What is an NFT—and Why Are Some Worth So Much Money?

How NFT's are all about property rights.

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You’ve probably heard about the development or sale of non-fungible tokens (NFTs) over the last few months. Digital artist Beeple set records in digital art when the piece Everydays—The First 5000 Days was sold for $69 million.

Depending on who you listen to, NFTs are either worthless and unexplainable or a major innovation in decentralization, rivaling cryptocurrency in importance. The complicated technical aspects of NFTs make the divergent views understandable, especially when paired with the high price points.

Although the volume of NFT-based transactions is likely impossible to track (due to their purchase method being cryptocurrency), a particular line of NFTs, the CryptoPunks, have changed hands for a total sale volume of $1.56 billion.

So what’s going on here? What are NFTs and why are they so valuable? Are they a scam as some people claim? A front for criminal enterprises?

A comparison of similar technologies and an economic analysis of property rights can help us understand.

As you likely noticed from the introduction as well as other NFT stories, NFTs are often associated with digital art. NFTs don’t have to be associated with art, but the fact that they are gives us a hint about why they matter.

First, however, I should highlight what an NFT is from a technical perspective. An NFT is essentially a unit of data which is unique and not reproducible. It builds off an existing cryptocurrency to generate this token. The value of the NFT exists in these two features: uniqueness and non-reproducibility.

Why does this matter? Consider the problem of digital art. Computer artists can spend hours or days creating a unique piece of art that people value. However, it’s difficult for these valuable pieces of art to sell. Why? Digital art is notoriously easy to copy. Most pictures on the internet can be perfectly copied with a right click. Even if this doesn’t work, the “Print Screen” button on most keyboards solidifies the problem of easy copying.

In theory digital artists might be able to leverage government to prevent images from being copied. However, in practice, this simply isn’t feasible. Is the government going to check the hard drives of the millions of viewers of millions of images on the internet to check for illegal screenshots? The cost is simply too high.

But NFTs present an intriguing solution. By creating an NFT for a particular piece of digital art, the creator is able to sell a unique, non-reproducible token that represents the original piece of art.

You may be wondering, “so does an NFT prevent screenshotting an image?”

No. But that isn’t the point.

To understand why, think of traditional art. Technology and the skill level of artists is so vast today, that it’s relatively easy to produce versions of say, the Mona Lisa, that the average person would be unable to distinguish from the original. In fact, you can have a picture of the Mona Lisa on your computer screensaver that is a literal copy of the original. Does this de-value the original?

Obviously not.

So long as the ownership of the original can be tracked, it maintains its value. The aspect that people value about the Mona Lisa is the originality. It doesn’t matter that you could make a copy of the original that looks just as good to the average person. They still probably won’t pay anywhere near the price of the original.

The NFT, then, allows the artist to sell an original copy. Regardless of the number of copies made of the pixels, the NFT acts like the artist’s signature, permanently tracking ownership of the original.

Part of the reason NFTs are difficult to understand is that ownership is typically thought of as binary. Someone either owns something or they don’t. And, while there may be a sense in which this is true, in practice it’s possible that certain attributes of a good are too costly to “own”

To understand this, we can utilize the work of UCLA economists Harold Demsetz. In “The Exchange and Enforcement of Property Rights” Demsetz considers the example of zero price parking offered by shopping malls. When shopping malls construct parking lots, they provide a benefit to stores close to the mall. Owners of these stores will see customers park at the mall but walk across the street to their store. As such, these owners will have more sales with relatively less parking lot expenditure.

At this point, you may be thinking that this is easily solved. The mall could simply police their parking lots and ensure no one leaves the mall. This would allow customers to park for free and prevent people from depreciating parking lots and taking up mall customer spaces. However, there is an issue with this. Policing is costly. And in any case where the cost of policing exceeds the benefit of catching one more parking space thief, the land owner loses control over his or her legal property. Then some of the value of the owner’s land is transferred to adjacent store owners in the form of higher sales.

However, all is not lost for the owner of the mall. In order to see why, consider the case of Walt Disney. When Disney created his first theme park, some of the value of the theme park leaked over to adjacent landowners. The huge amount of tourism boosted sales for surrounding business, and this boost in sales was capitalized in higher land values. Disney owned his park, but he didn’t own all of the value created by his park.

He wouldn’t make the same mistake again. In order to capture all the value created by development of future theme parks, Disney would use a variety of shell companies to buy massive areas of land surrounding future parks. By buying adjacent land, Disney captured ownership of the attribute of rising land values created by the cultivation of his parks. Once Disney’s parks were built, he was free to sell off the land at a higher price and capture the benefit.

NFTs serve a somewhat similar role. When a digital artist creates a new image, it creates value for the thousands of people who enjoy it. But like businesses surrounding a newly developed mall or theme park, the individuals who enjoy the image without having to pay are capturing value from the image.

This isn’t to say that enjoying free images is a bad thing. Only that doing so will lead to less compensation for the creator than if the image can be sold. By creating an NFT, digital entrepreneurs can better capture the value of their creation by creating an unmistakable original copy with a value directly related to how much people desire to own the original.

NFTs can thus be regarded as a technology for defining, enforcing, and ultimately transferring property rights. This function allows mutually beneficial exchange to occur between creators and connoisseurs, and, everything else constant, we should expect creators to be more interested in creating pieces of value when they’re able to capture that value.

The unique, non reproducible nature of NFTs has paved the way for a new use: digital membership cards. By presenting an NFT that only you own, you can be given exclusive access to certain privileges. For example, a new restaurant, Fishfry Club, is selling restaurant memberships in the form of NFTs. If you want to eat there, you better have the NFT or be the guest of someone who does.

This use for NFTs actually predates NFTs. Urbit is a reimagined version of the internet. The details of it warrant an article in itself, but one of the features of Urbit is it offers a “friendlier” internet.

How is this achieved? Well, you purchase an Urbit ID with money, and this ID follows you around everywhere. And with a non-changeable ID, your reputation follows you around. Unlike our modern internet where burner accounts can be made in minutes to anonymously troll people on Twitter, your identity costs money on Urbit.

This ID is an NFT, though as previously mentioned it predates the term.

Much like art isn’t new, ID cards and keys aren’t new. However, NFTs provide another alternative ID which, barring human error, would be impossible to fake.

On my view, NFTs are neither a complete scam nor a revolutionary concept. NFTs are simply a modern incarnation of a technology of property rights enforcement which is as old as humanity itself. Just like high value antiques come with papers for verification, NFTs provide verification of ownership of the digital equivalent of the “original”.

So while I won’t be buying any multi-million dollar pixel art of a zombie, you also won’t find me at high-end art auctions. I’ll settle for screenshots, but I’m happy for the new array of mutually beneficial exchanges that others will now be able to enjoy.

Peter Jacobsen
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Peter Jacobsen

Peter Jacobsen is an Assistant Professor of Economics at Ottawa University and the Gwartney Professor of Economic Education and Research at the Gwartney Institute. He received his PhD in economics from George Mason University, and obtained his BS from Southeast Missouri State University. His research interest is at the intersection of political economy, development economics, and population economics.

This article was originally published on FEE.org. Read the original article.

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