Economics of the blocksize limit

[jonny1000]

There is a discussion about this is the technical forum:
https://bitcointalk.org/index.php?topic=813324.0;all

However the blocksize limit also appears to be an economic type of problem.

Current supply & demand curves for space in blocks

• If the blocksize limit increases and transaction fees fall, this can increase the velocity of money, boost inflation and stimulate the economy.  
  
• In contrast if the blocksize limit falls, the velocity of money can fall, causing deflation and an economic slowdown.  

Having a “Blocksize policy committee” to manage the economy, is not very consistent with Bitcoin’s values.  Therefore some other mechanism to determine the blocksize limit may be required.  Does anyone have any ideas?

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[redHeadBlunder]

What is your source of this graph? It looks like something that was "drawn" with excel. I would disagree that the max block size would affect the amount that people are willing to pay for their TX to get confirmed.

You also need to remember that there is no "set" fee for a TX fee, but rather the fee is based on how big the TX is (among other things). Also there are many "free" TX that are confirmed in every block (or almost every block)

[odolvlobo]

What is your source of this graph? It looks like something that was "drawn" with excel. I would disagree that the max block size would affect the amount that people are willing to pay for their TX to get confirmed.

Block size does affect how much users will pay for a transaction because of the economics. If there are more transactions than will fit in a block, then users will have to compete for space in the block, and miners will accept the transactions that maximize their fee revenue. If the block size is increased such that there is enough room for all transactions, then there will be no competition for space to drive up fees.

Assuming there is no competition for space, then miners will include any transaction with a fee (assuming that the cost of including the transaction is 0) because not including a transaction with a fee is just throwing away money. Fees could drop to 1 satoshi per transaction because there is no reason for miners to turn away 1 satoshi transaction fees (other than pride).

You also need to remember that there is no "set" fee for a TX fee, but rather the fee is based on how big the TX is (among other things). Also there are many "free" TX that are confirmed in every block (or almost every block)

You are describing the current policy that is implemented in the reference code. There is nothing preventing miners from adopting other fee structures that will increase their revenue, and there is nothing preventing users from adopting other fee structures that will lower their costs. In the end, economics will determine the fees, and not the policies of the Bitcoin Foundation.

[Eisenhower34]

You also need to remember that there is no "set" fee for a TX fee, but rather the fee is based on how big the TX is (among other things). Also there are many "free" TX that are confirmed in every block (or almost every block)

You are describing the current policy that is implemented in the reference code. There is nothing preventing miners from adopting other fee structures that will increase their revenue, and there is nothing preventing users from adopting other fee structures that will lower their costs. In the end, economics will determine the fees, and not the policies of the Bitcoin Foundation.

Even if the block space is available there is noting that says each block must be "filled" to the max block size. Even if the max block size is large, miners to have a small incremental cost for including each additional TX in their found block so they would likely not wish to include a lot of no fee TXs

[jonny1000]

What is your source of this graph? It looks like something that was "drawn" with excel. I would disagree that the max block size would affect the amount that people are willing to pay for their TX to get confirmed.

I did "draw" the charts myself on excel, as you suggest.  The max block size does not directly impact demand, however it impacts the supply curve and therefore the price.

Even if the block space is available there is noting that says each block must be "filled" to the max block size. Even if the max block size is large, miners to have a small incremental cost for including each additional TX in their found block so they would likely not wish to include a lot of no fee TXs

Miners may have a small marginal cost of including a transaction and therefore there is likely to be some low fee level.  However, in a competitive mining industry and unrestricted market, price will equal marginal cost.  At this level the equilibrium difficulty level may be too low.  We need artificial restrictions on the market to increase fees and therefore have a higher equilibrium difficulty.

Suppose all the miners form a cartel. They will have no problem funding themselves; they can all agree not to include any tx that doesn't pay high fees. The users would pay this fee because they have no other choice.

Some users will try to pay a fee lower than the cartel's threshold. One miner decides to defect from the cartel; he includes in his block all these low-fee transactions. This costs him nothing, so this is a net profit for him (he benefits).

Seeing this, users will know that even if they don't pay the cartel's high fees, they can still get their tx included eventually. Thus, their willingness to pay high fees is lower (that is, the miner consumed their willingness). Thus, more users will try to pay low fees, and the total revenue of all miners decreases.

But it's not just the one miner. Every miner will, individually, have an incentive to include low-fee txs. This means that even with a low fee, it's easy to get a tx to the block. Thus, no user will want to pay high fees, and the total revenue of miners will be low (this is the tragedy - for the miners, and due to the effect on network health, for all Bitcoin users).

This is completely analogous to the classical instance of tragedy of the commons, where all herders would benefit if they all grazed just their fair share, but everyone is incentivized to defect and overgraze, depleting the resource and causing everyone to suffer.

[Gavin Andresen]

If the block size is increased such that there is enough room for all transactions....

Please be more precise.

Nobody "increases the block size" -- miners choose to create larger or smaller blocks, up to the maximum block size limit.

And quoting myself: (from my recent blog post):

The argument is that keeping one-megabyte blocks will push up transaction fees, so as the block subsidy falls smaller blocks will make it more likely that fees will make up the difference and keep the network secure.

The counter-argument is that bigger blocks allow more transactions, so even if each transaction pays a smaller fee, the total will be greater.

I think that both of those arguments are wrong, because they are equating apples and oranges. The supply being rationed by a maximum block size is some number of bytes, which translates into a certain number of transactions. But the demand for blockchain security depends on the value and nature of the transaction; very large value transactions are typically secured by real-world contracts, long-established trust relationships, lawyers, and court systems.

So there is no guarantee that future one-megabyte blocks will be full of high-fee million-dollar transactions; it is possible we would see blocks full of tiny-fee million dollar transactions, because Gringotts Bank will take the Bank of Elbonia to court if they double-spend some large value inter-bank-settlement transaction.

There is no guarantee that future one-gigabyte blocks full of smaller transactions will generate enough fees to secure the blockchain, either. Transaction confirmation speed is important for most small-value transactions, so it is likely they will be secured using semi-trusted third parties who co-sign transactions and guarantee to never allow double-spending. And if they are secured against double-spending that way, there is little incentive for either the sender or recipient to include a transaction fee

[BlindMayorBitcorn]

If the block size is increased such that there is enough room for all transactions....

Please be more precise.

Nobody "increases the block size" -- miners choose to create larger or smaller blocks, up to the maximum block size limit.

And quoting myself: (from my recent blog post):

The argument is that keeping one-megabyte blocks will push up transaction fees, so as the block subsidy falls smaller blocks will make it more likely that fees will make up the difference and keep the network secure.

The counter-argument is that bigger blocks allow more transactions, so even if each transaction pays a smaller fee, the total will be greater.

I think that both of those arguments are wrong, because they are equating apples and oranges. The supply being rationed by a maximum block size is some number of bytes, which translates into a certain number of transactions. But the demand for blockchain security depends on the value and nature of the transaction; very large value transactions are typically secured by real-world contracts, long-established trust relationships, lawyers, and court systems.

So there is no guarantee that future one-megabyte blocks will be full of high-fee million-dollar transactions; it is possible we would see blocks full of tiny-fee million dollar transactions, because Gringotts Bank will take the Bank of Elbonia to court if they double-spend some large value inter-bank-settlement transaction.

There is no guarantee that future one-gigabyte blocks full of smaller transactions will generate enough fees to secure the blockchain, either. Transaction confirmation speed is important for most small-value transactions, so it is likely they will be secured using semi-trusted third parties who co-sign transactions and guarantee to never allow double-spending. And if they are secured against double-spending that way, there is little incentive for either the sender or recipient to include a transaction fee

Bump. Head Cheese speaks the truth

[jonny1000]

Gavin thanks again for replying to my post.  

To repeat, I do think we may need artificial scarcity of something, to ensure the equilibrium difficulty level is sufficient.  However, I do not think this means we need to keep a one megabyte block limit, I do not think anyone is arguing that.  If you want to frame the discussion in that way by referring to one megabyte, then yes, you are correct and the block size limit should be increased.  Many are arguing that a limit of some kind may be important for economic reasons and it’s important not to rush ahead with permanent exponential growth in the limit.  If you want to increase the limit to say 5 megabytes now, not that it matters, but you would have my full support.

“The demand for blockchain security depends on the value and nature of the transaction”, this is a good point and may well be true, however it would be good to have a robust mechanism to transfer that demand into the willingness and the necessity to pay transaction fees, without the free rider problem.

What you say about small transactions going off chain to semi trusted third parties and therefore not adding demand for transaction fees is interesting, and probably correct.  As far as I am aware, currently, the only way to send bitcoin, without a third party intermediary, involves paying transaction fees to miners.  This situation may be necessary to ensure the network is secure.  If anyone finds an efficient, cheaper way around this, whether it is some clever Etheruem contract, a Sidechain or whatever, then the network security is under threat if no alternative mining incentivisation methodology is found.

Gavin, I share your optimism that there may be many people who want a secure network and will find a way of incentivising miners.  However this line of thought may not be robust enough.  Anyone can create a distributed consensus mechanism or new coin with some holes in the architecture and then claim, well when the system is large enough there will be many clever people and businesses with the right incentives to work it all out.  We should try to understand what happens when the block reward falls to a low level as early as possible, to inform better decisions now.  For example to decide whether Sidechains are allowed.

[Eisenhower34]

Even if the block space is available there is noting that says each block must be "filled" to the max block size. Even if the max block size is large, miners to have a small incremental cost for including each additional TX in their found block so they would likely not wish to include a lot of no fee TXs

Miners may have a small marginal cost of including a transaction and therefore there is likely to be some low fee level.  However, in a competitive mining industry and unrestricted market, price will equal marginal cost.  At this level the equilibrium difficulty level may be too low.  We need artificial restrictions on the market to increase fees and therefore have a higher equilibrium difficulty.

The marginal cost increases as the miners' blocks get bigger as the chances of their block getting orphaned will increase as the miners' blocks get bigger. I would also say that regardless of the block size, the number of no fee TXs will decrease as the block subsidy decreases as the miners are generally not going to want to confirm zero fee TXs when they are receiving a diminishing amount of revenue

[jonny1000]

Eisenhower, thanks for your response

I think you are probably correct it what you say.  However I am trying to put forward a framework to analyse the transaction fee market and consider scenarios which could occur.  We need to evaluate the potential characteristics on the mining industry and the price/difficulty mechanics which could exist.

Let us assume the following:
·         Mining has low barriers to entry and exit
·         Mining is potentially anonymous
·         There are many miners
·         Mining is competitive in nature
·         Miners want to maximise profit
·         Bitcoin price volatility is low relative to mining costs
·         The rate of innovation in mining equipment is low
·         The marginal cost of including transactions in a block is similar across the industry

We don’t know if mining will turn out this way, but it is both possible and desirable to have these characteristics in the long run.  Of course I could be totally wrong and the industry may never have these characteristics.

In this scenario mining cartels are not feasible as defections will occur.  A competitive market for transactions fees may therefore emerge.  Miners may want to earn every extra bit of revenue they can and lower fees until price = marginal cost.  At this point mining profitability will be very low and miners will exit the market.  The network difficulty then falls.  At this point two things could happen:

1.      Mining becomes more profitable as the difficulty is lower
2.      Miners begin to lower transaction fees again to increase revenue

In a genuinely perfect market, it is the 2nd of these things which will happen, resulting in a downward spiral in the difficulty.

There are probably many holes in this logic:

1.      If the difficulty falls, the value of Bitcoin will eventually fall, resulting in higher value volatility, then miners could join the network speculating that the price will increase.
2.      Users could want faster conformation times and even if some miners lower fee demands, users could keep fees high
3.      It is in the fundamental nature of the world we live in that there will always be volatility or change.  The change could occur in mining technology, the value of Bitcoin, demand for transactions, energy costs, mining tax rates ect.  This ensures the network is always in a constant state of flux.  The marginal cost of including transactions will always change in unpredictable ways.  Therefore there will always be incentives for entrepreneurial speculative miners to enter the market and therefore the network will always be secure.