Why does Bitcoin have value?

I started this explanation in the article where I talk about why I think the price of Bitcoin will decline in the near future, but the explanation ended up  in the weeds and was long enough that it warranted its own article.  It doesn’t have a point beyond trying to explain why the price of Bitcoin has been correlated to the price of electricity and the number of people mining.  As a warning, this article is also a simplification that isn’t entirely accurate, I’ve removed quite a bit of detail to make it a bit more accessible. My goal with it is less to explain the technical details of how Bitcoin works, instead its meant to convey the economic forces that play a role in determining its price.

Bitcoin doesn’t have a central bank, it’s an unregulated economy. What this would mean in a normal sense is that there isn’t someone determining how much money exists in the economy in total. Not having someone do that is normally a recipe for disaster, since more money can just be created out of thin air, which quickly makes the currency worthless. Traditionally, this has been solved by having a regulator, someone who determines how much money there is in the economy. If we trust that regulator, then everything works fine, and if we lose trust in that person (or institution), then bad things happen. Bitcoin avoids this problem by using mathematics to guarantee that more Bitcoins cannot be created out of thin air at a rate faster than a prescribed rate.

If you buy something from someone using a credit card, there is a bank that is assuring the person on the other end that they’ll get the money from the bank, regardless of whether you, as the consumer, actually ends up paying the bill in the end. If you didn’t have the bank doing this, then basically credit card transactions would just be an “I owe you” promise, and that wouldn’t work nearly as well in our global economy (they’d be unregulated).

Bitcoin transactions don’t have a “bank” that is validating the transaction, instead, the miners are doing that work (as part of the mathematics regulating the system that I spoke about above). They’re saying that they’ve had the opportunity to look at the consumer’s bank account, and yes, there is enough money in that account to pay the person selling. They don’t do this validation out of the goodness of their heart, what happens is that they get paid in Bitcoin for making those assurances, and the way they get paid is by “mining”.  I’m glossing over the details here, by avoiding transaction fees, but they’re not important for the purposes of this discussion. What is interesting about the mining is that the reward for doing so is fixed. There are 12.5 new Bitcoins created, and they are created every 10 minutes. Those new Bitcoins are divided up by the people doing the “mining”. The system itself is built in such a way that you are rewarded for the time spent mining, and not based on the volume transactions itself. In our simplified system, if there is 1 miner, then he can mine all day long (validating transactions). Every 10 minutes, that single miner would earn 12.5 Bitcoins. If you have 2 miners, you would think that would allow twice as many transactions to be validated. Instead, the difficulty of the mining is increased, so that the same number of transactions get mined, it’s just twice as difficult. Because you have 2 miners, they’re working twice as fast as a single one, and you still end up with 12.5 Bitcoins in 10 minutes. Since there’s 2 miners, they split the value of the reward to receive 6.25 Bitcoins a piece.

So how does this correlate to the price of electricity? To “mine” Bitcoins, you have a computer that has to do a bunch of work for 10 minutes, and then you get rewarded some piece of that 12.5 Bitcoins based on the work you’ve done. If you did 100% of the total work that occurred during that 10 minutes, you get the entire reward. If there are 2 people that did it, you each split it equally. Now let’s say that the computer required to run 10 minutes of mining costs me $0.10 every 10 minutes, and the price of Bitcoin is $1 per Bitcoin. That means that for $0.10 of electricity, I am earning $12.5. That’s quite the profitable business. Now, another miner comes into play, and there are 2 of us. It still costs me $0.10 of electricity every 10 minutes, but I only make $6.25. The other miner is the same. More miners will continue to come into the system as long as it remains profitable vs. the price of Bitcoin to do so. So at some point, we end up with 125 miners, each of us earning 1/125th of $12.5 (or $0.10), and it costs each of $0.10 in electricity to the mining. It wouldn’t make sense for any new miners to start mining, since they’d lose money if they did so, and it would become unprofitable for us to continue mining. Either the new entrant drops out, or someone else does, and then mining is profitable again.

The flip side of this coin is that price of a single Bitcoin goes up. It now sells for $2 per Bitcoin instead of $1, bringing up the value brought into the system to $25 every 10 minutes. Now there can be 250 miners paying $0.10 every 10 minutes for electricity while still making money on the rewards they receive. Roughly speaking, no matter how you try and influence this system, these things remain in balance. It’s a bit more complicated in the real world, since the price of electricity varies by country, and there are costs involved in setting up a Bitcoin miner, I could buy a more powerful computer (and do twice the mining as people with slower computers, therefore earning twice the reward. I glossed over that in my example), etc., but more or less, the price of Bitcoin tends to follow an equation based on the price of electricity & the total amount of computing power that is trying to earn Bitcoins. At times, the price of Bitcoin may go higher than this, as people speculate on the price and try and profit, but as they do so, they increase the financial reward for mining, and that brings in more computing power mining for Bitcoin. If the price of Bitcoin drops, then it becomes unprofitable for some miners, and they stop mining, which increases the reward for the miners left. This equation is a rough and simplified explanation, and doesn’t hold 100% of the time, but it does explain the strong correlation between mining/computing power, the price of electricity, and Bitcoin.

 

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