Protocol economics primitives: a starter mental model

Why primitives matter

Protocols are economic systems. Users, liquidity providers, validators, and other participants make decisions based on incentives. Understanding how these incentives work—and when they break—requires a shared vocabulary of primitives.

The goal isn't comprehensive theory. It's practical: define a few reusable concepts that apply across protocols. Once you can identify participants, actions, and payoffs, you can analyze almost any protocol's economics.

A simple 3-layer model

• Participants: users, liquidity providers, validators, traders, integrators.
• Actions: stake, trade, borrow, vote, provide liquidity, run infrastructure.
• Payoffs: fees, emissions, yield, utility, governance power, reputation.

When you can describe a protocol using these primitives, you can usually explain why it grows, stalls, or breaks. A lending protocol has depositors (provide capital, receive yield), borrowers (pay interest, receive capital access), and liquidators (monitor positions, receive liquidation rewards). Each action has a payoff that motivates the behavior.

Value flows

A quick checklist for any protocol:

• Where does value enter the system? User fees, token issuance, external subsidies.
• Who pays whom? Trace the path from value entry to final recipients.
• What needs to remain true for the system to keep working? Liquidity depth, price oracle accuracy, governance responsiveness.

Value creation and value capture are separate. A DEX creates value by enabling trades (utility). It captures value through fees. If captured value exceeds participant costs, the system is economically sustainable. If not, it relies on external subsidies like token emissions.

Constraints and failure modes

Every mechanism has constraints. Common ones include:

• Capital constraints: Protocols need deposits to function. Insufficient TVL limits utility.
• Liquidity constraints: Even with capital, liquidity must be available in the right places and sizes.
• Trust constraints: Smart contract risk, oracle reliability, governance capture all limit what users will deposit.
• Governance bandwidth: DAOs can only process so many decisions. Complex governance creates bottlenecks.

Failure modes emerge when constraints bind. A lending protocol with insufficient liquidity can't process withdrawals. A DEX with concentrated liquidity in wrong price ranges has high slippage. An oracle with slow updates enables arbitrage against stale prices. Identify constraints early to anticipate failures.

Related Concepts

Building on protocol economics primitives, explore these related frameworks:

• Protocol revenue: How to measure what protocols actually retain
• Fees vs revenue vs profit: The accounting framework for protocol economics
• Emissions vs revenue: Why token incentives function as expenses
• DeFi income statement: Apply GAAP-like principles to protocols
• DeFi business models: How different protocol types monetize