Research paper on Bitcoin Fundamental Value & Decision to Mine

[DumbFruit]

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.

That's an impossible debate. You can't have a price a-priori demand or supply, so they are both demonstrably wrong.

If you don't have any supply of a thing then you can't have demand for it, and no market clearing price could exist.

If you don't have any people that demand a thing, then the supply doesn't matter, and no market clearing price could exist.

If I come up to you and want to buy your shoes, is the price determined by the supply of your shoes, or is it determined by my desire for them? The correct answer is that neither of those answers are correct. We would arrive at a price at which we both feel we have gained in the bargain, or no transaction takes place. That process is informed by objective factors, including the properties of the shoes, the general market demand for them, and so on, but it is nonetheless also based on subjective valuations of both parties (Or groups in a more macro sense.) that evades neat mathematical algorithms.

But that's a red herring. You seem like you're not willing to defend your assertion in the abstract of your paper that the value of bitcoins will likely trend toward zero as the cost of production approaches zero (Due to increased efficiency in mining methods.), so have you conceded that this idea is wrong?

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[hazenyc]

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.

Perhaps the break-even price is better thought of as a price floor for an individual miner:

If the value is 100 and the market price is 102 I can produce for 100 and sell for 102 earning a profit
If the value is 100 and the market price is 98, I stop producing.
If somebody else can produce at a lower cost they will continue to produce and sell until it reaches their break-even.
If nobody else can produce at a lower cost everybody will stop producing, and the difficulty will drop making it once again profitable to begin mining.

That is the mechanism.
It doesn't predict a price, rather it sets perhaps a lower bound.

[hazenyc]

But that's a red herring. You seem like you're not willing to defend your assertion in the abstract of your paper that the value of bitcoins will likely trend toward zero as the cost of production approaches zero (Due to increased efficiency in mining methods.), so have you conceded that this idea is wrong?

If it costs next to nothing to produce on average then yes competition will drive the value down.
Right now if the average efficiency suggests a price around $200 but you get extremely cheap electricity from your own hydro-plant out in the backyard, then you will earn excess returns. If everybody gets extremely cheap electricity because they also have a hydro-plant out back then each will compete with each other to drive the price down. If it costs all of us $1 and the price is $200 I will offer $199, and then my neighbor will offer $198 and so on until it approaches $1.

If you don't understand the simple mechanism of competitive markets, then I can't help you understand much else.

[hazenyc]

Here's your competition: https://www.youtube.com/watch?v=K8kua5B5K3I#t=498
 

[odolvlobo]

Right now if the average efficiency suggests a price around $200 but you get extremely cheap electricity from your own hydro-plant out in the backyard, then you will earn excess returns. If everybody gets extremely cheap electricity because they also have a hydro-plant out back then each will compete with each other to drive the price down.  If it costs all of us $1 and the price is $200 I will offer $199, and then my neighbor will offer $198 and so on until it approaches $1.

Miners will compete with each other to mine the limited number of bitcoins available to them. As long as the cost of mining is below the price of the mined bitcoins, they will devote more resources to mining more bitcoins. The result is that the cost of production as a whole will rise to the value of the mined bitcoins. In other words, it will never cost only $1 to mine $200 worth of bitcoins because somebody will be willing to pay $2 to mine those bitcoins.

Furthermore, newly mined bitcoins are only a small part of the market. The market behavior of miners will have only a small effect on the price of bitcoins. Even if miners gave away there 3600 BTC/day for free, it will have little effect on the the price of the remaining 200,000 BTC/day.

[DumbFruit]

But that's a red herring. You seem like you're not willing to defend your assertion in the abstract of your paper that the value of bitcoins will likely trend toward zero as the cost of production approaches zero (Due to increased efficiency in mining methods.), so have you conceded that this idea is wrong?

If it costs next to nothing to produce on average then yes competition will drive the value down.
Right now if the average efficiency suggests a price around $200 but you get extremely cheap electricity from your own hydro-plant out in the backyard, then you will earn excess returns. If everybody gets extremely cheap electricity because they also have a hydro-plant out back then each will compete with each other to drive the price down. If it costs all of us $1 and the price is $200 I will offer $199, and then my neighbor will offer $198 and so on until it approaches $1.

If you don't understand the simple mechanism of competitive markets, then I can't help you understand much else.

You've assumed your conclusion, also called "begging the question".

"Right now if the average efficiency suggests a price around $200..." So you already know the market clearing price and therefore anything that follows can't help us understand where the price "begins". The down bidding of someone with more efficient energy production in an existing market of prices doesn't help us understand where the initial price comes from; You wrote that it either begins with supply or demand. I wrote that it begins with neither.

To illustrate my point; In a chain consisting of two links, A and B, which link initiates the "Chain"?

Obviously the answer is neither. The concept of the chain arises in relationship to both links at the same time. It is the same way with market prices. Prices arise in a bidding process with two or more people with perceived (Real or imagined) supply and demand.

All four — demand, supply, cost, and price — are interrelated. A change in one will bring changes in the others.

Emphasis mine.

http://mises.org/library/how-should-prices-be-determined

http://www.cavemannews.com/Supplysidevsdemandsideeconomics.htm

[zebedee]

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

Stopped reading there and realised it's worthless, thanks for saving my time.

[johnyj]

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.

If mining cost nothing, then the cheapest way to get coin will always be mining, no one will buy, the cost of zero will bring the coin value down to zero. In fact, if the demand rises and there is not enough daily generated coins to satisfy that demand, the mining cost will always rise due to competition. Mining cost is a good indicator for demand, since mining usually is the lowest possible cost to get coins

Value comes also from the fact that it is difficult to do something. Many people spend millions to just win the price of a tournament, psychological motivation is a great part of the value foundation, and for bitcoin many enthusiasts mining at a loss just for fun

In fact there are lots of feed back loops in the valuation of bitcoin, it is even driven by religious behavior, can't use a single profit based model to analyze it. What is the profit to be your own bank? What is the price for realize a dream of freedom?

[hazenyc]

I appreciate your feedback and criticisms. I really do ! That is the whole point of inquiry and understanding.

I have made edits to address many of the concerns raised including referring to the cost of production as an intrinsic value, which is a shaky assertion at the least.
Instead, I wish to draw attention to the break-even models put forward as well as the fact the cost of production based on energy efficiency is what will largely determine the objective decision to mine or not mine. I still assert that as efficiency increases it will provide downward pressure on price, but acknowledges this is only a tendency and there are a number of other subjective and technical issues at work including the propensity to hoard mined coins instead of selling each one immediately in the market and the linear rate of block production, once every 10 minutes.
Also as an aside, I am presenting bitcoin production as commodity production and not as money issuance--
You can check the link at the beginning of this thread for the latest version.

[odolvlobo]

I still assert that as efficiency increases it will provide downward pressure on price.

How then do you explain the fact that while miner efficiency increased by a factor of 10,000 from 0.1 MH/J to 1000 MH/J, the price also increased by a factor of 10,000 going from $0.10 to $1000? Shouldn't the price have decreased by a factor of 10,000? You have provided nothing to support your assertion, but even if what you say is true, the effect must be so small that it can be completely ignored.

[johnyj]

I still assert that as efficiency increases it will provide downward pressure on price.

How then do you explain the fact that while miner efficiency increased by a factor of 10,000 from 0.1 MH/J to 1000 MH/J, the price also increased by a factor of 10,000 going from $0.10 to $1000? Shouldn't the price have decreased by a factor of 10,000? You have provided nothing to support your assertion, but even if what you say is true, the effect must be so small that it can be completely ignored.

This is a very interesting phenomenon worth debating

In traditional economy, people tends to think that more efficiency means more production for given resource, and more production will bring more wealth. When many people first learn about bitcoin, they focus on how to produce it from a manufacturing point of view. Thus comes so many companies trying to build miners and mine coins. For these people, the exchange rate of bitcoin makes it a sell-able goods, they make bitcoin just like make an iphone

Then they learned that no matter how efficiency they are, the daily coin generation is fixed (the quick rise in difficulty and miner efficiency just showed how much excessive production capacity there is in today's society). Then mining becomes a tournament, it is getting harder and harder. As a result the reward gets more expensive, those who paid so much resource to get his reward will not easily sell his coin at a price level lower than his cost, it just does not worth it. They'd rather hold it and wait until the next reward halving to sell at a better price, this is especially true when bitcoin's long term potential can be as high as moon

[hazenyc]

I still assert that as efficiency increases it will provide downward pressure on price.

How then do you explain the fact that while miner efficiency increased by a factor of 10,000 from 0.1 MH/J to 1000 MH/J, the price also increased by a factor of 10,000 going from $0.10 to $1000? Shouldn't the price have decreased by a factor of 10,000? You have provided nothing to support your assertion, but even if what you say is true, the effect must be so small that it can be completely ignored.

This could be that for a long while at the beginning, bitcoin mining was NOT a competitive producer's market. There were also many less miners than now.  Until GPU rigs were cobbled together and set to mine in a dedicated fashion, CPU mining did not perhaps extract much more electricity than the computer was already using to run. Many have attributed the introduction of ASICs to the sudden spike and subsequent drop in market price.
Another, smaller factor was that the block reward was twice as large as it is now.

The model put forth only describes reality to any degree if bitcoin mining is a competitive process and that requires a great many competing producers.

And again, a tendency is just that. Real market prices may fluctuate violently around that tendency, and in fact may never get there.

[DumbFruit]

How do feel about the fact that production costs can actually follow demand?

Look at gold, for instance, as more people store it away arbitrarily as a store of value, they arbitrarily increase the price of the item, and as this price increases the amount of money companies are willing to spend to extract an OZ of gold increases commensurately.

This shouldn't happen, accorded to your assertion that the price of something is informed by it's production cost. If the price of a product overshoots the production cost (Because of ignorant consumers.) then the price should gravitate back down. It doesn't.

Consider also that the production cost of gold can be arbitrarily high. There's no reason we couldn't be spending $1,000,000/oz for gold. This could be accomplished through highly inefficient or efficient methods, it makes no difference.

The only conclusion one can come to is that production costs do not inform the price of a product. Price is a function of various factors, not the least of which is the subjective valuation of it's consumers.

So, getting back to the subject at hand, it's impossible to say what the price of bitcoin should be based on it's production costs alone, even if I granted that production costs have any effect on bitcoin's price whatsoever (It doesn't, since "production costs" are simply the redistribution through inflation of the currency at a fixed rate.).

[hazenyc]

So, getting back to the subject at hand, it's impossible to say what the price of bitcoin should be based on it's production costs alone, even if I granted that production costs have any effect on bitcoin's price whatsoever (It doesn't, since "production costs" are simply the redistribution through inflation of the currency at a fixed rate.).

Agreed, if you see the updated paper it pays a lot of heed to subjective valuation, the fact that people hoard, sentimental or speculative reasoning etc. The low cost producer will earn excess profits if subjective demand drive the price up. What the cost of production ends up being is a lower bound, so let's say the opposite happens and there is very little market demand for bitcoin - the price will drop as there are few bids. After time, miners will just stop mining instead of incurring daily losses. Eventually supply will meet demand at whatever low price it may be. Obviously the supply of bitcoin itself is regulated at 25 per 10 minutes or so currently, so what I mean more accurately is the supply of miners will be reduced - and the lowest cost producers would be the only which remain. Bitcoin also has the feature of difficulty adjustment - so again assume the demand and price both drop causing miners to exit. The network hashpower will drop and it will take longer than 10 min. to find blocks on average, resulting in a lower difficulty. The lower difficulty has the same effect as raising the price in terms of $ x BTC/day. You can either raise the price or raise the # of BTC expected per day to induce miners to return.

The reason somebody wouldn't produce gold with a cost of $1M per oz. is they would quickly go out of business providing there are many other gold producers who operate at a marginal profit.

As for demand spurring investment this is almost certainly true - the issue is that it can lead to 'mal-investment'.  A good example is happening now with shale oil producers.