The Economy of Ethereum: A Simple Explanation for Beginners

I worked in the non-crypto VC space but at the same time, I have a startup that was providing P2P crypto to fiat exchange. We started in 2019 but my own vision and view of the market were negatively impacted by the sheer amount of scam and fraud that the ICO wave has caused during those early days.

I almost completely ignored the market and thought that all coins are the same - scam lol. But still, ironically I try to maintain our exchange as I still think, crypto will dramatically change the way the global economy works in the near future with its almost instant and direct P2P payment.

Recently, I have come across a few events that strongly resonated with me. I found out how behind I am in this massive/aggressive development of the industry and I know I need to catch up quickly. I’m sure there will be many out there likeminded so I decided to do some writings so that I can share my view and understanding in a non-technical way for other fellows:

Bitcoin (I know we are talking about Ethereum!)

Now, let’s start with Bitcoin which is by far the most popular and well-known crypto in the world, one which normally accounts for 40 to under 50% of the total market cap. There are interesting things one would need to compare the purpose and structure of Bitcoin to Ethereum to really highlight the fundamental differences between the two.

Bitcoin was first designed to be a digital currency that will mainly facilitate decentralized Peer to peer payment and therefore each block of the Bitcoin blockchain has a roughly 1MB in size limit that will contain mostly payment transactional data. Bitcoin also uses Unspent Transactional Output (UTXO) as the way of storing transactional data on its block (I can go on about the UTXO in a separate post but this is important terminology, in my opinion, you can google it in the meantime). Essentially, due to its 1MB size limit, a Bitcoin block can contain around 1900 transactions, up from roughly 500 in its early days.

I won’t go long into Bitcoin as of now but the main idea here is to remember, Bitcoin block is limited by storage size (1MB), consequently limiting the amount of data that can be written into a block to around 1900 transactions. And lastly, Bitcoin was designed to be a digital currency for global decentralized payment.

Ethereum? Another coin?

In short, yes, and that is what I thought for quite some time - what a tragedy for a guy who runs a crypto-related company. If you are just a coin trader, that’s enough.

Decentralized computer infrastructure

Ethereum is a global decentralized computer, or someone calls it a decentralized computer infrastructure which I think is probably very accurate. I was honestly feeling a bit shocked when I can really visualize Ethereum as a computation infrastructure rather than just another coin as I can see how Ethereum built the fundamentals and paved the way for the very vibrant ecosystem of blockchain application today.

Ethereum was imagined as an evolved version of Amazon Web Services or AWS where an entire economy of new applications and products could be built on top of Ethereum

Alex Lieberman, Co-Founder and Executive Chairman of Morning Brew

I, amongst all the articles I read, particularly like this statement from Alex Lieberman and I think you should too. That explained quite simply the role of Ethereum. Now let’s look at how Ethereum limits its block in regards to being a computation infrastructure as opposed to the payment platform of Bitcoin. Ethereum has what is called Ethereum Virtual Machine (EVM) which can read the code and execute it. This is how “Smart contract” was made possible and is also the foundation of the vibrant Decentralized Application (dApp) nowadays.

For starters, Ethereum does not limit its block size in bytes (storage) but rather in gas which is similar to your car’s fuel tank, it needs gas to perform a movement from point A to point B. I was looking at gas almost every day for the past 2-3 years and always thought it was just another crypto gimmick, junky fancy word lol. How shameful!

As a computer (Turing-completed), the service Ethereum was offering is computation capability, and therefore it charges fees based on the amount of computation effort it has to make in order to deliver the result. Without diving into details, Ethereum has a menu where it quotes different gas prices for different operations that the computer will have to do such as writing, updating, storage, etc.

For me, personally, as a relative newbie, I found this combination of blocksize limit in gas and fee structure imposed by Ethereum very important in the sense that it is driving the developer community to produce lean/clean code and this, in turn, will drive the quality of projects. Another aspect of this is it also prevents the network from being attacked such as DDOS where malicious actors will produce several thousands of code execution that will congest the network. Having a fee and computation limit makes sure it is economically almost inviable to do such harmful activities to the network.

Now since we already mention gas and fee, let me just continue a little bit further on how the fee you normally pay works out and why it fluctuates.

The simple math

Payment (in ETH) = Gas limit (in gas) x Gas price (in Gwei which is one billionth of 1 Ethereum)

Gas limit & structure

Think of taxi service,

1. In order to move from point A to point B, there is mileage per distance of travel. This milage per distance is normally fixed for every car, let’s say 10 liters of fuel for every 100km and this is the Gas in Ethereum.
2. Now if you just go non-stop to B, there is no surcharge. This is essentially a basic transaction in Ethereum pricing (an Eth transfer cost 21,000 gas)
3. If you must make a stop halfway, the driver will charge you some additional money because the car will still need to be on and fuel keeps being spent while idled. This is essentially another gas cost in Ethereum where the system will charge you for any additional operation/computation/task.

The above is a super simplified explanation of the gas structure in Ethereum computer. Whatever you do, never go beyond 15,000,000 gas; similarly, in the taxi example above, the driver will not go beyond 100km due to the taxi’s fuel tank limit.

As a user, you will need to set the gas limit and make sure this limit is higher than the actual gas that will be consumed by the system. Don’t worry, if you buffer too much, the surplus gas will be returned to you. However, along the way, if the gas is not sufficient, the transaction will be reverted and the gas spent is not returning. Remember gas limit is always quoted in gas, the more complicated the transaction, the more gas will be required.

Gwei

Gwei is, first of all, giga-wei or 1,000,000,000wei (and 1,000,000,000gwei = 1 ETH). In the taxi example, gwei essentially refers to the price of one liter of fuel. There is just this difference that normally fuel price is fixed for a period but, in Ethereum, you are the one to offer a gwei number (to the miners). The higher you offer, the more likely your transaction will get through FAST. This is because miners will prioritize transactions with higher fees as this directly impacts their earnings. Simple economy right?

On to the above screenshot of a simple USDT ERC20 transfer screenshot that I took from Etherscan.

Even though it is a simple ERC20 token transfer but in line 2, you will see the transaction has to interact with the USDT Contract which incurs extra gas.

In this transaction, the user sets out gas limit at 200,000 and the actual gas consumed is 46,097; he/she will only pay this amount of gas.

Gas price (Gwei) was offered at 65.5gwei; if you take 65.5gwei and multiply by 46,097gas, you will have this number: 0.003019ETH (Remember 1 ETH = 1,000,000,000gwei) and then multiply with ETH’s price at the time, you will have USD10.89 equivalent in dollar term.

I hope my explanation is clear enough for newcomers and helps you understand Ethereum as a computation machine. Remember, Bitcoin was created to become a global currency/store of value medium while Ethereum was created to be a decentralized computer.

Also published on: https://medium.com/@ndong/the-economy-of-ethereum-f5e5be5659f4