How is the exchange rate arrived at?

[capomo]

Hello, newbie economics question, helping towards required post count..

Do the various Bitcoin exchanges always trade at the same exchange rate?

I can see that Mt.Gox and Bitstamp are pretty close - is this just a feature of the 'market'?
I've read about 'pegged' exchange rates for normal currency but I suspect with Bitcoin
there's no-one to do the pegging.

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[Foxpup]

The exchange rate (not just with bitcoins but with all currencies) is simply whatever price people are willing to pay, eg, if I want to buy a bitcoin for $100, and someone else wants to sell a bitcoin for $100, then we make a trade and the exchange rate is $100. If instead they want to sell for $105, then obviously we can't make a trade unless one of us changes our price. If I'm really desperate to buy, I might raise my price to $105, or if they're really desperate to sell, they might lower their price to $100, otherwise no trade will take place. It's really that simple.

The exchanges simply consist of many people all making many different offers, with buyers and sellers being matched by an automated system, eg, if Alice offers to buy a bitcoin for $100, Bob offers to buy a bitcoin for $101, Charlie offers to sell a bitcoin for $105, and Dave offers to sell a bitcoin "at market" (meaning "at the best price currently on offer"), then the exchange will automatically sell Dave's bitcoin to Bob for $101, without Dave or Bob actually having to talk to each other or do anything else.

Different exchanges will have different offers on the books, and this will result in slightly different prices, but only slightly, due to arbitrage. Arbitrage is when someone buys from a seller offering a low price and immediately sells to a buyer offering a high price. This has the effect of raising prices where prices are low (because once you've bought up all the cheap coins, the remaining ones are more expensive), and lowering prices where prices are high (because there are only so many people will to buy for a high price, and once you've sold to those people, the only buyers left are those who will only pay low prices). In this way, arbitrage causes prices to reach an equilibrium between different exchanges, and in practice the only reason you'll see a big difference in prices between exchanges is if something is making arbitrage difficult or impossible (eg, high fees making it too expensive to move money from one exchange to another).

In case you're wondering, all other markets (shares, commodities, foreign exchange, etc) work exactly the same way.

[capomo]

Makes sense, thanks for the clear description...

Follow up question.. what's the significance of volume?

Are there any decent economics primers out there that might apply to Bitcoins and currency?

[Foxpup]

Follow up question.. what's the significance of volume?

Volume is just the number of bitcoins (or shares, or whatever) that have changed hands in a given time period. On paper, anyway. If I sell you a bitcoin and then buy it back for the same price, that's BTC2 of volume (BTC1 for each trade), even though there's no net change to our position. So be aware that volume can easily be manipulated.

Are there any decent economics primers out there that might apply to Bitcoins and currency?

I recommend Economics in One Lesson by Henry Hazlitt. You can download it here (PDF, 1.3 MB).

[capomo]

Great thanks for the link... I'm on it