Ethereum: how smart contracts, gas, and blockchain economics work

Ethereum became the next stage in the development of blockchain technology after Bitcoin. While the first cryptocurrency proved that a decentralized network can support a monetary system and transaction ledger without a central governing body, Ethereum expanded this concept by making the blockchain programmable.

The key innovation was smart contracts – program code that automatically executes predefined actions when certain conditions are met. Thanks to them, developers gained the ability to create decentralized applications (dApps) that operate without traditional intermediaries. Such solutions are used in financial services, games, and other areas.

How Ethereum Accounts and Smart Contracts Work

In the Ethereum network, there are two main types of accounts. Externally Owned Accounts (EOA) are controlled by users with private keys. They can send and receive ETH, interact with smart contracts, and initiate transactions.

Contract accounts are managed by program code rather than private keys. They cannot independently initiate transactions; the execution of instructions embedded in them is triggered by actions from EOAs or other smart contracts.

Ethereum uses an account model where balances are stored directly in accounts. This differs from the UTXO model used in Bitcoin which tracks individual transaction outputs. The Ethereum account model simplifies balance verification and interaction of smart contracts with users and other applications.

Smart contracts are executed in the Ethereum Virtual Machine (EVM). It provides unified rules for code execution across all network nodes. This allows blockchain participants to agree on the outcomes of applications and operations.

DeFi and the Role of ETH

The programmability of Ethereum became the foundation for the development of decentralized finance (DeFi). Such protocols enable trading operations, lending and borrowing, collateral use, and earning income without the mandatory involvement of banks or brokers. Instead of traditional intermediaries, the rules of interaction are enforced by smart contracts.

The native token of the network, ETH or ether, is essential for the blockchain's operation. It is used to pay transaction fees and execute operations with smart contracts. These fees are called gas.

Fees serve several functions: they compensate validators for participating in network maintenance and prevent spam, as every action in the blockchain has a cost. The fee amount depends on the required computational resources and the demand for limited block space. During high user activity, fees can increase.

Gas prices are usually expressed in gwei. After the implementation of proposal EIP-1559, the fee structure includes a base fee determined by the network and an optional priority fee for the validator. This structure has made the fee calculation mechanism more understandable, although the final cost still depends on blockchain load.

Transition to Proof of Stake

Initially, Ethereum operated on the Proof of Work (PoW) algorithm, where miners confirmed transactions by solving computational tasks. Later, the network transitioned to Proof of Stake (PoS) as part of The Merge update.

In this model, blocks are created by validators, and their participation is linked to staking ETH. The locked funds serve as economic security for rule compliance: a validator can lose part of their stake for dishonest behavior through the slashing mechanism.

Network Updates and Blockchain Competition

Ethereum protocol changes are formalized as Ethereum Improvement Proposals (EIP). These documents describe potential network updates and undergo public discussion. After review and agreement, proposals may be implemented as part of protocol updates.

As Ethereum's popularity grew, it faced bandwidth limitations and increased fees. This created conditions for the emergence of other Layer 1 blockchains, including networks with alternative architectural solutions.

Layer 1 refers to basic independent blockchains that do not rely on another network for their operation. They may prioritize transaction processing speed, low fees, decentralization, developer-friendliness, or specific use cases.

When designing such systems, developers encounter the so-called blockchain trilemma. It describes the difficulty of simultaneously achieving three goals: security, decentralization, and scalability. Improving two characteristics may require compromises regarding the third.

Blockchain Economics and Scaling

Native tokens of Layer 1 serve not only as tradable assets. They are used to pay for block space, incentivize validators, and ensure network security through rewards and fees.

An additional Web3 infrastructure is forming around base blockchains. This includes wallets through which users interact with applications, RPC nodes and oracles that provide data transmission, as well as security and audit tools.

One of the main challenges for blockchains remains scalability. If the demand for operations grows faster than the base level can handle, the network may slow down and fees may increase. Therefore, for everyday use of blockchain applications, solutions are needed to increase throughput and reduce transaction costs.

The next stage in the development of this infrastructure is Layer 2 solutions, designed to scale the base networks.