Bitcoin Basics: The Economics Of Mining

To the outsider, mining Bitcoin sounds easy. All you do is buy a powerful computer, hook it up and watch while your stack of Bitcoin grows, right? Well not exactly. Computing power such as that needed to successfully mine Bitcoin at this point in the virtual currencys evolution doesnt come cheap, nor does the electricity needed to power it. If thoughts of mining have crossed your mind, take a look at the chart below from Coinplorer.com.

The thin red line represents the difficulty of mining Bitcoin, while the thin green line shows the value in U.S. Dollar terms (BTC/USD). The bold blue line is a function of both and represents the profitability of mining. As you can see, as the price of Bitcoin has fallen over the last few months the difficulty of, and therefore the expense involved in, mining the currency has continued to increase. Understandably the profitability of mining has fallen considerably.

Some have pounced on this dynamic as evidence that Bitcoin is doomed. See, they say even the devoted Bitcoin enthusiasts and miners are losing money. The whole thing is rigged. If you start from a position of looking for evidence of Bitcoins failure then I suppose this makes sense, but if you understand the currency, what it is and how it is supposed to function, then this chart isnt bad news at all. In fact, it is evidence that the system is working.

Bitcoin was designed as an online currency and a commodity that was deflationary by nature. As such it was modeled on existing commodities, such as gold. As more gold is mined from the Earth, so accessing reserves becomes more difficult and more costly. There are no more gold rushes, as deposits that can be panned from rivers or easily accessed from shallow mines no longer exist and supply is finite by definition. Similarly, the closer the number of Bitcoin gets to its 21 million total issuance limit, the harder it gets to access, and the days of miners making easy money are gone.

That doesn't mean that nobody will mine though. It simply means that less people will, and only those that can push the envelope of efficiency and technological innovation will continue to do so profitably. At some point, as the number of miners, and therefore the discovery rate, decreases, so supply will be restricted. Assuming that demand remains constant or continues to grow this will put upward pressure on the price. That, of course, is a big assumption, but acceptance is still growing and at some point, a low-cost efficient payment system will gain ground. Bitcoin is still well positioned to benefit from that move, so the demand looks more likely to grow than collapse.

If you believe that to be true, then mining is still an attractive long term proposition, but there is one important thing to be considered. Bitcoin is a new technology and as such there is little to tell us at what point the spread between the price of Bitcoin and the cost of mining will force a correction. We dont seem to be there yet as, despite some stabilization, in recent weeks BTC/USD still looks to be on a downward path, while the cost of mining will by definition continue to grow. Until that dynamic changes, either as the result of a price increase or a significant advance in technology, mining Bitcoin will remain a fascinating hobby for many, but not an economically viable proposition for most.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

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Bitcoin Basics: The Economics Of Mining