Economist Writing Every Day

John Duffy and Daniela Puzzello published a paper in 2014 on adopting fiat money. I think of that paper when I hear the ever-more-frequent discussions of crypto currencies around me. To research the topic, I went to John Duffy’s website. There I found a May 2021 working paper about adopting new currencies in which they directly reference crypto. Before explaining that interesting new paper, first I will summarize the 2014 paper “Gift Exchange versus Monetary Exchange.”

In the 2014 experiment, subjects who were consumers had to convince producers to make the general good. Subjects earned money by consuming that general good. Additionally, there were worthless tokens in play that did not convert to actual earnings at the end of the experiment. Having worthless tokens to trade back and forth helped the subjects to achieve a better outcome than they were able to achieve just through gift exchange. In theory, there is a profitable gift exchange equilibrium, but in practice the subject chose the monetary equilibrium. Here are two quotes from the paper:  

… the theoretical environments we study possess multiple equilibria. These include a number of gift-exchange equilibria including the first best equilibrium, as well as a monetary equilibrium where agents use a fiat money object in exchange, and a no-trade autarkic equilibrium. Equilibrium selection is ultimately an empirical question that experimental evidence can be used to address.

…subjects choose to include money in 80—100 percent of all exchange proposals and quantities and prices are close to monetary equilibrium predictions. Further, there is evidence that subjects are using the centralized meeting to re-balance their money holdings in the manner prescribed by the monetary equilibrium. By contrast, in the ACP environment where there is no money, subjects coordinate on inefficient gift-exchange equilibria involving the exchange of small quantities which is closer to the autarkic equilibrium than to the first best.

Although bitcoin started as far back as 2009, no one I know was talking about it back then, and there is no mention of “crypto” in the Duffy Puzzello 2014 paper (hereafter DP). Obviously, fiat currency generally was an important feature of the 2014 economy and a phenomenon of interest, since the gold standard was long gone.

Crypto features in the very first paragraph of the newest working paper by Jasmina Arifovic, John Duffy and Janet Hua Jiang (hereafter ADJ) “Adoption of a New Payment Method: Evidence from the Laboratory.” I should point out that this need not be about crypto at all. Anything “fintech” represents innovations in finance that could be widely adopted or not.

ADJ study the dynamics of how one payment method could replace another. For example, in the US many transactions take place through Visa credit card swiping or taping. Merchants need to have a way to process a Visa credit card at a physical point of sale or a code over the internet. For small merchants, the fixed cost of getting the equipment for processing a transaction is non-trivial.

The two equilibria of interest in DP were exchange with gift exchange norms versus exchange with fiat money. ADJ also present two equilibria: everyone trades with the initial currency or everyone fully switches to the new currency. The empirical question is whether lab subjects will jump to the new currency equilibrium to take advantage of lower per-transaction costs. To achieve the socially optimal equilibrium, all merchants have to pay an up-front fixed cost to be able to process the new currency. The decision to pay the fixed cost depends partly on beliefs about other subjects. No communication is allowed. It should also be obvious that there is no speculation allowed (e.g. buying Dogecoin because you plan to flip it for a profit).

What do people do when placed in this environment? If the fixed cost is low, then the group quickly adopts the new currency and carries out all transactions with lower fees. Although it is always socially optimal to switch, when transaction costs are high enough, merchants refuse to pay the fixed cost and the group does not switch. There are strong network effects to a currency. If buyers don’t believe that sellers will accept the new currency, then buyers will stick with the old currency to ensure that they can still trade for goods. ADJ elicit beliefs and develop an evolutionary learning model that explains behavior.

In some cases, buyers can’t get sellers to make the switch, even though all the buyers would prefer the new (higher-tech, so to speak) payment method. When I was reading the paper, I found myself asking “what if?” constantly. ‘Maybe consumers could force sellers to take Bitcoin because they all Tweet to each other and also because it’s a store of value for investment,’ I thought. Maybe it’s the communication between consumers that makes crypto work, and without that it does not have value. Maybe! A new experiment can test that.

When you test an idea in the lab, you have to create an actual environment with specific parameters. Designing an experiment forces you to think about the world in a new way and recognize the component parts of a phenomenon like credit cards or crypto. As I was reading the paper, I was writing thoughts about “trust” and “gambling” in the margins. It got me thinking about crypto in a new way, as experiments always do.

If you haven’t already, also read Mike on the $GME rush. Obviously that wouldn’t replicate in an environment where no communication was allowed.