Cryptocurrencies, Network Effects, and Switching Costs

Abstract

Cryptocurrencies are digital alternatives to traditional government‐issued paper monies. Given the current state of technology and skepticism regarding the future purchasing power of existing monies, why have cryptocurrencies failed to gain widespread acceptance? I offer an explanation based on network effects and switching costs. In order to articulate the problem that agents considering cryptocurrencies face, I employ a simple model developed by Dowd and Greenaway (1993) (Dowd, K., and D. Greenaway. “Currency Competition, Network Externalities, and Switching Costs: Towards an Alternative View of Optimum Currency Areas.” The Economic Journal, 103(420), 1993, 1180–89). The model demonstrates that agents may fail to adopt an alternative currency when network effects and switching costs are present, even if all agents agree that the prevailing currency is inferior. The limited success of bitcoin - almost certainly the most popular cryptocurrency to date - serves to illustrate. After briefly surveying episodes of successful monetary transition, I conclude that cryptocurrencies like bitcoin are unlikely to generate widespread acceptance in the absence of either significant monetary instability or government support.

JEL Classification: E40, E41, E42, E49