An Economic Model of Blockchain: The Interplay between Transaction Fees and Security

Abstract

A blockchain system, such as Bitcoin or Ethereum, validates electronic transactions and stores them in a chain of blocks without a central authority. Miners with computing power compete for the right to create blocks according to a pre-set protocol and in return earn fees paid by users who submit transactions. Such a system essentially operates as a single server queue with batch services based on a fee-based priority discipline, albeit with distinctive features due to the security concerns caused by decentralization. That is, a transaction is confirmed only after a number of additional blocks are subsequently extended to the block containing it, which complicates the interplay between miners and users. In our study, we build a model to analyze how miners’ participation decisions interact with users’ participation and fee decisions in equilibrium, and identify the optimal protocol design when the goal is to maximize total throughput or users’ utility. Our analyses show that miners and users may end up in either a vicious or virtuous cycle, depending on the initial system state. We validate our model and analytical results using data from Bitcoin.

Keywords: blockchain, queueing model, decentralization, transaction fee, security

JEL Classification: D40, D20, G10, G29