Hass McCook

Aug 21, 2018

5 min read

<<<back to Part I

Last week, we had a look at the definition of Perfect Competition, and how it may be applicable to Bitcoin mining. This week’s article will discuss Perfect Competition and its impacts on managerial decision-making.

The Porter’s Five (or Six) Forces[1] framework is a mainstay of the MBA Curriculum. The forces within the Bitcoin mining market are illustrated below.

Figure 1 — Porter’s Five Forces Analysis of the Bitcoin Mining Industry

Mapped out, prospects look quite daunting for an industry competitor. 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, and unless they are an innovation leader in the fields of hardware manufacture and research-and-development, data centre ownership, and/or electricity provision, they have little control over their suppliers too. As mentioned previously, collaborators (i.e. other ecosystem participants) currently have equal potential for benefit and detriment whilst the market is still susceptible to shocks. Competition is stiff within the mining industry, and a prompt extinction awaits if you are not a cost or innovation leader[2]. This is expected — economic profit tends to zero in long-term equilibrium in a perfectly competitive landscape [3], and the marginal cost of producing and the market price oscillate around an equilibrium point[4], with evolution and improvement the only way to stay in business. In such competitive markets, there is also a natural tendency for the market to be dominated by three or four players[5],[6]. The Pareto Principle, also known as the 80/20 rule[7], states 20% of the market participants control 80% of the market. In November 2015, the 5 largest pools provided 79% of mining power. In June 2018, the largest 5 provided 70% of hash rate, with 78% of power coming from the top 6. That said, the pools are not monolithic entities.

Figure 2 — Bitcoin Network Hash Rate (NHR) Distribution[8]

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. Table 1 shows the relationship between hash rate and price and shows the outcomes for miners in six different scenarios.

Table 1 — Price — Hash Rate Relationship Matrix

Effectively, if price of the commodity (i.e. demand) increases well beyond the cost to mine the commodity, miners will enter the market until the price and cost are equal. If price decreases, miners leave the industry until there are only profitable miners (i.e. either cost or innovation leaders) remaining. If price is dramatically lower than cost to mine, some miners may elect to simply buy bitcoin up to the current cost to mine. If the market is flat, profit tends towards zero until the market is shaken up again. This is similar to the workings of physical commodity miners in the commodity[9] and oil[10] 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[11], 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[12] 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[12] 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[7], 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[13].

Now that you have a very thorough understanding of the market and what is going through a miner’s mind, the focus of the series will shift to the cost of mining Bitcoin.

[1] Johnson, G., Scholes, K., Whittington, R. (2008) “Exploring Strategy- 8th Edition”, Essex: Pearson 59–67

[2] Afuah, A. (1998) “Innovation Management: Strategies, Implementation and Profits — 1st edition” Oxford: Oxford University Press. 13–46

[3] Parkin, M. (2014) “Microeconomics — 11th Edition”, New York: Pearson 272–296

[4] Parkin, M. (2014) “Microeconomics — 11th Edition”, New York: Pearson 272–296

[5] Henderson, B. (1976) “The Rule of Three and Four”, s.l.: Boston Consulting Group.

[6] Sheth, J. N., Sisodia, R. S. (2002) “Competitive Markets and the Rule of Three”, London, Ontario, Canada: Ivey School of Business.

[7] Pareto, V. (2014) “Manual of Political Economy”, Oxford: Oxford University Press

[8]Blockchain.info, “Bitcoin Hash rate Distribution”, http://archive.fo/jPsCb

[9] Deaton, A., Laroque, G. “Competitive Storage and Commodity Price Dynamics”, Journal of Political Economy 104.5 896–923 (1996)

[10] Kilian, L. (2006) “Not All Oil Price Shocks are Alike: Disentangling Demand and Supply Shocks in Crude Oil Markets” CERN Discussion Paper №5994 1–57

[11] Mackey, M. “Commodity price fluctuations: Price dependent delays and nonlinearities as explanatory factors”, Journal of Economic Theory 48.2 497–509 (1989) doi: 10.1016/0022–0531(89)90039–2

[12] Colangelo, G. “Vertical vs. Horiztonal Integration: Pre-emptive Merging”, The Journal of Industrial Economics 43.3 323–327 (1995) doi: 10.2307/2950583

[13] Schumpeter, J A. (2003) [1943] “Capitalism, Socialism and Democracy”, London, Routledge 83