Research paper on Bitcoin Fundamental Value & Decision to Mine

[hazenyc]

Many of the miners already know most of this stuff, but it's still a worthwhile read.
Not only does this develop a model for the intrinsic value of bitcoins based on cost of production, but also cautions that with increasing efficiency lowering the cost of production (i.e. lower watts per GH/s), the value of bitcoin may also decline. The block reward halving in late 2016 may have the effect of eliminating all but the most efficient miners.

https://www.researchgate.net/publication/272022750_The_Decision_to_Mine_for_Bitcoins_A_%28Computational%29_Labor_Theory_of_Intrinsic_Value

[odolvlobo]

Not only does this develop a model for the intrinsic value of bitcoins based on cost of production ...

Bitcoins are produced at a fixed rate and are not consumed. The cost of production has no effect on their supply or demand, so it has no effect on their value.

Take a look at Stellar, NXT, and Mastercoin. These three coins have the 2^nd, 5^th, and 8^th highest market caps, and yet their production costs are 0.

[hazenyc]

Not only does this develop a model for the intrinsic value of bitcoins based on cost of production ...

 The cost of production has no effect on their supply or demand, so it has no effect on their value.

Value and price are different things. Supply and demand forms price. Cost of production forms value. Read the paper it discusses the difference.

[johnyj]

Very true, to the end, it is the electricity cost decide bitcoin's value. After a certain degree of consolidation, only the miners without equipment cost (means the equipment cost is already paid back) can stay in the network and mine. Any new equipment investment will cost too much and have too little hope of ROI due to extremely low income (barely make back the electricity), unless they are much better in efficiency. A 20% increase in efficiency will not motivate the upgrading due to equipment cost

At beginning of 2012, bitcoin exchange rate is $5, hash rate is 8TH, for a general GPU miner at 2MH/W, the whole network consumed 4MW

At beginning of 2015, exchange rate is $200, hash rate is 320PH, for a general ASIC miner at 2GH/W, the whole network consumes 160MW

So the exchange rate jumped by 40x and the electricity cost also jumped by 40x

However, since the coin per day now is only half of 2012, it can mean two things: Either the current price is too low and should bounce back to $400, or the daily coin supply on market has not changed too much despite the daily coin generation has been cut by half (Due to more sell-off by centralized mining farms)

[johnyj]

Not only does this develop a model for the intrinsic value of bitcoins based on cost of production ...

Bitcoins are produced at a fixed rate and are not consumed. The cost of production has no effect on their supply or demand, so it has no effect on their value.

Take a look at Stellar, NXT, and Mastercoin. These three coins have the 2^nd, 5^th, and 8^th highest market caps, and yet their production costs are 0.

Bitcoin is consumed, many people buy some coins and hold it for at least 10 years, and in these 10 years they are disappeared from the network, just like a house bought

Of course from a long term perspective they might get spent some time later eventually, but just like central banks' gold reserve, they could also accumulate more and more and never get spent in generations. A large amount of reserve can serve many other purposes, security for example

If there is a demand for the coin, people will always select the method with lowest possible cost to get coin, which will make the exchange rate very close to the mining cost

[odolvlobo]

I read your paper. It is concise and well-written. You do a good job of describing the economics of mining.

The intrinsic value of a bitcoin should therefore be the marginal cost of mining, or more abstractly the (computational) labor value of mining. ... I argue that computational labor power confers value to digital currencies such as bitcoin, and present a way to model that intrinsic value.

You claim that the intrinsic value of bitcoin depends on the production cost, but nowhere in the paper do you actually present any arguments to support your claim.

These equations are useful in application. It informs miners at which price they should undertake or give up mining. It also informs miners when to stop and start mining given changes in mining difficulty and in electricity costs.

These are interesting statements because they contradict your claim that the intrinsic value is the marginal cost. You imply here that if the cost rises beyond the break-even value, then the miner should stop mining (because it exceeds the value of the product), yet if the value rises to equal the cost (as you claim), then there would be no reason to stop.

[Q7]

I'm a bit skeptical on whether the next block reward halving expected to take place in late 2016 may have profound effect of eliminating all but the most efficient miners but I'm very sure the following halving will really make the difference. I've given myself another 5 years for bitcoin.

[hazenyc]

I read your paper. It is concise and well-written. You do a good job of describing the economics of mining.

The intrinsic value of a bitcoin should therefore be the marginal cost of mining, or more abstractly the (computational) labor value of mining. ... I argue that computational labor power confers value to digital currencies such as bitcoin, and present a way to model that intrinsic value.

You claim that the intrinsic value of bitcoin depends on the production cost, but nowhere in the paper do you actually present any arguments to support your claim.

These equations are useful in application. It informs miners at which price they should undertake or give up mining. It also informs miners when to stop and start mining given changes in mining difficulty and in electricity costs.

These are interesting statements because they contradict your claim that the intrinsic value is the marginal cost. You imply here that if the cost rises beyond the break-even value, then the miner should stop mining (because it exceeds the value of the product), yet if the value rises to equal the cost (as you claim), then there would be no reason to stop.

I don't want to make this a microeconomics lesson -- but very briefly:
-the arguments for cost theories of value exist and go back to the time of Adam Smith, there is no need to restate centuries of theory in a small paper on a specific topic, if you are interested you can educate yourself there are a ton of resources for that.

-along the same lines, it is basic econ. theory that marginal cost = marginal product = price. All 3 equal each other in a competitive market. Marginal simply means the cost of the last unit produced. So it is the production on the margin that matters and not what has been produced in the past, for example. The break-even price is not the market price, the market price will fluctuate all the time do to imbalances in supply and demand.

-the value will only rise or fall based on the average cost for the network. That means there will always be some producers with lower than average costs that will earn excess profits and some who operate at a loss. Over time, the ones operating at a loss drop out of the market and the average efficiency tends to increase with those out of the picture. This will LOWER the value of bitcoin, not raise it since the average cost of production for the network will have decreased.

[ajareselde]

I'm a bit skeptical on whether the next block reward halving expected to take place in late 2016 may have profound effect of eliminating all but the most efficient miners but I'm very sure the following halving will really make the difference. I've given myself another 5 years for bitcoin.

It probably will, and thats bad because we allready practicaly only have industrial mining, eliminating little guy.
And that also means majority of money will go onto mining equipement instead market cap, so once again the man selling shovels is going to earn more than the one digging gold.
imo it was best when there were gpu-s only, ever since asics were introduced its not the same.

[odolvlobo]

[I don't want to make this a microeconomics lesson -- but very briefly:

Sorry. I wasn't clear, or perhaps my point is subtle. You claim that the value depends on the cost of production. I disagree -- the cost of production depends on the value. You claim that as the efficiency rises, the price will fall. I claim that as the efficiency rises, the difficulty rises and the cost of production is unaffected (assuming the price is constant).

[hazenyc]

[I don't want to make this a microeconomics lesson -- but very briefly:

Sorry. I wasn't clear, or perhaps my point is subtle. You claim that the value depends on the cost of production. I disagree -- the cost of production depends on the value. You claim that as the efficiency rises, the price will fall. I claim that as the efficiency rises, the difficulty rises and the cost of production is unaffected (assuming the price is constant).

No no. The causation is certainly cost of production confers value. Competition amongst producers will create innovation and lower the cost of production. This is classic economics and it occurs in every competitive commodity market. The difficulty rising does not affect the rate of production- the rate of production will always be one block every 10 minutes on average.

[odolvlobo]

[I don't want to make this a microeconomics lesson -- but very briefly:

Sorry. I wasn't clear, or perhaps my point is subtle. You claim that the value depends on the cost of production. I disagree -- the cost of production depends on the value. You claim that as the efficiency rises, the price will fall. I claim that as the efficiency rises, the difficulty rises and the cost of production is unaffected (assuming the price is constant).

No no. The causation is certainly cost of production confers value. Competition amongst producers will create innovation and lower the cost of production. This is classic economics and it occurs in every competitive commodity market. The difficulty rising does not affect the rate of production- the rate of production will always be one block every 10 minutes on average.

In the Bitcoin industry, increased efficiency does not lower the cost of production because competition causes the difficulty (and thus the cost of production) to rise. Miners with higher efficiency will increase their hash power, which results in a higher difficulty and a higher cost of production. Miners effectively bid for a fixed quantity of bitcoins. The factor that limits their bids is the price of the bitcoins they produce.

Producing bitcoins is not like producing any other commodity. Name another commodity in which the total production quantity is fixed regardless of production cost.

[hazenyc]

[I don't want to make this a microeconomics lesson -- but very briefly:

Sorry. I wasn't clear, or perhaps my point is subtle. You claim that the value depends on the cost of production. I disagree -- the cost of production depends on the value. You claim that as the efficiency rises, the price will fall. I claim that as the efficiency rises, the difficulty rises and the cost of production is unaffected (assuming the price is constant).

No no. The causation is certainly cost of production confers value. Competition amongst producers will create innovation and lower the cost of production. This is classic economics and it occurs in every competitive commodity market. The difficulty rising does not affect the rate of production- the rate of production will always be one block every 10 minutes on average.

In the Bitcoin industry, increased efficiency does not lower the cost of production because competition causes the difficulty (and thus the cost of production) to rise. Miners with higher efficiency will increase their hash power, which results in a higher difficulty and a higher cost of production. Miners effectively bid for a fixed quantity of bitcoins. The factor that limits their bids is the price of the bitcoins they produce.

Producing bitcoins is not like producing any other commodity. Name another commodity in which the total production quantity is fixed regardless of production cost.

Yes and no. I see what you're getting at--

the value of bitcoin = $cost of electricity used per day per GHs/how many bitcoins you can mine each day per GHs.

If the difficulty increases, the denominator gets smaller meaning the value will go up.

If the energy efficiency increases, the numerator gets smaller and the value will go down.

So both forces will be at work, true.

But as the energy efficiency increases, the 'break-even' difficulty also rises- meaning that the efficiency factor is more influential on the price than the difficulty. If the efficiency increases twofold, the breakeven price drops 50% AND also the breakeven difficulty rises 2x.
In reality the difficulty increase will serve to stabilize the fall in value but it will not outweigh it.

[DumbFruit]

Your understanding of economics is quite bad. Leaning on the thoroughly debunked labor theory of value to calculate the "price" of something that is literally not sold is so far gone that I'm not sure where to throw the rope so that it might be within your reach.

The most salient points;

1.) Bitcoin mining is paid completely through inflation. Nearly any fee above zero is acceptable to miners. There is no "price" for mining.
2.) "Prices" are a function of supply and demand. Labor, work, and difficulty have exactly nothing to do with the price of a product except insomuch as it inhibits supply.
3.) There is no such thing as “intrinsic value”. There are only intrinsic properties that are subjectively valued by people.

Detonating the logic bomb;

According to your paper, the price of a product gravitates towards it’s production cost. You essentially argue that as the cost of producing Bitcoins approaches zero, the price must also approach zero. This would be true if you totally ignored the supply side of the Supply and Demand graph.
Since the amount of bitcoins increases asymptotically, the cost to create more bitcoins always necessarily approaches impossible, and by your own premise, also approach infinite price, not zero. QED.

[hazenyc]

Your understanding of economics is quite bad. Leaning on the thoroughly debunked labor theory of value to calculate the "price" of something that is literally not sold is so far gone that I'm not sure where to throw the rope so that it might be within your reach.

If you adhere to mainstream neoclassical economics then yes you are absolutely right
If you adhere to a post-keynesian or keynesian point of view then cost of production = value in competitive markets.
I am not suggesting a Marxian labor theory of value, and again do not confuse value with market price which is determined by supply and demand. Market price and value may never meet, it is only a point of gravitation, and this is only from the perspective of miners who produce bitcoin and not necessarily from the perspective of any other user of BTC.

As for your second point, ultimately you are correct: Once the block reward is tiny, the value will become very high. But if the efficiency becomes very low that will counteract that factor as well. But even after the last block is mined, there will still be electric consumption to verify transactions in order to earn tx fees. Or at least that's how it's supposed to work.

The thing is, if you look at historical price data and compare it with the model, it does a really good job-

[DumbFruit]

This;

As for your second point, ultimately you are correct: Once the block reward is tiny, the value will become very high. But if the efficiency becomes very low that will counteract that factor as well. But even after the last block is mined, there will still be electric consumption to verify transactions in order to earn tx fees. Or at least that's how it's supposed to work.

The thing is, if you look at historical price data and compare it with the model, it does a really good job-

Directly contradicts this;

Looking at the market price, the average mining efficiency of the network as a whole might be estimated. As the average efficiency increases over time due to competition driving technological advancement – as inefficient capital becomes obsolete is removed while new capital replaces them – the intrinsic value of bitcoins denominated in dollars will fall. The irony is that increased efficiency, although necessary to maintain competitive advantage over other miners will ultimately drive the value of bitcoin down approaching, perhaps, zero.

[hazenyc]

Not necessarily, I am only saying the tendency is to a falling value, not that it will be the case.

Consider iron ore extraction. Every year, it becomes harder and harder to extract iron ore from mining operations since every ton of ore is marginally more difficult than the previous one (one average). It is either deeper in the mine, or it is coming from less productive veins or there is less percentage of iron in the rocks being mined. All the easier ore has already been mined. So every year the difficulty increases, and yet the world gets a fairly steady supply of iron ore -- the cost of production has gone up.

But technological progress as also made it cheaper to mine for the difficult ore over time. Competition between ore producers in order to get a competitive advantage invests to develop machinery and technology to obtain the ore faster and more efficiently. Even though the ore is more difficult to mine - the same ton of earth has less ore in it to extract - it is still cheaper to produce that difficult ore than it was to produce the easier ore using yesterday's technology, which may now be obsolete. Mining the difficult ore with picks and shovels would be fruitless.

What I am saying is that technological progress leading to greater efficiency in mining may outpace increases in difficulty, which on net will reduce the cost of production.

The price of ore in the world market IS the cost of production. Why? because there are many competing ore producers each trying to undercut the next guy. If your cost of production is say $1000 per pound of ore and mine is $900, I will start by selling it at $999. Somebody else that can produce for $900 will come in and offer $998. I will react with $997 and so on. The dance will go on until $1000.01 is reached (in theory of course). And what of demand? Well if there isn't enough demand then the price will drop below $900 and I will stop producing. If there is more demand, we will all be incentivized to expand our operations to produce more and that will lead to making our operations more efficient. It all stabilizes.
Bitcoin production is the same --- BUT this assumes that producers are selling what they mine. And that is a big But. If miners hoard it won't work.

The paper models a theoretical process, not reality. Does the cobb douglas production function or the solow-swan growth model accurate describe reality? of course not.

[DumbFruit]

The price of ore in the world market IS the cost of production. Why? because there are many competing ore producers each trying to undercut the next guy. If your cost of production is say $1000 per pound of ore and mine is $900, I will start by selling it at $999. Somebody else that can produce for $900 will come in and offer $998. I will react with $997 and so on. The dance will go on until $1000.01 is reached (in theory of course). And what of demand? Well if there isn't enough demand then the price will drop below $900 and I will stop producing.

So you're saying that the cost of production does not determine price. Price controls production.

In which position is the horse in relation to the cart? You're not being very consistent.

[hazenyc]

The price of ore in the world market IS the cost of production. Why? because there are many competing ore producers each trying to undercut the next guy. If your cost of production is say $1000 per pound of ore and mine is $900, I will start by selling it at $999. Somebody else that can produce for $900 will come in and offer $998. I will react with $997 and so on. The dance will go on until $1000.01 is reached (in theory of course). And what of demand? Well if there isn't enough demand then the price will drop below $900 and I will stop producing.

So you're saying that the cost of production does not determine price. Price controls production.

In which position is the horse in relation to the cart? You're not being very consistent.

Supply and demand controls price. Cost of production controls value (or call it break-even level)
As for the carts and horses, this is a huge matter of debate amongst economists - whether prices are set supply-side vs. demand-side.
Supply siders say the horse is production sets prices initially.
Demand siders say the opposite.

[odolvlobo]

Supply and demand controls price. Cost of production controls value (or call it break-even level)

Your paper states that value (as defined by you) affects price, but you still have not described how. What is the mechanism?

Generally, a change in the cost of production affects the price because it shifts the supply curve. Is this your line of reasoning? Bitcoin production is different because the cost of production has no effect on the supply curve.