Source: a16z crypto; Compiled by Jinse Finance

Pricing is a common dilemma faced by market builders. Many markets heavily subsidize user activity to promote early growth and liquidity - offering products or services for free (or at a significant discount). But this practice is unsustainable: at some point, if builders want the network's value to match the business it generates, the network must begin to charge substantial fees.

Turning on the 'charging switch' may seem concerning because when a market starts charging for something that was previously free, usage is almost certain to decline, at least in the short term. However, it is important to remember that while raising prices may drive away some customers, it also means earning more profit from the users who remain. Even if the number of users ultimately decreases, the fact that these users are paying can actually enhance the value of the network.

The question is not whether to turn on the switch, but when to turn it on.

This article will explore the logic behind the answers. The result is that many businesses charge for too long or price too low.

But first, what is a fee switch?

The 'fee switch' in the market refers to the compensation the market receives for facilitating and supporting transactions. The fee switch is 'on' when the market itself earns considerable revenue from transactions (often referred to as 'cut,' 'commission,' or 'commission rate').

In blockchain protocols, this is typically achieved through a literal fee switch - a programmatic function that, once activated, charges fees for each transaction. For example, in DeFi protocols, the fee switch is a mechanism that allows a portion of the transaction fees (such as fees generated by DEX) to be directly allocated to the protocol's treasury or stakeholders.

Once activated (with the fee switch 'on'), a portion of the fees will accumulate to the protocol's network token—either through a slight increase in total fees or by redirecting some fees previously allocated to other stakeholders.

Why do protocols charge fees?

Fees are necessary because protocols need to cover operational costs. This seems fundamental but is worth mentioning. Any business - whether a gardener, an internet retailer, or a blockchain protocol - cannot last long if it cannot cover costs.

But in a decentralized blockchain network, there is a twist: fees are not only used to cover costs themselves but also to reward those who have contributed to the health of the network for a long time.

Owning a protocol incentivizes token holders to create value by contributing to the network. This is the superpower of blockchain: market participants holding tokens are your partners. Reasonable market pricing can strike a balance between subsidizing liquidity, ensuring smooth operations, and coordinating long-term incentives. The fee switch is a key mechanism to achieve this goal.

How to consider timing.

The decision of when to turn on the fee switch boils down to a demand question: when is demand strong enough that a slight increase in price won't drive users to competing protocols (or cause them to abandon the market altogether)?

Businesses that rely on network effects (think: most if not all of your favorite online marketplaces) typically avoid charging high fees in the early stages of development because they need that network effect to be large enough to suppress participants' willingness to switch. For example, think about how Amazon subsidized customers for years, foregoing dividends to maintain and grow its network and lock in its competitive position.

It seems that blockchain interoperability favors switching to competing protocols—in other words, because user activity is easily portable—blockchain networks may wait longer than traditional platforms. But tokens disrupt this logic: by sharing ownership through tokens, protocols transform users into partners and create network effects through their shared incentive mechanisms that drive the success of the protocol.

To make this token network effect work, token holders must have reasonable expectations that their stake in the network can appreciate. Thus, blockchain protocols may want to start charging fees earlier than traditional protocols. Conversely, shared ownership achieved through governance can buffer the high fees we see in Web2.0 businesses.

When to turn on the fee switch.

Turning on the fee switch may have legal or even operational reasons, but from an economic perspective, the logic is simple: when the network of the protocol is strong enough, it should turn on the fee switch so that fees do not drive too many users to other protocols (or lead them to exit the market altogether), significantly reducing the network's value.

It's easier said than done, but what reasons can justify this? Under what circumstances would a protocol lose participants but not lose value? If the services offered by the protocol are practical and have network effects and embedding, then in equilibrium, any competitor with the same cost structure cannot offer the same service at a lower cost. In short: when a protocol is both practical and widely used, other protocols facing the same cost structure simply cannot provide the same product or service at a lower cost while maintaining sustainability.

Protocols can also reason through price experiments: how many users would be driven away by increased fees? In industrial organization analysis, this is known as the churn rate. To get a rough sense of the churn rate, you can look for 'natural experiments' caused by external shocks that affect the effective cost users pay for your service - that is, when some factors beyond your control make your service more expensive for users. Take the changes in gas fees as an example: how much would demand for your application decrease when gas fees skyrocket? Similarly, protocols may be able to estimate the churn rate based on fluctuations in token prices. This analysis is only directional - and it's important to consider sensitivity - but it is certainly better than doing nothing, guessing, or not charging fees at all.

Lastly (perhaps most importantly), you can also infer prices from basic principles: how much value do people derive from this service? Take an extreme example: if a customer derives $1 million in value, then the protocol could possibly afford a $5 fee.

If you analyze here and conduct some experiments, you can determine the best timing to press the switch. To quickly recall the logic behind it, here is the essence of a haiku:

Create value.
Supplement network strength.
Fee switch turned on.