The Cost & Sustainability of Bitcoin — Part IV — Perfect Competition & Microeconomics
The example of “the hypothetical firm in a perfectly competitive market” is taught in most introductory economics classes. A literature review of primary academic texts[i],[ii],[iii],[iv],[v],[vi] identifies nine conditions that define a perfectly competitive market:
- Homogeneous products
- guaranteed property rights
- non-increasing returns to scale
- zero transaction costs
- perfect factor mobility
- no barriers to entry or exit
- many buyers and sellers
- perfect information
- no externalities
When compared with real world data, the Bitcoin mining market (BMM) does not meet all aforementioned conditions of perfect competition, due to a relatively low number of ecosystem participants, currently resulting in wealth and information asymmetry. However, the BMM is trending towards becoming perfectly competitive as the wider Bitcoin macroeconomy grows, which will now be demonstrated.
As at date of writing, the BMM satisfies six criteria of a perfectly competitive market. Bitcoin’s nature as an open-source, encrypted, distributed ledger means that the blockchain guarantees property rights and homogeneity, at zero or near-zero transaction and storage cost[vii]. The factors of production (labour, equipment, and capital) are mobile to the extent that only a communication link and a power source is required to participate in the ecosystem. Due to its economic incentive mechanisms[viii], any mining entity approaching 50% of network hash rate (NHR) would experience non-increasing returns to scale, if not jeopardize its own existence, as witnessed during the GHash.io saga of 2014[ix]. Developing on top of Bitcoin requires no permission, and if entrepreneurs have a good enough idea, securing start-up capital is not a difficult barrier to entry to overcome, with over one billion US dollars invested in Bitcoin start-ups to date[x]. Low barriers are also commonplace in very young markets, with imitative entry into the market quite rampant[xi]. Conversely, barriers to exit are quite low for most market participants except for heavily leveraged or undiversified miners, who risk holding highly specialized computing equipment that may be unable to mine other digital commodities. This is no different to traditional undiversified commodity miners[xii].
The satisfaction of the final three conditions relies solely on the growth of the network and passing of time. The current size of Bitcoin’s user base is speculative, and always will be due to its pseudonymous nature. CNBC reported[xiii] that 8% of American adults had invested in cryptocurrency (or, 8% of 250 million people[xiv] = 20 million). Yahoo Finance reported[xv] that 16.3 million Americans buy and sell bitcoin frequently. Coinbase reports that they have over 20 million users[xvi]. Meanwhile, in some parts of Europe is estimated that an average 4% of consumers use cryptocurrency as a payment method every day as of 2016, with Eastern Europe leading the charge at 11%[xvii]. The numbers play out as follows[xviii]:
When adding US and European numbers, a high estimate of over 50 million users can be made. Although this sounds like a market with “many buyers and sellers”, 50 million people only accounts for 0.8% of the World’s adult population18. A much lower estimate of between 2.9 million and 5.8 million has been highlighted in a very detailed assessment of the global cryptocurrency market produced by Cambridge University in April 2017[xix] (granted, things have changed dramatically since April 2017 when price was only USD$1000, right before the “big hype” of late 2017, where a significant number of new users would have come into the ecosystem).
From a commercial markets point of view, a strong case can be made that a few participants have an inordinate, albeit temporary, grip over pricing and information. The temporary nature is shown in the table below, comparing wallet balance distribution since December 2014. We can see that there has been a flatting of the distribution of coin holdings away from large wallet balances to much lower balances. As can be seen, coins held in wallets with balances containing between 0.001 to 10 BTC have grown dramatically.
It should be noted that all wallets with a balance of over 100,000 coins belong to identified exchanges / custodial wallets[xxi]. The identifiable custodial wallets, alongside their “total wallet balance rank”, is as follows:
The above table does not include coins held in custody by other major custodians such as BitMex, Poloniex, Coinbase, and others. It is expected that a lot of wallets with very large balances are custodial wallets, especially as those wallets have several hundred inputs and outputs over a short period of time, which means that the distribution may be even flatter than demonstrated above. A study of Bitcoin Unspent Transaction Outputs (UTXO) by Unchained Capital[xxii] studying the shift of old coins into new hands over time, noted that 15% of BTC moved out of wallets that had been dormant for 2 to 5 years during the 2017 Bitcoin rally. This trend of a flattening in distribution is expected to continue, as spent bitcoin is spent forever, and needs to be earned back.
Bitcoin’s current major externality is the CO2 emitted by hardware operating and securing the network, which is discussed in depth in later parts of this series. Therefore, as the world moves towards carbon-free energy sources over the coming centuries, in additional to cleaner and more efficient mineral mining and e-waste recycling technology, Bitcoin’s CO2 emission externalities will eventually tend towards zero. Based on strong and predictable trends indicating technological improvements driving down costs of renewables[xxiii], as well as the potential for fossil fuels to be priced fairly (i.e. more expensively) under future carbon trading schemes[xxiv], we may witness a more expedient migration to renewables. As history has shown several times, the death of an incumbent technology is swift when displaced by something better[xxv].
Bitcoin is not perfectly competitive in its current state but is very close to becoming so. Note, no matter how close it comes to being perfect, reaching perfection in nature is impossible. 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), should Bitcoin have a “long-term”.
Most importantly, in a perfectly competitive environment, marginal cost to produce a good (MC) is equal to the marginal revenue from selling that good (MR), i.e., in long-term equilibrium (another purely theoretical, never-reached moment) cost to mine will be equal to the price of a bitcoin, and in the short term, this equilibrium point will be established by the market.
Next week, we’ll look at Perfect Competition and Managerial Economics.
References
[i] Parkin, M. (2014) “Microeconomics — 11th Edition”, New York: Pearson 272–296
[ii] Mankiw, N. (2011) “Principles of Economics — 6th Edition”: South-Western Cengage 291- 314
[iii] Makowski, L., Ostroy, J. “Perfect Competition and the Creativity of the Market”, Journal of Economic Literature, Vol. XXXIX (June 2001) 479–535
[iv] Stiglitz, Joseph E.; Walsh, Carl E. (2006). “Economics (4th ed.)”, New York: W.W. Norton & Company 205–222
[v] Dean, J. (1951) “Managerial Economics” New York: Prentice Hall
[vi] Semulson, W., Marks, J. (2012) “Managerial Economics 7th edition”, New York: John Wiley & Sons 283–318
[vii] Bitcoin Wiki, “Transaction Fees”, (accessed 27 February) https://en.bitcoin.it/wiki/Transaction_fees (21:33)
[viii] Nakamoto, S. “Bitcoin: A Peer-to-Peer Electronic Cash System.” No Publisher (2008) https://bitcoin.org/bitcoin.pdf, 1–9
[ix] Wile, R. (14 June 2014) “Today, Bitcoin’s Doomsday Scenario Arrived” (accessed 26 February 2016), http://www.businessinsider.com.au/today-bitcoins-doomsday-scenario-arrived-2014-6?r=US&IR=T, (21:37)
[x] Pagliery, J. (2015) “Record $1 billion invested in Bitcoin firms so far”, (accessed 26 February 2016) http://money.cnn.com/2015/11/02/technology/bitcoin-1-billion-invested/ (21:38)
[xi] Geroski, P. “The Evolution of New Markets”, Oxford University Press Scholarship Online, 61–100 (2003) doi: 10.1093/0199248893
[xii] Washbourne, M. “Diversified Miners Are Best Bet”, Australia’s Paydirt, 1.217 40 (2014)
[xiii] Guez, G. “Just 8 percent of Americans are invested in cryptocurrencies, survey says” http://archive.is/Mmvqh
[xiv] US Census Bureau, Quick Facts (Accessed 11 June 2018), https://www.census.gov/quickfacts/fact/table/US/PST045217
[xv] Hahm, M. “16.3 million Americans buy and sell bitcoin frequently” (accessed https://finance.yahoo.com/news/16-3-million-americans-buy-sell-bitcoin-frequently-181415210.html
[xvi] Coinbase, About Page (accessed 11 June 2018) http://archive.is/3xPpy
[xvii] Statista, “Share of consumers using cryptocurrency as a payment method every day in Europe as of 2016, by country”, http://archive.li/czwvf
[xviii] PopulationPyramid.net, “World Population Pyramids”, http://archive.li/Bq9va
[xix] Hileman, G., Rauchs, M. “Global Cryptocurrency Benchmarking Study”, Centre for Alternative Finance, University of Cambridge, pp 10, http://archive.is/eKjmR
[xx] BitcoinRichlist, “Top 100 Richest Wallet Balances (Dec 2014)” http://archive.is/yECCV
[xxi] BitcoinRichlist, “Top 100 Richest Bitcoin Addresses” (June 2018), http://archive.is/Fx3K0
[xxii] Bansal, D. “Bitcoin Data Science (Pt. 1): HODL Waves” http://archive.is/l7atC
[xxiii] Fraunhoffer Institute (2013) “Levelized Cost of Electricity — Renewable Energy Technologies” (accessed 26 February 2016) http://archive.fo/0KPll
[xxiv] Ellerman, A., Convery, F., de Perthuis, C. (2010) “Pricing Carbon — The European Union Emissions Trading Scheme”, Cambridge, Cambridge University Press 85–122
[xxv] Afuah, A. (1998) “Innovation Management: Strategies, Implementation and Profits — 1st edition” Oxford: Oxford University Press. 13–46
