Blogs & Articles: The economics of Proof of Work 🔗 3 years ago

In a previous post, I explained that proof of work does absolutely not back Bitcoin value. Recently I’ve been debating in twitter about Bitcoin scarcity being a consequence of its costs of production, which I strongly disagree and I’ll briefly explain why. First, I’ll set forth my understanding of scarcity: “A scarce good is a good that has more quantity demanded than quantity supplied”(source wikipedia).

New bitcoin units come into existence through a special transaction in each block called “coinbase” that miners include in the block to collect their reward consisting of transaction fees and the block subsidy (new coins issued). The subsidy started with 50 BTC units and the amount halves every 210,000 blocks until block 6,930,000 when there will be no more subsidies.

The block reward is necessary because the Bitcoin protocol needs a decentralized timestamp server to avoid double spends by chronologically ordering transactions. This is absolutely crucial for a medium of exchange or a store of value. Exchanging is all about transferring ownership and storing is all about owning, so for ownership to be meaningful, double spends are unnaceptable.

The purpose of the reward is to incentivize miners to provide hashes for that timestamp server. Calculating hashes is costly, so if the network wants the hashes, it has to give something valuable in exchange so the miners are willing to bear those costs. Namely transaction fees, that is, those who are interested in sending a bitcoin transaction attach a fee for the miners.

Fearing that during the first years of Bitcoin transaction fees would not be enough incentive for the miners, and also trying to figure out a way to distribute the coins, Satoshi came up with the idea of subsidizing each block with bitcoin units. And it worked well because despite the increase in quantity the market value of bitcoin units have been steadily increasing, so bearing with the cost of calculating hashes has been a profitable business for the miners.

It is interesting to note what experience shows us. Most miners (pooled miners) don’t even know about the mempool, transactions, the UTXO or the blockchain. They just produce hashes.

From the point of view of economics, producing something implies that I own the result of my production. Proof of Work implies I found and therefore I own the nonce of a hash with a number of leading zeroes. If I am the first to produce such a hash but I fail to broadcast it to the network, I get no subsidy. So I am in the position of owning the nonce of the hash, having spent electricity and computing power to produce it, but I don’t own the subsidy coins? Why? Because I didn’t sell the hash to the stakeholders (i.e. owners of bitcoin units).

The correct way of looking at this process from an economic point of view is that subsidies are not produced by miners, but exclusively issued and sold by the stakeholders through the protocol in exchange for a hash with specific characteristics. By exclusively, I mean that this is the only way contemplated by the protocol to issue new units. As of the rules implicitly agreed by all the stakeholders (otherwise they would have sold their units to opt out of the rules) there is no other way.

Moreover, it is not accurate either to qualify the hash as a right to write in the blockchain. Blocks are voluntarily accepted by the network in exchange of that precious hash, which is the economic equivalent of paying for the services of the miner as of the rules of an auction where the miner bids by providing a valid block including a hash that has very specific and determined characteristics. New bitcoin units can only be issued through this auction process, the rules do not contemplate any other way to issue new units. The difficulty adjustment is how stakeholders modify the terms of the auction in order to get the most hashing power from the miners.

An alternative way to look at this process is to ask what would be the cost for Satoshi to create new coins assuming, for the sake of this example, that he was mining alone for a few days or weeks, setting the minimum difficulty level to no leading zeros and then mine only for a few miliseconds every 10 minutes, any nonce would do the trick, so the cost of generating the hash would be just one hashing round. I think it would fair to say that it would be a negligible cost. It is important to note that this negligible cost would be a consequence of Satoshi’s demand.

In conclusion, Bitcoin limited supply is determined by the issuing rules within the protocol agreed by the stakeholders, not by proof of work. Proof of work will still be needed when the subsidy ends. Bitcoin scarcity is not the result of costly production but the result of the demand of units being greater than the available supply arbitrarily and determinalistically agreed by the stakeholders.