I understand that the market reaches this consensus through buyers and sellers placing their bids and asks on the exchanges, but WHY is a Bitcoin worth that price?

If Bitcoins were at $50 right now we would all probably think that was completely reasonable. If they were trading at $1000 a Bitcoin we would accept that too. Do buyers just pick arbitrary sell prices in their head, and then sellers pick arbitrary buy prices, and then the market reaches a consensus? Does anyone actually have a good understand of this or is there no "good answer". Thanks.

The way to determine to determine the price is by using the money velocity equation:

V*M=nT (1)

where V is average velocity (how fast money changes hands in actual transactions), M is the number of money units, i.e., bitcoin - currently about 11m. nT is the nominal value of all transactions measured in

BTC.

nT=P*Y where Y is the real value of all transactions and P is the price level (antiderivative of inflation level) which is inversely proportional to the value of the money, so nT=Y/val.

Whence

(1)=> V*M=Y/val => val=Y/(V*M) (2)

Lets put some values into this equation (2), note that I am just making qualified guesses now. Some people may very well improve upon this answer below:

Y is the real value of actual Bitcoin transactions, I say actual because many transactions in the Blockchain are just transfers between different accounts which have the same owner. Satoshidice transactions are real transactions, though, since they fulfill a market demand. I choose to measure Y in dollars. Let's just assume the Y is currently 20 times the value of the revenue of

bitcoinsstore.com, so Y=20*400,000$/month=8,000,000$/month=96,000,000$/year ~100,000,000$/year.

I assume V=1/year which is close to that of state fiat currencies. Plugging this into (2) yields:

val=100,000,000$/(1*11,000,000)~9 dollar/

BTCThis is a fairly low value since I have not accounted for speculation (buying because some expect

BTC to rise in value comp. to $) and since I may have underestimated Y. Speculation can be accounted for in a higher Y and a lower V which both raise the value of "val".

I hope this gives you an idea of how to evaluate

BTC's potential, though. It all depends on Y in the long run, i.e., how large the market for actual Bitcoin transactions will become in the future.

Regards,

Sword Smith

Edit: I want to point out that I see my estimate on Y as an estimate of the current value of transactions and by no means an estimate of the value of future transactions. The value of M is also highly debatable.