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Note: A follow-up version of this post was published in March 2023, which aimed to simplify the concepts further.
TL;DR
The circular flow of income model is developed to understand how money is exchanged between participants in an economy. Participants are classified into 5 sectors: Households, Firms, Government, Foreign, and Financial.
Economic health can be gauged by the calculation of GDP. GDP increase indicates economic growth and is achieved when total injection exceeds total leakage.
We can extrapolate from the model to inform the design of a sustainable crypto economy:
Separate player motivations into Households and Firms
Circulate Household and Firm sinks/sources
Introduce the concept of “Factory NFT” (vs. gameplay NFT)
Manage injections and leakages in the economy
Circular Flow of Income
The circular flow of income is an economic model developed to understand how money is exchanged between participants in an economy. At the most basic level, the model considers two economic agents (“sectors”) – Households and Firms.
Households are individuals with the goal of maximizing utility, which can also be thought of as maximizing consumption of goods and services. Households receive money by providing resources to Firms and spend money to purchase and consume goods and services from Firms.
Firms are businesses with the goal of maximizing profit. They pay Households in exchange for their resources (costs), use the resources to produce goods and services, and sell them to Households (revenue).
We call the resources needed to produce goods and services “factors of production.” The factors can be categorized as Labor, Land, Capital, and Entrepreneurship, with the corresponding factor income as Wages, Rent, Interests, and Profits. There is general ambiguity in terms of where each factor of production resides (Households vs Firms). However, Labor always lies with Households and Entrepreneurship is often considered a Firm resource.
In this two-sector circular flow model, Households and Firms complete the circular movement of money through the exchange of factors of production (resource market) and goods & services (product market).
A third sector can be added to the model as Government. The Government receives money from Households and Firms by charging taxes and spends money on developing public goods (e.g., infrastructure, education) and providing transfer payments and subsidies.
The Foreign and Financial sectors can be added to round out the circular flow (five-sector model). The Foreign sector receives money through export and spends money through import. The Financial sector receives savings (Household income less consumption, and Firm profits), and in turn reinvests the money as investments into the economy.
Using the five-sector circular flow model, we can quantify the size of the economy by calculating the GDP, which is equal to the sum of consumption (C), investments (I), government spending, and net export (X-M).
Furthermore, money flowing into the Government (taxation), Foreign (import) and Financial sectors (savings) add up to total leakage; money flowing out of these sectors (government spending, export, investments) represents total injection. Economic growth, depicted by GDP increase, is achieved when total injection exceeds total leakage.
Crypto Gaming Economy
Web 2 game economies generally follow a single flow model, where players pay money to the game developer in exchange for virtual goods. The game developer then takes all the proceeds out of the economy as corporate revenue/profit. End of story.
Crypto game economies can be a lot more holistic, thanks to the true property rights on digital goods enabled by the blockchain technology. We can interpret the design of a crypto economy in the framework of the circular flow model and extrapolate learnings to build a more sustainable economy.
1. Separate player motivations into Households and Firms
The first step is to design a crypto economy to resemble a circular flow economy more. It starts with recognizing the separation between Households and Firms as two sectors/economic agents. Households represent players who maximize consumption (e.g., fun) and Firms represent players who maximize profit. In reality, a single player can take on both roles, but having a mental model to segregate each motivation makes it easier to model out the economy and value flows.
Since Firms optimize for profits (i.e., money surplus), Households need to be net spenders via consumption (i.e., money deficit). This is a very long-winded setup to point out that crypto games need to be fun to play. However, not all Household players are required to spend. In F2P games, top 5% (or even top 0.5%) of players in terms of spending usually cover most of the game revenue. The same power law should apply to crypto games where a small percentage of power players are willing to spend enough to cover for the entire Households sector. This should be met with game loops that enable huge spend depths, which are to the tune of hundreds of thousands of dollars in F2P games. Identifying the top paying player segments and crypto game-specific spend depths are still work in progress in the space, although referencing the playbook of successful F2P games may be a useful first step.
2. Circulate Household and Firm sinks/sources
After distinguishing the two player motivations between Households and Firms, the challenge is to strike a balance between them. Notice that Households receive income through the resource market as paid by Firms; Firms generate revenue by enticing Households to pay for goods and services through the product market. This observation creates much more definite design criteria than simply “sinks > sources.”
Using Axie Infinity as a case study against this framework, we can see several design insufficiencies that contributed to its eventual economy collapse. First, on the leg of Household Income = Firm Cost, $SLP is used as the common denominator to reward gameplay (akin to wages for labor) and breed Axies (costs to produce goods). However, there is a disconnect between how much $SLP is rewarded to Households vs. used by Firms for Axie production. Gameplay rewards scale linearly with number of games played whereas Axie production costs scale linearly with amount of Axie produced – without considering the other factor.
An improved design is to build a dynamic rewards mechanism, where the size of $SLP reward pool scales with Axie production activities. For example, $SLP paid to breed Axies (Firm cost) may be used to replenish the reward pool (Household income). The reward pool will then be distributed to players in accordance to their engagement. In fact, Axie Origin already implemented some version of this by scrapping PvE rewards and introducing leaderboard rewards – every season a fixed $AXS prize pool is set by the developer (likely based on game traction and token demand) and dynamically shared by all players. In this case, engagement is measured in terms of time (games played) and skill (win rate).
On the leg of Firm Revenue = Household Consumption, Axie Infinity did not generate enough consumption. Axie breeders sell their new Axies predominantly to new joiners who are also profit-seeking breeders – Firm revenue was supported by new Firm costs. Even on the player (Households) side, there is no spend depth to entice players to spend beyond owning an ideal roster of Axies. As mentioned above, F2P games have developed well-established playbooks to enable spend depth that crypto game developers can reference from.
3. Factory NFT
One potential method to balance between Households and Firms motivations more explicitly is to separate gameplay NFTs and profit-seeking NFTs, which we will call “factory NFTs.”
Factory NFT is a concept where players are required to own a certain collection of NFTs to produce new game assets. In other words, Factory NFTs are like PP&E (property, plant, and equipment) in the real world. All other NFTs, including the game assets produced with factory NFTs, are used only for gameplay (consumption). Players in the Households sector own and use gameplay NFTs like heroes, gears, and skins in-game without the ability to produce new assets (other than earning rewards token in the labor → wage loop). Players in the Firms sector own factory NFTs and produce new gameplay NFTs to be sold to Households.
In this construct, Firm revenue from producing and selling new assets is directly tied to Household consumption of buying and using these assets. Likewise, Firm costs can be tied to Household income (labor → wage) by making gameplay reward tokens a requisite resource for factory NFTs to produce new assets, thus obligating the Firms sector to pay for player engagement. Besides completing the circular flow of income, this design allows game developers to control productivity growth in the game economy through the supply and pricing of factory NFTs in the market.
Factory NFTs are already being experimented in the crypto gaming world. Gabe Leydon recently made waves with his latest startup Limit Break and project DigiDaigaku, having previously co-founded the F2P pioneer Machine Zone. DigiDaigaku launched via a free mint of its genesis Digi NFT collection, which was described as “factory for future assets,” meaning they can be used to generate more NFTs. Subsequent Spirits NFTs airdropped to Digi holders shows how Gabe intended the production to occur (for now):
Digi NFTs are factory NFTs
Spirits NFTs are the resources generated from Digi NFTs to Digi NFT owners via airdrop
Spirits NFTs can then be burnt to mint “Digi Heroes,” which are gameplay NFTs
For DigiDaigaku, there is a simple metagame for the production process: the quality of a Digi Hero is determined by the compatibility of the Digi NFT and Spirit NFT. In future iterations, we can gamify the production loop in the Firms sector further and contextualize the production metagame more. For example, owners of factory NFTs may unlock higher production capabilities (in terms of either quantity or quality) via strategic decisions or Firm leaderboard placements.
4. Manage injections and leakages
Another facet of the circular flow model is the quantification of economic growth, namely GDP increase. Game developers should drive for higher injection than leakage, which can be broken down to the Government, Foreign and Financial sectors.
The Government sector is fairly straightforward. The Government represents the game developer or the DAO that manages the development of the project. It commonly taxes via trading royalties and other transaction fees (e.g. breeding, NFT upgrades) and provides public goods in the form of infrastructure (e.g. in-app marketplace) and content (new NFT collections, game modes, and higher levels).
Game infrastructure and content are by far the most important value creation components of a game. Thus, as long as the developer builds thoughtfully and is not overly extractive with the fees, net positive value injection can be achieved.
Managing the Financial sector involves lowering savings and increasing investments. This ties back to enabling spend depth and maximizing consumptions mentioned above. Moreover, factory NFT also provides a mechanism to encourage Firm investments, especially if a thoughtful production metagame is introduced.
The Foreign sector follows the Financial sector closely in a crypto economy. Since tokens can be mostly freely converted in the DeFi market, it can be assumed that broadly speaking any savings not put into use will be valued-out (“Import,” converting game token into ETH) and any excess investment demand will attract value-in (“Export,” converting ETH into game token). Though some projects, such as Decentral Games/ICE Poker, are experimenting with exit tax (sometimes called “redemption penalty”) to add a stop-gate to deter value-out.
Final Thoughts
Many of the design heuristics proposed in this article are hypotheses, based on first principles referenced from traditional economics and adjacent industry practices. They do not guarantee success. However, this is what the crypto gaming space needs: take educated risks and fail forward.
WAGMI.
Additional Reading
Circular Flow Model | Investopedia
The Circular Flow Model of a Market Economy | Jason Welker (YouTube)