(Warning: This time it was a couple of beers.)
If you are a post-doc in Economics, here is an idea for a paper: The economics of Bitcoin mining.
You can open with a little summary of the Bitcoin network, SHA-256 hashing, etc., just to show you did your homework.
Here is the deal. There is a bit of an arms race for mining Bitcoins. (As with any good gold rush, those most likely to profit are selling shovels. But I digress.) For a nice background, read this Business Insider article. Apart from the awful analogy of searching for primes and the author’s plagiarization of my tulip bulb example, it is a pretty good piece.
But briefly…
In the beginning, you could mine Bitcoins profitably on any workstation running simple software. You might find a new block in a few hours or days. Then software appeared that used multiple cores, vector instructions, etc., so the Bitcoin system adapted by increasing the difficulty. Then you had to have that new software, too, or it would take you months or years to find a block. And the cost of electricity alone makes that uneconomical.
Then implementations on graphics processing units (GPUs) appeared, and you had to get one of those to mine profitably. Then FPGA implementations supplanted GPUs. In the past month or two, custom ASICs have come on-line, and they are starting to supplant the FPGAs.
As a reminder, all of this hardware is devoted to one thing: Computing meaningless SHA-256 hashes over and over. Burn, baby, burn.
So, Dr. Econ, here is what I suggest. Build a mathematical model of this phenomenon and solve for the equilibrium state. That is what you people do, isn’t it?
Here is why it is interesting. A key assumption in Bitcoin’s design is that no one entity will control more than 50% of the computational power devoted to mining. But if it is cheaper for me to mine than for you, it seems to me my logical course of action is to scale up my mining operation until it is just barely profitable for me… Thus making it unprofitable for you. The stable state might be one entity controlling not 50% of the mining power, but 100% of the mining power. Lowest-cost Bitcoin producer wins? Show that any system like Bitcoin does (or does not) reach such an equilibrium state.
For extra credit, include some stochastic model for the price of electricity in Bitcoins, the probability that a SHA-256 break is discovered, and so forth.
Maybe somebody has already written such a paper. If so let me know so I can read it.
P.S. $2 billion.
[Addendum]
Groda asks how this differs from gold mining. Great question. Upon reflection, though, I think it is very different.
With gold mining, the low cost producer certainly can undercut the competition… for a while. But increasing your own mining production eventually depletes your mine, making everyone else’s mining job relatively easier.
With Bitcoin, increasing your own mining production raises the global difficulty level and your own share of the global computing power, thus making everybody else’s mining job relatively harder. This is the exact opposite dynamic from physical mining.
Has this dynamic ever existed before? I do not know. If so, then it probably applies to Bitcoin mining and might be worth a short paper. If not, then it might be worth a whole series of papers.
[Addendum addendum]
And it is not exactly like making widgets, either. When you increase your production of widgets, you also increase the global rate of supply. With Bitcoin, the global rate of supply is fixed by design; increasing your own production just increases your share of it.
Unless I’m missing something only the supply of bitcoins is fixed, not the profits from mining. At some point the transaction fee component of mining profits should dominate the ever shrinking creation profit, which is just a bootstrap trick isn’t it? The fees are not as such (practically) limited as the same bitcoins can be processed as fees ever and ever again (the stock vs. flow thing).
I have trouble wrapping my head around it but I wonder if that may not be one of the ways Bitcoin might fail as a practical currency — transaction fees becoming so expensive that it makes it impractical to use for regular small/medium transactions.
Re electricity prices, mining doesn’t destroy energy as such, it just turns electricity into heat, which can be used for space heating, so you’d expect ultimately mining to only be profitable where its cold at that time, as people who waste the heat are priced out by people who make a profit through lowering their heating bill (compared to non-BTC-producing forms of space heating).
(great series btw!)
“it seems to me my logical course of action is to scale up my mining operation until it is just barely profitable for me”
This makes a very big assumption, that the Bitcoin price will be stable. In reality, even if it does become a huge success the Bitcoin price is likely to be volatile. So you would need someone who was willing to risk spending a fortune on top of the line Bitcoin mining equipment while not knowing what the Bitcoins will be worth. For that they would need a quite big risk premium, barely profitable won’t do it (unless they paid for the Bitcoin mining rig in Bitcoins of course). As you say electricity prices, which are also volatile would make it even riskier.
Digression: if people do decide that it is a store of value and put lets say 10% as much money in Bitcoins as they do in gold that would be 800 billion USD which with 20 million Bitcoins would mean 40 000 USD per Bitcoin (not that I think that will happen I think the whole thing will crash).
@groda That is true, and I alluded to it with “…some stochastic model for the price of electricity in Bitcoins”. That model might well involve modelling Bitcoins per Euro (or whatever) times Euros per kilowatt-hour.
Whether the Bitcoin price in Euros/pounds/whatever is stable or not, it affects the incentives of all miners equally and therefore might not impact the ultimate equilibrium.
Your crash prediction at $240 is noted. You only get partial credit, though, if it crashes because governments decide to crush it.