What Is Ethereum and How Does It Work?

The internet revolutionized the way we live, work, and communicate. It has become an essential part of our daily lives. However, despite its widespread adoption, the internet remains centralized, relying on intermediaries to function.
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Blockchain technology, considered the next step in digital evolution, introduces a decentralized system that eliminates the need for third-party authorities. Bitcoin, the first successful blockchain-based project, demonstrated how financial transactions could operate on a decentralized network. Ethereum took this concept even further, offering an ecosystem for building applications on blockchain technology.
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Ethereum’s innovation extends beyond digital money—it provides a platform for decentralized applications (dApps). Instead of relying on centralized internet providers and corporations, Ethereum runs on a network of computers worldwide.
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In this lesson, we will explore Ethereum’s purpose, functionality, and structure.

Contents

• What is Ethereum?
• What are Ether and Gas?
• How does Ethereum work?
• Ethereum’s Challenges & Ethereum 2.0

What Is Ethereum?

Ethereum is an open-source blockchain network that allows developers to build and deploy decentralized applications (dApps).

After Bitcoin gained traction, a young programmer and co-founder of Bitcoin Magazine, Vitalik Buterin, saw potential in using blockchain for more than just transactions. In 2013, he introduced Ethereum in his article, “Ethereum: The Ultimate Smart Contract and Decentralized Application Platform.”
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Ethereum is often called a second-generation blockchain, improving upon Bitcoin’s model.
Unlike Bitcoin, which is primarily a digital currency, Ethereum provides a programmable blockchain that supports a wide range of applications.
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The core objective of Ethereum is to expand blockchain’s utility beyond peer-to-peer payments.

What Are Ether and Gas?

Many people mistakenly use the terms Ethereum and Ether interchangeably, but they serve different purposes.
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Ether (ETH) is Ethereum’s native cryptocurrency, similar to Bitcoin. It can be used as a store of value or as a means of payment.
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While Bitcoin is considered “digital gold,” Ether is often called “digital oil” because it fuels operations on the Ethereum network.
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Ethereum is more than just a digital currency – it powers decentralized applications. To process transactions and execute smart contracts, the network requires computational resources. This is where Gas fees come in.
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Gas is the unit that measures the computational effort needed to process transactions or execute smart contracts.
The cost of Gas is paid in Ether, ensuring that validators (previously miners, before Ethereum's transition to Proof of Stake in 2022) are incentivized for processing operations.
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Gas fee formula: Gas Fee = (Gas Limit) × (Base Fee + Priority Fee).
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Gas fees fluctuate based on network activity. During periods of high congestion, Gas prices rise significantly. The smallest unit of Ether used to calculate Gas is called Gwei (1 Gwei = 0.000000001 ETH), similar to how cents are a fraction of a dollar.

How Does Ethereum Work?

Ethereum consists of three main layers that work together to create a decentralized network.
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1. Base Layer (Hardware Layer)
   A network of computers (nodes) maintains the blockchain.
   Validators secure the network and validate transactions under the Proof of Stake system.
   Validators are rewarded with Ether (ETH) based on the Gas fee system.
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2. Smart Contracts (Software Layer)
   Smart contracts are self-executing agreements written in code.
   Developers create smart contracts using Solidity, a programming language for Ethereum.
   Once conditions are met, smart contracts automatically execute transactions without the need for intermediaries.

Example of a smart contract:
Imagine you and your friend place a $50 bet on the weather.
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• You predict rain; your friend expects sunshine.
• Both of you deposit $50 into a smart contract.
• The smart contract checks the weather using oracle technology.
• If it rains, the contract automatically transfers the money to you. If it’s sunny, your friend gets the payout.

Smart contracts eliminate third parties and ensure transparency.
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Ethereum’s hardware layer and software layer together create the Ethereum Virtual Machine (EVM), a global decentralized computer where developers can build dApps.
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3. Decentralized Applications (Application Layer)
The top layer consists of dApps built on Ethereum.
DApps operate across industries such as gaming, real estate, healthcare, finance, and identity verification.

Ethereum’s Challenges & Ethereum 2.0

Ethereum previously operated on a Proof of Work (PoW) system, similar to Bitcoin. However, Ethereum had scalability issues:
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The network could only process 7–15 transactions per second.
Gas fees were high during peak usage, making transactions costly.

Ethereum transitioned to Ethereum 2.0 in 2022, switching to a Proof of Stake (PoS) model. Goals of the upgrade:
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Reduce transaction fees.
Increase transaction speed.
Improve energy efficiency.

Ethereum’s upgrade is ongoing, with additional scaling solutions like sharding expected to be implemented in later phases to further enhance performance.

Conclusion

Ethereum is more than just a cryptocurrency – it’s a decentralized computing platform that enables developers to build smart contracts and dApps.

While Ethereum faces scalability challenges, the transition to Proof of Stake and other planned upgrades will significantly enhance its performance.
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In the next lesson, we’ll explore how Ethereum’s smart contracts revolutionize industries.