Bitcoin Mining Competitive Economics 101 — The Oversimplified Version

To understand how to quantify the cost and sustainability of Bitcoin, we must understand what makes a miner tick. The following is a 4-layers deep, overly-simplified, intro to Bitcoin Mining Economics and miner decision-making. This piece will be completely unreferenced, with all data and references coming from my in-depth “Cost & Sustainability of Bitcoin (August 2018 Edition)” — which was broken down in these 3 earlier medium posts:

Layer 1 — The Global (Legacy) Macroeconomy

Macroeconomics looks at the wider economy at the national and global level, such as monetary policy, interest rates, taxes & duties, trade policies, inflation, unemployment and the like. Although a Bitcoin miner can’t affect Macroeconomics, they can still benefit from it, or be jeopardized by it. Some examples of macroeconomics affecting CEO decision-making are offshoring for tax or regulatory reasons, moving to countries with high unemployment to benefit from cheaper labour, and so on. Bitcoin has its own self-regulating monetary policy which isolates it from the legacy macroeconomy

In this context, the “Macroeconomy” is all economic activity occurring on the planet.

Layer 2 — The Crypto Macroeconomy

The Crypto Macroeconomy is a subset of the Global Macroeconomy. This is the sum of all “crypto-economic” activity occurring globally. This includes all miners, product and service providers.

In the highly competitive-yet-collaborative, largely open-sourced and decentralized crypto macroeconomy, anyone can collaborate with others or create new or copycat ecosystems, ensuring evolution and adaption to changing market needs.

Here, Bitcoin miners need to keep an eye towards alternative digital ecosystems that are gaining traction in the wider free market, and whether their mining equipment can also mine these alternative digital currencies, or even potentially put them out of business.

Layer 3 –Bitcoin Microeconomics

The theory of Perfect Competition is just that, a theory. Although it is not seen in the real world, it is taught in all introductory economics courses due to its intuitive, survival-of-the-fittest nature. If you understand nature and evolution, you understand perfect competition. The reason perfect competition hasn’t been seen in the real world (yet) is because of rules, regulations and tangible and intangible externalities. I believe that Bitcoin mining’s “end-game” microeconomic model will be the first real-world case of Perfect Competition.

A perfectly competitive market can typically be defined by the following 9 conditions:

Bitcoin is not perfectly competitive in its current state but is very close to becoming so. The first six of the above conditions are met in the short-term, with the last three destined to be met (if not already partially met). In Perfect Competition, economic profit tends to zero in long-term equilibrium, and the marginal cost of producing and the market price constantly oscillate around an equilibrium point, with cost and/or innovation leadership the only way to stay in business

Layer 4 — Bitcoin Managerial Economics (Or, Micro-microeconomics)

The Porter’s Five (or Six) Forces framework is a mainstay of the MBA Curriculum. The forces within the Bitcoin mining market are illustrated below.

Mapped out, prospects look quite daunting for a miner. They cannot easily protect themselves from new miners or substitute products such as other digital currencies. They are price takers with little power over their buyers (i.e. everyone), or suppliers (i.e. utilities, silicon fabs, shipping companies, etc.). In such competitive markets, there is also a natural tendency for the market to be dominated by three or four players. This is consistently reflected in the mining pool stats

In a perfectly competitive market, a firm’s decisions are predictable. All firms need to decide to start up, how to run their business as cost-effectively as possible, and whether to stay in business or not. In the Bitcoin world, the decision-making process relies on market price of bitcoin, operating expenditure, and the network hash rate, i.e., how much competing mining power exists on the network. It also indirectly relies on the continued faith and investment of miners in the value of their commodity i.e. continued research, development, capital expenditure, and strategic partnerships with collaborators. The table below shows the relationship between hash rate and price and shows the outcomes for miners in six different scenarios.

The above logic applies to the workings of physical commodity miners in traditional industries. The difference is that a Bitcoin firm’s decisions take hours and days to implement, and days and weeks to take effect, instead of months and years. The same is true regarding the time taken to reach equilibrium after a price shock; “two-to-four times the duration of the production-to-storage cycle” (i.e. months to years) for commodities, 4 to 8 weeks for Bitcoin.

Trends & the Future

Since the future appears full of opportunities for the digital macroeconomy, one should expect digital microeconomies to become more perfectly competitive as time passes. Should long amounts of time, say, 50 years pass, when all bitcoins have effectively been mined, and the ecosystem is still healthy and has entered the redistribution stage, microeconomies such as the bitcoin mining market will start to resemble the textbook examples of perfect competition. In time, miners will vertically integrate backwards by acquiring data centres, chip fabricators, research-and-development teams, and renewable power plants; and integrate forwards by acquiring exchanges, brokers, and other places to sell what they have mined. They can horizontally integrate by acquiring entities that enrich the value of their commodity such as wallet hardware and other product manufacturers, financial services companies, and media outlets. 80% of the market will be controlled by the 20% of the largest and most integrated market participants, with the other 80% providing the niche and evolving needs of the market. As time goes on, the makeup of the microeconomy will evolve until its extinction and replacement.

Now that you have a very thorough understanding of the introductory economics and what is going through a miner’s mind, you’re ready to analyse cost and sustainability!

Bitcoin Evangelist. BEng MEngSc MBA