Demand Elasticity on Arbitrum
VeradiVerdict - Issue #302
Introduction
Crypto is fast-moving and multidisciplinary. In such a context, informative data is essential for good strategic decision making. One of the most important pieces of information is demand elasticity, a measure of how much users change their behavior in response to changes in price.
Random changes to supply (or demand) provide valuable opportunities to measure demand elasticity, as they create natural experiments that isolate the effects of price changes on user behavior.
The Pantera Research Lab estimated Arbitrum users’ demand elasticity prior to EIP-4844 as near unit elastic.
This upgrade reduced gas fees for Ethereum’s Layer-2 networks by a factor of 10-100x, likely changing user behavior as a result.
Post EIP-4844 analysis suggests that the initial unit elasticity measurement should be considered a lower bound due to structural changes in the data.
Fee Switches & Demand Elasticity
Consider the question of when/whether to “flip the fee switch” and charge users more for transacting on your app or protocol. The “fee switch” was long a debate in the Uniswap DAO, and is more recently being debated on the Arbitrum governance forums. One important consideration is that if you flip the fee switch and users are extremely elastic, they’ll just leave. But if they’re inelastic, the fee won’t matter to them. So the demand elasticity would be nice to know!
Unfortunately demand elasticity is hard to measure. The problem is that prices fluctuate due to demand and supply changes, and it’s hard to tell what is changing what. This is why there’s a saying in economics: “you don’t reason from a price change alone.” Instead, we look for natural experiments where there are changes to price that are sudden and unexpected. If the supply side changed suddenly and the demand side stayed the same, then we can be confident that the result of these changes tells us something about demand.
What natural experiments like this might exist in crypto? Pantera Research Lab and a PhD student in the Pantera Catalyze Fellowship have recently looked into such a design for Arbitrum in order to better inform perspectives in the debate about a potential fee raise.
Estimating Elasticity on Arbitrum:
To estimate demand elasticity on Arbitrum we treated Layer 1 gas fees as external price shocks imposed on the Layer 2 system. Because Arbitrum posts its transactions to Ethereum, users have to pay (some proportion) of this cost. When those costs are high due to activity on the Layer 1 itself, this is like a sudden price increase on Arbitrum users. Using these shocks as natural experiments, we can try to estimate demand Elasticity on Arbitrum.
Pantera Catalyze Fellow and UCLA PhD Student Dongryeol Lee found that:
Arbitrum users exhibited a price elasticity of demand of -1.11.
For every 1 unit increase in gas fees, users' demand decreased by a factor of 1.11.
Arbitrum users are roughly “unit elastic.”
But that’s not the end of the story! The implementation of EIP-4844 dramatically reduced gas fees for Layer 2s by a factor of 10-100x. It’s not likely that users have the same elasticity after such an enormous reduction in price, and so we’d like to be cautious in how much to interpret Lee’s results. Pantera Research Lab therefore conducted a test to measure whether demand elasticity after 4844
was fundamentally different. Formally speaking we were testing for a “structural break” in the data following the implementation of 4844.
We had a pretty good natural experiment for discovering the elasticity of demand pre-4844, but we aren’t sure those results apply post 4844. Our follow-up data work supports the theory that elasticities have changed. As a result, we are probably best off considering Lee’s estimate as more of a lower bound on elasticity, rather than as a precise estimate.
It might seem disappointing to do careful empirical work on elasticities, only to have that work expire and become a “lower bound” for our variable of interest. But this is what it takes to do good empirical analysis!
Stay up to date with the latest research from Pantera Research Lab by following our Head of Research, Matt Stephenson, and Research Engineer, Ally Zach.
- Paul Veradittakit
DIGESTS
The Evolving Efficiency of Bitcoin Markets
Low liquidity, regulatory uncertainty and speculative behavior contributes to inefficiency in crypto markets. But systematic approaches, including momentum indexes, can reduce risks to investors, says Gregory Mall, head of investment solutions at AMINA Bank.
BUSINESS
Coinbase Asset Management Plans Tokenized Money-Market Fund, a Hot Area After BlackRock's BUIDL Success: Sources
Tokenization is one of the hottest corners of the blockchain ecosystem.
Ethereum ETFs Approved by SEC, Bringing Popular Funds to Second-Largest Cryptocurrency
Issuers received approval for their latest S-1 filings, which means that the funds could begin trading as early as Tuesday.
REGULATION
Is Donald Trump Insulating Bitcoin’s Price From the Tech Stock Slide?
With bitcoin steady and tech stocks tanking, is this BTC’s decoupling moment? If so, former president Trump may be the reason, says CoinDesk’s senior analyst George Kaloudis.
Coinbase Narrows Demand for SEC Chair Gensler's Crypto Messages
In its court battle with the Securities and Exchange Commission, the crypto exchange is seeking internal messages from Gensler and others, but not from his pre-SEC days.
NEW PRODUCTS AND HOT DEALS
Atari Launches Ethereum Retro Arcade on Base, Starting With ‘Asteroids’
Atari, the classic video game brand, is launching a series of its retro games with NFT access passes and on-chain scoreboards.
Privacy-Focused Proton Launches Self-Custody Bitcoin Wallet
The inspiration for Proton Wallet came from a company “near-death experience,” its CEO tells Decrypt.
LETS MEET UP
Walks and coffee meetings in San Francisco throughout the year!
ABOUT ME
Hi, I’m Paul Veradittakit, a Managing Partner at Pantera Capital, one of the oldest and largest institutional investors focused on investing in blockchain companies and cryptocurrencies. I’ve been in the industry since 2014, and the firm invests in equity, early stage token projects, and liquid cryptocurrencies on exchanges. I focus on early-stage investments and share my thoughts on what’s going on in the industry in this weekly newsletter.
If you have an projects that need funding, feel free to DM me on twitter.