Why cost of production only started to matter with ASICs

[hazenyc]

*Please note the axes are mislabeled. The left y-axis is 1/log difficulty and the right y-axis is log J/GH


People have been pondering whether cost of production matters in bitcoin value formation. And it certainly does: http://papers.ssrn.com/abstract=2580904
But the rebuttal is well this may be the case now but it wasn't before. This post will try to give a reason why. And this is aside from the fact that there was rampant price manipulation and fraudulent trading in 2013 bringing the price well above $1,000 for no fundamental reason.
Economics would predict that marginal cost and marginal product, like supply and demand, will eventually converge to an equilibrium, and we see that during much of 2014 as ASIC tech kept pace with network growth in the graph above. But I am getting ahead of myself.

Whenever the orange line (energy efficiency) is above the blue line (difficulty), changes in difficulty are exceeding changes in efficiency and vice versa. So right now, difficulty is outpacing tech. progress. When ASIC first introduced, technology outpaced network growth (difficulty is a direct measure of network size)

So put one last way - the purple shaded area exists when the network growth is outpacing technological change. The data on GPU mining is admittedly not complete having just one representative data point, but I think that it nonetheless tells the same story.
Green areas exist when technological change is outpacing network growth. When they line up, the "supply and demand" is in equilibrium..

This also tells a nice economic story: In the beginning, people mined with CPUs and all was well. GPU mining came along and only served to crowd out CPU miners by growing the network exponentially. But since GPU cards are not developed with the express purpose of mining - they are made mainly for computer graphics - they were not induced to improve. GPUs just happened to be better than CPUs. It's like mining for gold with a shoe because it happens to be better than a sock. Also, since CPUs and GPUs run inside a PC which is normally left powered on anyhow, the electricity usage extracted for mining was less obvious than it is now. CPUs and GPUs also consume electricity to do other fun things like run spreadsheets and render video game worlds.  
GPU mining also started to crowd out lesser GPUs. We see this as the difficulty chart starts to level out a bit in 2012.

This all changed with ASICs - specifically designed to mine. The shoe was replaced by a shovel. The shovel then turned into a steam shovel and then a modern-day mining operation. It is only with ASICs that the economics begin to line up because the induced technological change is making for better shovels and not finding something better than shoe which also not a shovel. It is easy to find a new low-cost producer of shovels by improving upon the last. Economic theory works when diggers use shovels and falls apart when they dig with shoes and socks. This is why shovels needed to be brought to bear for economic theory to show up in practice. Of course, this implies that Bitcoins are commodities produced in a competitive market, but that's fine by me!
Right now we are reaching a point where network growth is outpacing technological change, and the logical step will be for new 22 or 18nm technology to come online. Hashcoins Uranus is a machine that claims 0.26 J/GH efficiency but it might just be vaporware for now...

[lyth0s]

*Please note the axes are mislabeled. The left y-axis is 1/log difficulty and the right y-axis is log J/GH


People have been pondering whether cost of production matters in bitcoin value formation. And it certainly does: http://papers.ssrn.com/abstract=2580904
But the rebuttal is well this may be the case now but it wasn't before. This post will try to give a reason why. And this is aside from the fact that there was rampant price manipulation and fraudulent trading in 2013 bringing the price well above $1,000 for no fundamental reason.
Economics would predict that marginal cost and marginal product, like supply and demand, will eventually converge to an equilibrium, and we see that during much of 2014 as ASIC tech kept pace with network growth in the graph above. But I am getting ahead of myself.

Whenever the orange line (energy efficiency) is above the blue line (difficulty), changes in difficulty are exceeding changes in efficiency and vice versa. So right now, difficulty is outpacing tech. progress. When ASIC first introduced, technology outpaced network growth (difficulty is a direct measure of network size)

So put one last way - the purple shaded area exists when the network growth is outpacing technological change. The data on GPU mining is admittedly not complete having just one representative data point, but I think that it nonetheless tells the same story.
Green areas exist when technological change is outpacing network growth. When they line up, the "supply and demand" is in equilibrium..

This also tells a nice economic story: In the beginning, people mined with CPUs and all was well. GPU mining came along and only served to crowd out CPU miners by growing the network exponentially. But since GPU cards are not developed with the express purpose of mining - they are made mainly for computer graphics - they were not induced to improve. GPUs just happened to be better than CPUs. It's like mining for gold with a shoe because it happens to be better than a sock. Also, since CPUs and GPUs run inside a PC which is normally left powered on anyhow, the electricity usage extracted for mining was less obvious than it is now. CPUs and GPUs also consume electricity to do other fun things like run spreadsheets and render video game worlds.  
GPU mining also started to crowd out lesser GPUs. We see this as the difficulty chart starts to level out a bit in 2012.

This all changed with ASICs - specifically designed to mine. The shoe was replaced by a shovel. The shovel then turned into a steam shovel and then a modern-day mining operation. It is only with ASICs that the economics begin to line up because the induced technological change is making for better shovels and not finding something better than shoe which also not a shovel. It is easy to find a new low-cost producer of shovels by improving upon the last. Economic theory works when diggers use shovels and falls apart when they dig with shoes and socks. This is why shovels needed to be brought to bear for economic theory to show up in practice. Of course, this implies that Bitcoins are commodities produced in a competitive market, but that's fine by me!
Right now we are reaching a point where network growth is outpacing technological change, and the logical step will be for new 22 or 18nm technology to come online. Hashcoins Uranus is a machine that claims 0.26 J/GH efficiency but it might just be vaporware for now...

That is an interesting hypothesis, however I do not agree with your conclusion that "the logical step will be for new 22 or 18nm technology to come online". New technology doesn't just research, develop and manufacture itself into existence, even though it does provide incentive to do so (if there is demand for the product). With Bitcoin price decreasing and network difficulty going up a more logical conclusion would need to be looking at what happens to the mining power or price per bitcoin in the near term *if* new technology does not come out to change the trend.

[hazenyc]

The theory of induced technological change suggests it will happen.

[lyth0s]

The theory of induced technological change suggests it will happen.

Technological change (TC) is a term that is used to describe the overall process of invention, innovation and diffusion of technology or processes.[1][2] The term is synonymous with technological development, technological achievement, and technological progress. In essence technological change is the invention of technologies (including processes) and their commercialization via research and development (producing emerging technologies), the continual improvement of technologies (in which they often become less expensive), and the diffusion of technologies throughout industry or society (which sometimes involves disruption and convergence). In short, technological change is based on both better and more technology.

I learned something new today, thanks!

[Amph]

the main factor is, that amd and nvidia are not interesting in mining, and thus their production cycle is not of few months, they develop new HW every year, much slower than asic's production cycle

if the bitcoin algo had been changed continuosly(a bit extreme to fork everytime but still..) to prevent asic, we would have a much better hash distribution around the world, permitting many people to join the mine's experience without buying costly miners every 4 weeks

[BillyBobZorton]

the main factor is, that amd and nvidia are not interestin in mining, and thus their production cycle is not of few months, they develop new HW every year, much slower than asic's production cycle

if the bitcoin algo had been changed continuosly(a bit extreme to fork everytime but still..) to prevent asic, we would have a much better hash distribution around the world, permitting many people to join the mine's experience without buying costly miners every 4 weeks

Like you said, forking is too extreme of a solution to do that periodically specially later on.
With POW, no matter what you do, at the end you'll always end up with a similar situation like we have now. And thats the point: Difficulty in mining - > more security.

Thats why even with its cons, I trust POW better than the other options.

[Amph]

the main factor is, that amd and nvidia are not interestin in mining, and thus their production cycle is not of few months, they develop new HW every year, much slower than asic's production cycle

if the bitcoin algo had been changed continuosly(a bit extreme to fork everytime but still..) to prevent asic, we would have a much better hash distribution around the world, permitting many people to join the mine's experience without buying costly miners every 4 weeks

Like you said, forking is too extreme of a solution to do that periodically specially later on.
With POW, no matter what you do, at the end you'll always end up with a similar situation like we have now. And thats the point: Difficulty in mining - > more security.

Thats why even with its cons, I trust POW better than the other options.

not exactly, with gpu is very difficult to achieve the current hash, i would say it's impossible with the current amd and nvidia line-up, 1 single s5 antminer is 1000 time more powerful than a gpu(last model), not to mention about wattage....

the current hash would have been reached only in many years, probably around the time where the miners only mine for fees, in other words the hash would have been increase in a steady way and not a boom every month

a better spreading over many years which is also good with the halving that happen every 4 years

[odolvlobo]

Interesting graph, but I don't think it is clear what your point is unless it is that cost of mining affects price of bitcoin. If that is the case, I don't see where you support it.

People have been pondering whether cost of production matters in bitcoin value formation. And it certainly does: http://papers.ssrn.com/abstract=2580904

That paper makes too many assumptions and unsupported claims to be credible.

Green areas exist when technological change is outpacing network growth. When they line up, the "supply and demand" is in equilibrium..
...

Not "supply and demand", but marginal cost and marginal product -- like you wrote earlier. Besides supply and demand are never in "equilibrium".

[hazenyc]

Interesting graph, but I don't think it is clear what your point is unless it is that cost of mining affects price of bitcoin. If that is the case, I don't see where you support it.

Yes I am a firm believer that bitcoin value is based on cost of production.
The problem was before ASICs came along the model didn't work. This graph and the accompanying explanation describes why that might be.
Which assumptions do you believe are unsubstantiated or false?

As for your second point you are absolutely right it represents mc = mp not supply and demand (per se). Pardon for misspeaking
Although, one might say that supply and demand are ALWAYS in equilibrium, just depends on at what price.

[Nagle]

Yes I am a firm believer that bitcoin value is based on cost of production.

Bitcoin doesn't work that way. Remember how difficulty adjusts to keep the Bitcoin production rate constant. Adding more total hash power does not yield more Bitcoins. This is not like other forms of production.

[hazenyc]

Yes I am a firm believer that bitcoin value is based on cost of production.

Bitcoin doesn't work that way. Remember how difficulty adjusts to keep the Bitcoin production rate constant. Adding more total hash power does not yield more Bitcoins. This is not like other forms of production.

Oh really  ...  ?

Yes, of course I know that. The difficulty increasing actually increases the cost of production though. Difficulty ends up being the manifestation of price elasticity of supply since there will always be 1 block every 10 minutes no matter what. Any other produced commodity would be able to adjust supply to accomodate changes in demand. Bitcoin cannot (directly). In other words, it is actually more costly per GH/s to mine in a network of 300 PH/s than if it were 200 PH/s for example.

the cost of production valuation model is:
$/BTC = ($cost of bitcoin a day per unit of hashing power) / (expected number of bitcoins you'll find each day on average given the same unit of hashing power)

the difficulty directly affects how many BTC you'd expect per day per GH.

read the paper it's all there.

[maku]

Yes I am a firm believer that bitcoin value is based on cost of production.

Bitcoin doesn't work that way. Remember how difficulty adjusts to keep the Bitcoin production rate constant. Adding more total hash power does not yield more Bitcoins. This is not like other forms of production.

I can just give you guys some very insightful quote to chew on. It is a quote by Satoshi Nakamoto Feb. 21, 2010: - "The price of any commodity tends to gravitate toward the production cost. If the price is below cost, then production slows down. If the price is above cost, profit can be made by generating and selling more. At the same time, the increased production would increase the difficulty, pushing the cost of generating towards the price. In later years, when new coin generation is a small percentage of the existing supply, market price will dictate the cost of production more than the other way around." And I think that Satoshi explained this problem you guys are talking about so well in a just few words.

[hazenyc]

"...when new coin generation is a small percentage of the existing supply, market price will dictate the cost of production more than the other way around."

This is actually a very interesting point. Satoshi envisioned that sometime after the next block reward halving that transaction fees would begin to be more sizeable than the block reward.
The problem is today, there is only something like 15-20 BTC generated as fees per day. Given 144 blocks per day that is only an average 0.1389 BTC per block (using 20 for fees). Or 0.56% of the total block reward.

The cost of production depends on the block reward -- including fees, but right now fees are negligible. When there are 100x more transaction fees a day and they generate 13.89 BTC per block, and let's say the 'official' block reward is 6.125 = 20ish BTC per block - then that is the value that will determine the cost of production (cost of production is per BTC, not per block). Block reward size (inclusive of fees) is a parameter in the valuation model.

The problem right now is that transaction fees are generated per transaction and don't (yet) depend much on the actual transaction size. Just watch the mempool fill up with new transactions and they all have 0.0001 - 0.0002 fees pretty much across the board whether it's a 1 BTC, 100 or 1000 BTC transaction that goes through. Of course you also have some freeloaders with 0.0000 fees that still get confirmed.

So it's a matter of adoption and not market price. The more adoption, the more daily transactions. Adoption increases by 100x, presumably 100x the fees, as a generalization. Also, one might presume that if 1 BTC = something dumb like $10,000, then why would they pay 0.0001 in fees ($1) per transaction? They wouldn't..

[odolvlobo]

Interesting graph, but I don't think it is clear what your point is unless it is that cost of mining affects price of bitcoin. If that is the case, I don't see where you support it.

Yes I am a firm believer that bitcoin value is based on cost of production.
The problem was before ASICs came along the model didn't work. This graph and the accompanying explanation describes why that might be.
Which assumptions do you believe are unsubstantiated or false?

In short, you do not explain how production cost affects supply and/or demand (which is necessary in order to affect the price).

Furthermore, your hypothesis is that production cost affects price, and you use a model based on that hypothesis to support the hypothesis. That's called begging the question.

[hazenyc]

Interesting graph, but I don't think it is clear what your point is unless it is that cost of mining affects price of bitcoin. If that is the case, I don't see where you support it.

Yes I am a firm believer that bitcoin value is based on cost of production.
The problem was before ASICs came along the model didn't work. This graph and the accompanying explanation describes why that might be.
Which assumptions do you believe are unsubstantiated or false?

In short, you do not explain how production cost affects supply and/or demand (which is necessary in order to affect the price).

Furthermore, your hypothesis is that production cost affects price, and you use a model based on that hypothesis to support the hypothesis. That's called begging the question.

1] Cost of production models are used widely in valuing commodities such as oil, ore, agricultural products, etc. This is not a new thing in terms of economic theory. Cost of production models in competitive markets can explain things like today's oil price collapse, for example. So the "hypothesis" of cost of production in commodities is not a new one, and it has been supported theoretically and empirically many times over. If you don't believe that bitcoin is a produced commodity in nature, then that is another debate entirely. Cost of production doesn't ever affect supply and demand. Supply in the case of bitcoin is fixed so there cannot be an accommodation in the rate of production, but instead it is expressed through changes in mining difficulty.

2] Production costs affect values and not prices. Although the difference is subtle, prices are the result of supply and demand in the market at a given time. Due to imbalances in supply and demand at a given moment market price may vary above or below the expected value. The models are for values not prices. Think about stock market valuation models, asset valuation models, discounted cash flow models etc. All of these predict an expected value, but actual market prices are affected by supply and demand. The fundamentals serve as a center of gravity around which prices tend to fluctuate. Again, this understanding of finance and economics is 100+ years old.

3] what I said is that for any one individual miner, the market price compared to their own cost of production determines whether or not they will operate or remove themselves from the network, as no rational profit-motivated individual would produce at a marginal loss for a prolonged period of time. Therefore, as new lower cost producers enter the network they can still be profitable at lower and lower market prices while those at the margin drop out. This theory of competition with low-cost producers goes back to Adam Smith or earlier.

4] the model is meant to be a model. Does the cobb-douglass production model actually describe the real world? no. Does the Solow model actually describe reality? no. But they don't have to. They are still useful in the insight that they bring to real-world phenomena.

[odolvlobo]

1] Cost of production models are used widely in valuing commodities such as oil, ore, agricultural products, etc. This is not a new thing in terms of economic theory. Cost of production models in competitive markets can explain things like today's oil price collapse, for example. So the "hypothesis" of cost of production in commodities is not a new one, and it has been supported theoretically and empirically many times over. If you don't believe that bitcoin is a produced commodity in nature, then that is another debate entirely. Cost of production doesn't ever affect supply and demand. Supply in the case of bitcoin is fixed so there cannot be an accommodation in the rate of production, but instead it is expressed through changes in mining difficulty.

Cost of production affects the supply in the commodity examples you gave above, and that is why it affects the prices of those commodities. On the other hand, it  does not affect the supply of bitcoins and I'm glad that you agree that it therefore does not affect the price.

[johnyj]

Cost of production affect market supply/demand dynamics: If it costs much less than market price to mine, then everyone will mine and sell to get a quick profit, almost no one will buy, so the price will drop quickly to the mining cost, which happened during last year.

Now when mining cost is higher than market price, many who want to get bitcoin will give up mining and purchase directly from market, while other more efficient miners will hold their coins waiting for a future appreciation (which is risky of course), but anyway buying support on market increased and sell pressure decreased, so the price tends to stabilize

The price would eventually drop if no one is interested in getting more coins (altcoin for example), in that case more and more miners will quit mining and difficulty will go all the way down, drag the cost down, and in turn the market price will drop

So far the difficulty is still high, means the people who want to get coins are not retreating, in fact they are powering more advanced ASIC development right now

One interesting thing about bitcoin is that it is like a racing, when others getting ahead of the race by using more powerful gears, people will become jealousy and put more money to upgrade their gears to stay ahead in the race, or directly buy coin to claim the reward. That is the craziness we have seen in last 2 bubbles