Written by: DeFi Cheetah

Compiled by: Deep Tide TechFlow

This article aims to explain how the first principles of Web3 play a role in the different business models of Web3 and Web2. If you are a builder or come from a Web3 VC, this will be very helpful for you.

How do successful Web3 models differ from Web2 models?

i. Trust-minimized setups lower the switching costs and loyalty of Web3 users, making it difficult for Web3 projects to scale their user base.

ii. The industry is open-source, products are homogeneous, and network effects are weak.

iii. Lack of economies of scale: the costs borne by current Dapp users do not significantly decrease with each additional user.

Many Web3 projects attempt to replicate successful Web2 business models by aggregating vendors, distributors, and users onto a single platform. This pays homage to the theory of aggregation, where most successful Web2 businesses have simplified consumer markets, such as FB and Amazon.

Why are Web2 aggregators so successful?

a. User stickiness is a powerful weapon against competition.

b. Strong network effects reduce user acquisition costs.

c. Economies of scale: the more users there are, the less each person pays.

This is not the case in Web3.

For a, as aggregators develop, Web2 users exhibit stronger stickiness due to the customizability of services and higher brand recognition. Aggregators have more data to optimize user experience while operating their businesses. Users also find it risky to build trust and confidence in unknown new platforms.

In other words, in Web2, users must trust that aggregators provide excellent service discovery and curation through good quality control of service providers. Therefore, platform stickiness is strong, and the "winner takes all" phenomenon is evident.

For example, online shopping does not guarantee the delivery of goods, so most people choose Amazon because it has quality control and rating systems to ensure sellers are legitimate. Coupled with Amazon's brand, the risk of default is much lower compared to sellers on unknown platforms. Thus, more consumers choose to shop online at Amazon rather than easily switch to other new platforms.

However, protocols in Web3 operate on trust-minimized setups run by smart contracts, where operations are transparent, predetermined by certain rules in the code, and automated by smart contracts. Therefore, the switching costs in Web3 are much lower, and brand recognition is much weaker.

For example, Uniswap does not take a cut from LP fees. Some believe this is due to regulatory issues, but that is not convincing. A more reasonable explanation is that the Uniswap team knows that changes in fees could have a huge negative impact on their trading volume.

Thus, rather than profiting directly from order flow, Uniswap prefers to leverage its first-mover advantage to expand horizontally by launching the intent-driven architecture Uniswap X, challenging current liquidity aggregators like 1inch and CoWSwap.

In addition to the fact that most trading volume does not come from individuals, the cost for users to trust new Web3 platforms is not high because operations are open to the public through code, allowing everyone to know if the new protocol is genuinely effective; in contrast, Web2 aggregators hide how they work in the background. Some Web2 service providers need to take over users' assets in custody, requiring users to rebuild more trust in them, while in Web3, users interact with aggregators in a non-custodial manner. All of this lowers the switching costs for users.

At the same time, the cleverly curated token incentive mechanisms in Web3 can allow newcomers to surpass market leaders. This is also how most successful protocols guide initial Total Value Locked (TVL) and users in Web3 and address the cold start problem in Web3. Before the airdrop on Blur, Opensea was the market leader in the NFT market. However, it is well known that Blur's token incentives overturned Opensea's dominance, forcing Opensea to make significant adjustments to its reduced market share. For newcomers to surpass market leaders, this is unprecedented in Web2.

In Web3, due to lower user loyalty, the relationship between aggregators and users is more dynamic, making it harder for protocols to scale their user base. Competitors can execute "vampire attacks" or lower fees to remain competitive.

For b, as the user base of Web2 aggregators grows, more service providers are attracted to them, which in turn attracts more users because they become more valuable to users. Therefore, user acquisition costs decrease over time. But the dynamics in Web3 are entirely different.

In other words, Web2 aggregators can create more value for users as they integrate more service providers into their platforms. This product heterogeneity allows aggregators to differentiate themselves from other competitors in the market.

For example, as more small property owners join Airbnb, more travelers become members because it can offer them more options for apartments/accommodations during their vacations. When network effects start providing more value to users, Airbnb does not need to spend much to acquire users.

In contrast, even if more service providers are integrated into Web3 aggregators, the network effect flywheel does not easily start in Web3 because the permissionless nature of Web3 leads to product homogeneity: most supply-side dApps are open-source and universally accessible to aggregators, providing similar value to users.

In fact, unless they continuously innovate and offer more advanced features, market leaders cannot provide a very different product suite for users, and newcomers can easily replicate them. Ongoing development and maintenance costs are a form of acquisition cost for Web3 aggregators.

For cross-chain bridges, they need to continuously add support for new blockchains as new blockchain ecosystems emerge. Not to mention token incentives as another form of cost for retaining users. These recurring costs greatly diminish the network effects that Web3 aggregators can enjoy.

Users in Web2 can benefit from economies of scale because the more users there are, the less each user pays on average. This is because fixed costs are a significant part of some aggregators' expenditures. Netflix is an illustrative example of economies of scale.

On Netflix, even with the same amount of on-demand video content, the more users there are, the less each user should pay because the costs are already fixed. Therefore, more users reduce costs. Again, this is not the case in Web3.

Despite the ongoing R&D and maintenance expenses in Web3, users still have to bear significant variable costs independent of economies of scale—the costs of decentralization, paying validator fees for consensus on the blockchain state.

EIP-4844 can help reduce fees on DA, but congestion fees due to limited block space are unrelated to economies of scale, weakening the dominance and moat of aggregators. No matter how cheap 1inch is, when the network is congested, users still have to pay higher fees.

There is one exception: L2. The more users there are, the less each user should pay.

L2 fees typically include a fixed cost and a variable cost: (i) the cost of publishing blocks on Ethereum and (ii) the cost of running sorters.

Let’s take Optimism as an example:

Assuming the Gas price on Ethereum is 25 gwei, and 1 ETH is $2k:

• One-time cost of deploying OP Stack on the mainnet = about 1 $ETH

• Fixed cost of OP Stack, even without running any transactions: (ii) about 0.5 $ETH per day

• Variable cost (DA), (i): $0.000075 $ETH per transaction

After EIP-4844, assuming (i) is reduced by 10 times, i.e., each Tx is reduced to about $0.015 + (ii) fixed cost, using $0.00001 $ETH (about $0.02) as Tx markup to cover fixed costs, it requires 50k transactions per day to cover (i) + (ii) costs (before EIP-4844, the price per Tx was about $0.17, after it is $0.03).

Assuming a positive correlation between the number of users and transactions, the more users there are, the more transactions there are, and the lower the Tx markup needed to cover L2 costs. But for most Web3 aggregators, economies of scale cannot be easily achieved due to the increase in user numbers.

Therefore, by applying first principles to simplify the nature of the Web3 industry into the simplest dimensions and reasoning from there, what Web2 aggregators enjoy cannot be directly applied to Web3: user stickiness, network effects, or economies of scale. Token incentives, trust minimization, and permissionlessness are some of the fundamental principles reshaping Web3 business models.