in IoT increases the demand for cloud servers.
Composite demand: goods with more than 1 use, like basic fundamental product. Think of butter, garlic and onion for chefs. Most recipes require them.
Joint demand: a product is positively related to another. They are complements. Like fish and chips.
Competitive demand: products that are close substitutes of each other.

Application to Token Economics

Now, let’s apply supply and demand to token economics.

Supply

Fixed supply: these are fixed supply by design or the supply is fixed in the short-term. That means supply can change in the long-term, but it takes a longer time. Example, tokens relating to property in real life (limited just because) or in a game (limited by design).
Diminishing supply: depending on the token’s purpose, diminishing supply can be useful for certain tokens. Exchange tokens are a fan of this mechanism, eg the hyper-deflationary token of BNB.
Fluctuating supply: supply changes algorithmically, depending on the inputs. A classical example is seigniorage shares in the crypto space.
Diminishing increase in supply: you are most familiar with this. That is the example of Bitcoin, where supply increases daily, but halves every 4 years.

Things for you to consider when deciding supply schedule:

Do you need governance to control supply of tokens?
What is the purpose of token and why does it exist?
Pegged token or synthetic tokens or complicated tokens?
What behaviours do you want to encourage via your tokens?

Demand

Effective demand: you can see the charts on 17-18 March 2020, where people purchased more Bitcoins when prices fell. In general, this is most evident in secondary trading markets.
Latent (potential) demand: the best way to see this is through crowdfunding and presale of a project.
Derived demand: as more Dapps are built on ethereum, transactions will require gas and the more transactions on Dapps, the more expensive the fees are.
Composite demand: protocol layer tokens focusing on interoperability increases the demand of tokens as it gets more interoperable.
Joint demand: for DeFi products like crypto-ETF and pieDAO, the increase in demand affects the demand of the individual goods.
Competitive demand: BTC and BCH are similar yet different.

Conclusion

This episode covers the basic fundamentals of supply and demand, and how it relates to tokens. Sometimes, it is so basic that it goes over our head. This episode just brings us back to the fundamentals, when things get more complicated. Fundamentals are good because they rarely change. And so, we can build funky models on the fundamentals.

Drop any questions you have and catch them on Spotify, iTunes or Google Podcast!

Ps: Does anyone get my titles? Are they not punny enough?