This article was originally published in economic forces the news.
Price theory is about supply and demand. Why is the price of commodity Y equal to X dollars? Well, it’s just supply and demand. This sounds simple, but people often get it wrong.
A prime example can be found in the discussion about Bitcoin. The price of Bitcoin is down about 70 percent from its all-time high in less than one year. One of the common things is that the price cannot drop much due to the cost of bitcoin mining. It is common to hear people claim that the energy cost of producing Bitcoin sets a floor for its price.
Understanding this argument requires understanding how Bitcoin works. In the typical payment system most of us are accustomed to, there are some central authorities involved. If you and I use the same bank and I want to send you a payment, this requires our bank to verify that I have the money to send. If so, the bank deducts the money from my account and credits your account. If we use different banks, this implies more centralized powers, but the basic process is the same.
Bitcoin works differently. If I want to send you bitcoin, there is no central authority to verify or deposit and debit. Instead, this process is decentralized. Payments are verified by consensus of the network. People who want to send Bitcoin to others broadcast transactions to the network. They do this through their own node on the network or a node connected to their Bitcoin wallet. The nodes that receive these messages will then pass valid transactions that are not yet registered on the blockchain to the other nodes so that those transactions are propagated throughout the network.
Some nodes on the network (known as “miners”) compete to “mine” the next block of transactions. Doing so adds a block of transactions to the blockchain, which is a record of all validated transactions on the network. What mining entails is that these nodes collect groups of transactions that have been broadcast to the network and combine this information with some additional information. The information is then passed through the cryptographic hash function. This results in an output called a hash. If the hash value is less than a certain threshold value, the miner broadcasts that solution to the rest of the network. Then all other miners check this solution. Miners indicate that this is a valid block by moving to the next block of transactions. A miner who successfully mines a new block is rewarded with the newly issued bitcoin (and any transaction fees from that block).
One piece of information that is passed through the hash function is a number called “nonce”. Adjusting the value of the nonce is critical to finding a hash that is less than a lower bound. In fact, one can think of bitcoin mining as a competition to be the first to find one that results in a hash below a certain limit. The only way to do this is through brute force. The miner guesses the nonces and generates hashes so that one miner can successfully find a hash less than the minimum. Of course, a machine that can create hashes faster than other machines has an advantage. More hashes mean there is a higher probability of successfully mining a block and receiving a block reward.
However, a new block is added approximately every 10 minutes. The reason for this is that the hash threshold is updated as quickly as the blocks are produced. If blocks are produced faster than every 10 minutes, the threshold will be lowered to increase the difficulty of finding a hash below the threshold. If blocks are produced more slowly than every 10 minutes, the limit will be increased to make it easier to find a hash less than the minimum.
Participating in this mining process requires the use of a large amount of computing power. Early on, people used regular personal computers to mine bitcoin. However, to gain an advantage, people started building machines specifically designed for this purpose. In fact, there are now publicly traded companies that only operate large numbers of these machines and use the computing power to mine bitcoin.
Running these machines requires energy. This energy generally comes from an ordinary electrical network, but there are many creative solutions to using the resources that are wasted for this. For example, instead of burning natural gas, some capture this natural gas to generate power that is used to power bitcoin miners. Others use waste coal to generate energy for bitcoin mining. Others capture energy from landfills to mine bitcoin. As a result of energy use and these creative solutions, much of the debate surrounding bitcoin mining is whether it generates positive or negative externalities.
Regardless of the discussion of externalities, bitcoin mining requires the use of energy, and this is where the cost fallacy emerges. The common argument is that because bitcoin mining requires energy, the cost of producing that energy sets a floor for the price of bitcoin. The logic is that miners process the blocks because they want the block reward, but they won’t mine bitcoin if the energy cost exceeds the benefit. I agree that this is true. This does not mean that energy costs put a floor on the price of Bitcoin.
The cost of producing Bitcoin does not explain the price. Like anything else, the price of bitcoin is determined by supply and demand.
The crucial feature of Bitcoin is that the block rewards I described above are halved (in terms of Bitcoin) approximately every 4 years. In the end, there will be no block rewards and all that block miners will get from processing blocks is transaction fees. Thus, a new bitcoin will be issued every 10 minutes until the supply reaches approximately 21 million. This Bitcoin advantage indicates that in the short-term and in the long-term, no amount of mining efforts can affect the supply of Bitcoin. In other words, the supply of bitcoin is independent of the price of bitcoin. As a result, the price of Bitcoin is completely determined by demand.
As with any market, excess demand will cause prices to rise and excess supply will cause prices to fall. However, since supply is constant, the only source of excess demand or excess supply is the change in demand.
But what about the cost of energy?
The fact that the price of Bitcoin is determined by demand does not mean that energy use and price are unrelated. Instead, the cost fallacy specifically sets the relationship back. It is not the cost that determines the price, it is the price that determines the cost.
If the price of bitcoin goes up by 20 percent, this makes mining significantly more profitable than it is now with the current use of energy. As a result, one should expect more bitcoin miners to run until the expected marginal benefit from mining equals the marginal cost of the last unit of power. This can come from new miners entering the market, or from existing miners who are operating more machines.
On the other hand, if the price of Bitcoin drops by 20 percent, this will make mining significantly less profitable. In fact, it is likely to be unprofitable for some miners. One might expect a number of these machines to be decommissioned or moved to where there is cheaper energy until the expected marginal benefit from mining equals marginal cost again.
Thus, the cost of energy does not put a lower bound on the price. Instead, it is the price that influences the cost of energy.
Bitcoin price is just about supply and demand. Same as it ever was.