The Fallacy of Mining Cost and Bitcoin Price

[DrYe5]

I have yet to see a rational explanation of why the price should track mining difficulty. Anyone?

[Sannyasi]

in theory: higher difficulty = less production of coins = less new coins coming into the market = supply/demand does the rest

[drknark]

Since the difficulty adjusts to keep the supply constant, I don't think that argument is valid. There is no reason for the price to track the difficulty. There are however some reasons why the difficulty should follow the price. When the reward for mining increases, more people are likely to start mining or to expand.

[lakehead]

As new people discover bitcoin as an investment, they'll each make a choice... buy bitcoins, or mine bitcoins.  So it goes, the more difficult they are to mine, the more attractive they are as simple buy option.

[fabianhjr]

No, it is more of:
1)Diff rises
2)Supply remains constant
3)Cost of producing a coin increases
4)Miners increase the ask in order to maintain a profit
5)Cycle repeats

[DrYe5]

No, it is more of:
1)Diff rises
2)Supply remains constant
3)Cost of producing a coin increases
4)Miners increase the ask in order to maintain a profit
5)Cycle repeats

Miners can't both buy coins to increase ask and sell coins to maintain profit. This requires new holders.

[Sukrim]

Well, as difficulty can influence supply

Difficulty does not influence supply. Supply is practically constant.

If 50% of miners quit because of difficulty, supply will go down 50% and difficulty will go down LATER to make supply catch up.

Just look at the graphs right now - as soon as there is less hash rate than what the difficulty suggests, you'll see a drop in supply too. Also since the network grew quit a lot so far, even a "correct" block rate of 6 blocks/hour would be quite a cut in supply!

Yes, it can be argued, that if 1 Bitcoin is worth 1 Million USD, it will still be worth to mine with very high difficulties and just get a few Microcoins.
You also need to factor in the psychological aspects of mining - it is much nicer to get 10 BTC worth 10 USD each than one single Millibitcent (0.001 BTC)  when 1 BTC is worth 100 000 USD. People are used to 2 digits max. after the decimal seperator when it comes to currencies. Yes, we could then just switch to trading in Millibitcents or so - BUT this is currently not happening, so people are more reluctant to spend 50 USD for 1 BTC than 50 USD for 1000 Millibitcents!

Currently for an average miner, you only get "a few cents" per day. Even if these would be worth more than a dozen coins some time ago, it sounds less, so they are being valued less. Even right now with >15 USD/coin I rarely see "uneven" amounts of Bitcoins asked/offered in the marketplace for example!

[Teej]

Let me put it this way.

In the past 17.5 hours, there's been approximately (17.5 * 50 * 6)= 5250 new bitcoins produced.

The total number changing hands on the open markets (as represented by bitcoincharts) is less than half of that.

Therefore, at least for this 17.5 hour sample of time, difficulty hasn't mattered in the least.

[kjj]

The system is a chaotic multi-variable nonlinear system where all the parts are interlinked.  Please stop trying to make sense of it by inventing serial relationships that do not exist.

If you serialize it into a false string of A causes B causes C relationships, you can be absolutely positive that you will never understand it.

Edit: 2011-06-26, proofreading failure.  understanding

[tsvekric]

ok, since people like to use gold as an example:

Lets say x amount of gold is worth $100.  It costs you $80 to mine x once you get the equipment and training to do so.  You still sell at $100, although your new gold entering the market will slightly drag the price down (slight increase in supply).  This drag down varies because who knows how much gold can be mined in a day - it changes.  This is not the case with bitcoins, no matter the difficulty there will always be the same amount of bitcoins mined.  This makes the currency facing constant pressure of an increasing supply - but this rate is mostly constant (as in, independent of difficulty).

Now back to gold; suddenly it costs you $10,000 to mine x amount of gold (that sells for $100) and you stupidly decide mining is a good idea.  You spend $10,000, you mine x gold, and you come to the market and want to be compensated for the increasing cost of mining and you are greatly disappointed - from the market's perspective, it is the exact same scenario as was first presenting: x gold enters the market, very slight pressure for the value of gold to move down due to an increase in supply.  The only difference is you were stupid enough to pay $10,000 to get $100 worth of gold.


Eventually mining will become not very profitable - it will only be left for people in it for the long haul who have already bought GPUs, or people who can mine on a free ride (at work or something).  Difficulty will adjust to price, not vice versa.  Once difficulty gets high enough to be not profitable at all, miners will start to leave - price won't just magically go up to help out the poor miners.  As of a month ago mining was profitable for anyone who chose to enter it - this is obviously not something that can be sustained.  Difficulty will rise to the point that it will not make sense for most people to enter it.

[bittersweet]

There was a huge diffuculty update last time, its not easy to mine bitcoins now.
So why peaople sell them for a $15 at tradehill?

It has been explained many times that difficulty doesn't determine price. What determines price is supply and demand. The factor of current difficulty is neglible. First of all, there are millions of coins on the market mined when the price and difficulty were much lower than now. Second, you are wrong if you think selling Bitcoins if it's below profitability margin doesn't make sense. It makes perfect sense if you believe price will go down so you can buy the Bitcoins back later. Or if you need cash. Or if you think investing in mining was your biggest life mistake and just want to quit and sell the hardware and Bitcoins before their price drops even more.

[bitcoinBull]

There was a huge diffuculty update last time, its not easy to mine bitcoins now.
So why peaople sell them for a $15 at tradehill?

Because they are scared they'll have to sell them for less tomorrow.

I've been updating graphs of the price over difficulty ratio since a couple of months ago (check my sig).  With difficulty at 1.3 million and price at $15, that's near the 1:1 ratio which is quite low historically.  Record low was around 0.75 in march when but difficulty was at 100,000 and price was $0.75.  (Yea, it rose that much that quick).

Speculators are fearful right now.  A lot got burned buying at $30.  Now they're selling on the cheap.  Look to price increases around the corner (yes, it will be increasing as a result of the difficulty increase.  Price drives difficulty and difficulty drives price: two-way causality).

[Thanak]

The difficulty of mining has gone up because a lot of people are mining because ... well it's still pretty easy. Right now most of the bitcoin market is for speculator.

Bitcoin has A LOT of potential as a currency but it's just that... potential. If you want to see the price really go up, you need to see real trade being made in bitcoin. That means goods and services, and not the type of services that are linked to bitcoin (mining contract, gambling).

You need to have people offering something of value in exchange for bitcoin... and those people will do it is they expect to get something of value in turn. Gambling and piramide junk are just spam that are keeping real economy from actually happening.

[bitcoinBull]

You need to have people offering something of value in exchange for bitcoin... and those people will do it is they expect to get something of value in turn. Gambling and piramide junk are just spam that are keeping real economy from actually happening.

Us dollars, Euros, etc. aren't something of value in return?  They are.  All that trading for USD is the real economy.  It doesn't need to be trades for drugs, porn, or socks to be real economic activity.

[chiropteran]

Difficulty and BTC value are related, but there is some wiggle room involved.


At one extreme is the cost to produce 1 BTC based on electricity.  If you assume hardware cost is free (as it is for some miners, who only mine on hardware they already bought for other purposes), the cost to produce a BTC is only the additional electricity expended.  

This sets the hard lower limit for value.  If value ever gets lower than this point, NO rational miners will mine, and difficulty will plummet.

At the other extreme is the total package cost to buy hardware, pay for it's leased location, electricity, etc, and pay it all off.  It's harder to pick an exact point, but i'd say for most people when you can pay off the entire hardware investment plus electricity and opportunity costs within 2 weeks of mining...

This sets the hard upper limit for value.  If value gets higher than this point, mining becomes so insanely profitable that even the cautious investors will start buying hardware to mine and difficulty will increase massively.

Reality is that the market adjusts well before these hard limits are ever reached.  But you have to realize, there is a wide spread of values between these extremes.  Based on current difficulty and hardware costs, the hard lower limit is around $2-3/BTC for many electricity costs, while the hard upper limit is around $80/BTC based on some very rough estimates I just made in my mind.  Don't sue me if I am off, the point is there is an upper and lower limit based on difficulty, but it is a wide range and there won't be immediate changes based on difficulty.

[bittersweet]

Us dollars, Euros, etc. aren't something of value in return? They are. All that trading for USD is the real economy.  It doesn't need to be trades for drugs, porn, or socks to be real economic activity.

No, it's not the same. If you have to exchange money every time you want to buy some real goods you can just as well get rid of Bitcoins completely and stay with USD and gold - it's less hassle and less risk. "Economy" based solely on generating numbers and selling them for USD is not sustainable in the long run.

[Thanak]

Us dollars, Euros, etc. aren't something of value in return? They are. All that trading for USD is the real economy.  It doesn't need to be trades for drugs, porn, or socks to be real economic activity.

No, it's not the same. If you have to exchange money every time you want to buy some real goods you can just as well get rid of Bitcoins completely and stay with USD and gold - it's less hassle and less risk. "Economy" based solely on generating numbers and selling them for USD is not sustainable in the long run.

Exactly, the gain of using bitcoin is not worth the hassle of switching cash to bitcoin and then bitcoin to cash (except maybe for drugs  ).

The current price is based on the speculation that real economy will pick up and has little to do with how rare a coin is.  Let's say I invent Thanakcoin, there are just like bitcoin, there will only be 10 of them in the world... they are super hard to mine. How much would they trade for.... zero ! no one expect Thanakcoins to be worth something in the future.

No matter how hard it is to get a bitcoin, if people don't expect a real economy to pickup in the long run, the price will not climb with the difficulty.

[tsvekric]

Difficulty and BTC value are related, but there is some wiggle room involved.


At one extreme is the cost to produce 1 BTC based on electricity.  If you assume hardware cost is free (as it is for some miners, who only mine on hardware they already bought for other purposes), the cost to produce a BTC is only the additional electricity expended.  

This sets the hard lower limit for value.  If value ever gets lower than this point, NO rational miners will mine, and difficulty will plummet.

At the other extreme is the total package cost to buy hardware, pay for it's leased location, electricity, etc, and pay it all off.  It's harder to pick an exact point, but i'd say for most people when you can pay off the entire hardware investment plus electricity and opportunity costs within 2 weeks of mining...

This sets the hard upper limit for value.  If value gets higher than this point, mining becomes so insanely profitable that even the cautious investors will start buying hardware to mine and difficulty will increase massively.

Reality is that the market adjusts well before these hard limits are ever reached.  But you have to realize, there is a wide spread of values between these extremes.  Based on current difficulty and hardware costs, the hard lower limit is around $2-3/BTC for many electricity costs, while the hard upper limit is around $80/BTC based on some very rough estimates I just made in my mind.  Don't sue me if I am off, the point is there is an upper and lower limit based on difficulty, but it is a wide range and there won't be immediate changes based on difficulty.

No, that doesn't make sense.  Miners do not all pay the same costs, they will drop out gradually as price drops/difficulty rises and will start up as price rises/difficulty falls.  Some people have very little costs, and if BTC gets low enough difficulty could drop to a point where even CPU mining would make sense again (especially for people who don't pay the electricity costs of the computer they are mining on).  I don't understand why you are using the term 'hard limit' for any of this.  It is a gradient.  As price rises, so will difficulty.  If electricity costs fall, difficulty rises (if price stays the same).  It is a marginal adjustment and BTC could rise to $100 each and depending on other factors it might not be rational to buy a mining rig.  

[Jaime Frontero]

The system is a chaotic multi-variable nonlinear system where all the parts are interlinked.  Please stop trying to make sense of it by inventing serial relationships that do not exist.

If you serialize it into a false string of A causes B causes C relationships, you can be absolutely positive that you will never understanding it.

^^this.

[bitcoinBull]

Us dollars, Euros, etc. aren't something of value in return? They are. All that trading for USD is the real economy.  It doesn't need to be trades for drugs, porn, or socks to be real economic activity.

No, it's not the same. If you have to exchange money every time you want to buy some real goods you can just as well get rid of Bitcoins completely and stay with USD and gold - it's less hassle and less risk. "Economy" based solely on generating numbers and selling them for USD is not sustainable in the long run.

You've already assumed that people buy BTC in order to buy real goods.  They don't.  We know that because the volume on the exchanges (who trade BTC for USD etc) is far greater than the volumes merchants see (who trade BTC for goods). 

So we know that most people buy BTC to store and transfer value, not goods per se.  They do so because bitcoin has many advantages over USD and gold (digital, decentralized, etc).  I agree it carries more risk, but with that risk also comes reward .  Bitcoin is like any other speculative asset (which can include any investment: currencies, real estate, commodities, tulips, etc) and is certainly one of the riskier (since it is newer).

But the speculation is not that people will want bitcoins as collector items or to buy alpaca socks or virtual avatars or anything else.  I speculate mainly that people will want bitcoins to store or transfer value not seizable by a central authority (which is to say that bitcoin is secure), and that others will continue speculating.

Ask the financial industry if speculation isn't a "real economy".  Or ask a homeowner burnt buy the mortgage crisis.  Bitcoin is a very real economy of a digital good and could be sustainable for as long as we live in a digital age.