The Economics of Token Pricing

Economics is being applied more and more to analyze issues involved with tokens. One question that is attracting a huge amount of attention is that of token pricing. Many suggestions are out there. In a previous post, “The Quantity Theory of Money for Tokens,” I discussed the potential pitfalls with that approach to pricing.

This post continues that discussion by presenting a menu of possible other approaches, of other economic theories, that could be potentially be used for token pricing. I present several different approaches because there are many different kinds of tokens and they differ along money dimensions. Consequently, one approach will not fit all for all of them. The correct approach will depend on the characteristics of the token.

Here’s my menu of theories and the general type of tokens to which each might be applicable.

(1) Asset Pricing Theory

Because tokens are, at least potentially, assets, it is tempting to think that asset pricing theory can be applied to determine the pricing of tokens as is for equities, bonds, and other similar assets. That is not the case, although the asset pricing approach may be applicable to a particular types of tokens.

In simplified terms, asset pricing theory states the price of an asset should equal the present discounted value of the stream of returns it generates.

Here’s an example that illustrates asset pricing theory. Suppose that an asset generates the stream of dividends or returns {d0, d1, …, dt}, where is the USD value of the asset’s dividends or returns that can be sold in period t. Then asset pricing theory states that the USD price of the asset, P is:

where r is the interest rate at which returns are discounted. Since the returns are all in terms of USD and since they are generated by the asset, the result is USD/asset, which is the USD price of the asset.

The asset price approach seems to make sense for pricing tokens. After all, a token is an asset. But there’s a problem. Suppose we try to apply Equation (1) to pricing a token, the stream of returns would have be the USD stream of returns generated by the token.

Asset pricing theory could be a good place to start when thinking about the USD price of utility tokens that offer the holders discounts on the USD price of the service offered on a platform or by a project. The dt would be the USD value of the discounts offered over time.

However, an important caveat: If the price of the service on the platform is not in terms of USD but is instead in terms of some other token like BTC or ETH, then Equation (1) would yield the BTC or ETC price of the token. It would not be the USD price. As I pointed out in “The Quantity Theory of Money for Tokens,” when talking about token prices, you have to make sure the price you think you are determining is consistent with the equation(s) underlying your analysis.

I must also point out that would not make sense to invert the units of price to get token price of a USD. The reason: USD do not generate streams of returns in terms of any existing token.

(2) Purchasing Power Parity

Another economic theory that could be applied the pricing of some types of tokens is Purchasing Power Parity (PPP). In its most basic terms, PPP argues that arbitrage should drive the exchange rate between two currencies to the point at which the prices of goods are the same regardless of the currency with which they are being purchased.

When applied to USD and tokens, purchasing power parity could imply:

where E is the USD price of the token (USD / token), Pusd is the USD price of the good being sold by the token’s project, and Pz is the token price of the good being sold by the token’s project. Rearranging yields:

Of course, there is one obvious potential diffculty with this approach. Pusd could be unobservable because the goods that are purchased with the token are (very likely) not sold for USD. Thus, PPP requires finding some proxy, some good close to the goods purchased with the token that are priced in USD, and substituting that USD price for Pusd in Equation (2) and Equation (3).

The type of token that could be priced according to PPP is one issued by a project or platform that offers a good or service that is also available from some other provider and priced in USD by that provider. Utility tokens could be potential candidates.

(3) Exchange Rate Theory

The third alternative for token pricing draws upon the huge economics literature on determining the exchange rates between national currencies. However, some adjustments have to be made to apply this theory to tokens. Much of the exchange rate literature assumes that the currencies of different countries do not compete. It is assumed that a nation’s currency can only be spent in that country. Currencies of other countries cannot. Obviously, such an assumption is inappropriate for thinking about tokens. Tokens not only compete with each other, but they also compete with national currencies. The first adjustment is to allow competition between currencies.

The second adjustment is allow for the possibility that there are tokens, I like to call them “currency tokens” or “P2P tokens,” that do not offer holders any direct consumption value, that are not useful in production, and that are not claims to any good or service offered by any project or platform. Bitcoin and Litecoin are prime examples. In the terminology of monetary theory such tokens would be “intrinsically useless.” That is, if they weren’t accepted as media of exchange (if they could not be spent for goods or services), they would have no value.*

Whether or not intrinsically useless tokens will be valued at a point in time depends entirely on people’s expectations about whether they will be valued as media of exchange in the future. As long as people expect that a currency token will be exchangeable for goods and services in the future, they will accept it in exchange today. It will be valued today. However, if at any point in time people come to expect that a currency token will not be valued at some time in the future, it will immediately become valueless at that point.

Once the adjustments are made to allow for currencies to compete and to be intrinsically useless, there are two results from exchange rate theory that can be specifically applied to the pricing of currency tokens:

• A whole range of exchange rates between a currency token and national currencies or other currency tokens are possible. Because currency tokens are intrinsically useless, there are no fundamentals to tie a currency token’s value down, as there could be with discount tokens or utility tokens. That is, there is nothing that says a currency token could never be worth more than $10,000 or less than $0.01.
• The exchange rate between a currency token and national currencies or other currency tokens can be subject to fluctuations that are completely random and unrelated to any economic fundamentals. (Economists love to call the source of these “sentiments,” just to make clear that the source has nothing to do with economic fundamentals.)

When thinking about pricing tokens, there many choices for which economic theory to use. I have described three possibilities here. When deciding about which one might be the best one for a particular token, it is extremely important to take that particular token’s fundamental characteristics into account.

Note: I do own some small amounts of tokens. However, I do not and will not provide investment advice or recommendations. Nor should anything in this article be taken as giving investment advice or recommendations.

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*This is the reason that it does not make sense to call Bitcoin “the new gold.” Gold is intrinsically valuable. It has consumption value as jewelry and production value in some industrial uses. Thus, even if gold were to cease being a medium of exchange, which is essentially the case today, it will still have value. In contrast, if Bitcoin were no longer accepted as a medium of exchange, it would not be valued.

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