Understanding the Economics of Bitcoin

Bitcoin's decentralized nature means there's no central authority controlling its supply, which is capped at 21 million units. This scarcity is a key factor in its value.

The proof-of-work consensus algorithm requires miners to solve complex mathematical problems, which helps secure the network and validate transactions. It's an energy-intensive process, but one that ensures the integrity of the Bitcoin ledger.

As a result, the cost of mining Bitcoin can be quite high, often exceeding $5,000 per transaction. This has led to a situation where some miners are selling their computing power to third parties, creating a secondary market for mining services.

Bitcoin is a digital currency that allows for peer-to-peer transactions without the need for intermediaries.

It was created in 2009 by an individual or group using the pseudonym Satoshi Nakamoto.

Bitcoin is decentralized, meaning it's not controlled by any government or financial institution.

Transactions are recorded on a public ledger called the blockchain, which helps to ensure the integrity of the network.

The blockchain is maintained by a network of computers around the world, rather than a single central authority.

Each bitcoin is divisible into 100 million smaller units called satoshis.

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To buy or sell Bitcoin, you can use online exchanges, where participants offer buy and sell bids. This approach comes with some risk, as 45% of exchanges fail and take client Bitcoins with them.

You can also buy Bitcoins offline, either directly from an individual or at a Bitcoin ATM. Bitcoin machines, however, are not traditional ATMs, and they may charge transaction fees as high as 7%.

As of 2016, there were over 800 Bitcoin ATMs operating globally, with the majority being in the United States, specifically over 500.

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The economic aspects of Bitcoin are complex and multifaceted, but one thing is clear: it's a medium of exchange, a measure of value, and a unit of account, just like traditional currency.

Bitcoin's decentralized nature means that there's no single point of failure, which can be a major advantage over traditional financial systems.

The hash price is a crucial metric in the mining industry, representing the price the network pays to incentivize hashes, which ultimately produce blocks and secure the ledger of transactions.

Miners collectively perform trillions of proof-of-work calculations per second, and the hash price provides a view into their income based on overall hash rate.

Here are some key factors that influence the hash price:

The halving of the subsidy period has historically led to an increase in price, roughly one to one-and-a-half years later, but this may not be as straightforward as it seems.

Classification is a fundamental concept in understanding the economic aspects of cryptocurrency. One way to classify cryptocurrency is by its acceptance as a medium of exchange, measure of value, and unit of account, making it real money.

Cryptoeconomics, the study of cryptocurrency, can be divided into two subdisciplines: crypto-macro and crypto-micro economics. This division is similar to traditional economics, which separates macroeconomics from microeconomics.

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Cryptocurrencies have been touted as a revolutionary new way to manage finances, but like any new technology, they come with their fair share of advantages and disadvantages. One of the biggest advantages of cryptocurrencies is that they remove single points of failure, such as large financial institutions, that can cause global crises.

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Easier to transfer funds between parties is another advantage of cryptocurrencies. By using public and private keys, transactions can be secured and processed without the need for a trusted third party. This makes transferring funds faster and more efficient.

The decentralized nature of cryptocurrencies also removes the need for third parties, such as banks and credit card companies. This can be beneficial for individuals who want to make transactions without the need for intermediaries.

Cryptocurrencies can also be used to generate returns, such as through decentralized finance (DeFi) transactions. According to Example 4, "How Does Crypto Make You Money?", there are several ways to make money with cryptocurrencies, including staking, lending, and holding onto them in the hopes of their value increasing.

Remittances are also streamlined with cryptocurrencies, making it easier to send money across borders. This is especially beneficial for individuals who need to send money to family members or friends living in other countries.

However, there are also some significant disadvantages to cryptocurrencies. One of the biggest drawbacks is their volatility, which can make it difficult to predict their value. According to Example 1, "Price and volatility", the price of bitcoins has gone through various cycles of appreciation and depreciation, making it a challenging investment.

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Another disadvantage of cryptocurrencies is their energy consumption. Mining popular cryptocurrencies requires a significant amount of energy, which can have a negative impact on the environment. According to Example 3, "Disadvantages Explained", mining popular cryptocurrencies requires as much energy as entire countries consume.

Cryptocurrencies also lack regulation, which can make them vulnerable to hacking and other forms of cybercrime. According to Example 3, "Disadvantages Explained", many cryptocurrency exchanges and wallets have been hacked over the years, resulting in the theft of millions of dollars in coins.

Here is a summary of the advantages and disadvantages of cryptocurrencies:

In Asia, the regulatory landscape for cryptocurrencies is quite diverse. Japan's Payment Services Act recognizes Bitcoin as legal property, requiring cryptocurrency exchanges to collect customer information and wire transfer details.

This is a stark contrast to China, which has banned cryptocurrency exchanges, transactions, and mining within its borders. China is, however, exploring the development of a Central Bank Digital Currency (CBDC).

India is currently formulating a framework for cryptocurrencies, but until it's enacted, crypto remains unregulated. Exchanges are free to offer cryptocurrencies, but this may change once the framework is in place.

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Venture capital plays a significant role in the bitcoin ecosystem, with investors funding companies that provide essential services to the community.

Venture capitalists like Peter Thiel's Founders Fund invest in bitcoin infrastructure, such as payment systems for merchants, exchanges, and wallet services, rather than buying bitcoins directly.

In 2012, Adam Draper founded an incubator for bitcoin-focused start-ups with help from his father, venture capitalist Tim Draper, who is one of the largest bitcoin holders after winning an auction for 30,000 bitcoins.

The incubator aims to fund 100 bitcoin businesses within 2-3 years, providing each with $10,000 to $20,000 in exchange for a 6% stake.

Investors also put money into bitcoin mining, which is crucial for validating transactions and maintaining the security of the bitcoin network.

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Crowdfunding has proven to be a viable option for raising funds with Bitcoin.

One notable example is a college football sign that netted over $20,000 in donations from a bitcoin enthusiast.

This shows that Bitcoin can be a successful medium for crowdfunding efforts.

The estimated number of Bitcoins owned by Satoshi Nakamoto is over a million, although this is a figure that remains unverified.

Some countries have significant Bitcoin holdings, including the United States, with an estimated 530k-600k Bitcoins, and China, with 194k-200k Bitcoins.

Here is a breakdown of the reported Bitcoin holdings by country:

Note that these figures are estimates and may not be entirely accurate.

The halving of the block subsidy, also known as the security budget, is a crucial aspect of Bitcoin's economics. This decrease in subsidy will have a significant impact on the network's security and miners' revenue.

The current subsidy is 6.25 BTC, but it has fluctuated between $93,000 and $400,000 per block with a price of $15,000 to $64,000 per BTC. The computing power competing for that reward is approximately 506,385,212 terahashes per second.

As of the end of 2023, the hash rate has climbed 8000% since the 2016 halving and 394% since the 2020 halving. This includes a 40% hash rate decline in 2021 following China's ban on Bitcoin mining.

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The block subsidy or "security budget" is made up of many variables, but the most important variable is arguably the hash rate. Historically, as the supply of new bitcoin issuance is halved, the price per bitcoin grows, offsetting the loss in bitcoin-denominated subsidy with a higher USD-denominated subsidy.

However, a price increase is not guaranteed, and adoption may continue to be progressively more important. In theory, this could create higher transaction fees that could eventually replace the diminishing network subsidy.

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Miners are incentivized by the hash price, which is the price the network pays to incentivize hashes that produce blocks, securing the ledger of transactions.

The hash price represents a miner's expected revenue derived from block rewards and user transaction fees. It's a crucial metric in the mining industry.

A single mining machine can produce 110 terahashes per second, and at a daily hash price value of $0.086, it can expect to generate $9.51 a day.

However, block production is like a lottery, and not all players are rewarded equally. A single machine by itself may not have a return of $9.51 per day, but it could reach this average with a long enough time horizon.

A collective, or pool, of miners is a more efficient course of mining today. This is because their combined hash rate can increase their chances of producing blocks and earning rewards.

The hash price is made up of multiple variables, including block reward, user transaction fees, energy input cost, block target difficulty, and mining efficiency. It's a product of a miner's daily revenue divided by the hashes produced per day.

If the cost of production is above the hash price, miners may choose to turn off their machines, driving the difficulty down. This keeps the network and individual miners' incentives aligned.

In the past, a decline in subsidy was offset by a higher USD-denominated subsidy due to a higher price per bitcoin. However, this is not a guarantee, and adoption may become more important in the future.

Elevated fees may present an opportunity for miners to maintain or even increase revenue outside of the block subsidy. The average percentage of miner revenues from fees has been around 1% outside of bull markets.

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Economists have a wide range of opinions on bitcoin, with some seeing it as a speculative bubble and others viewing it as a legitimate digital currency.

Nobel laureate Robert J. Shiller has stated that bitcoin exhibited many of the characteristics of a speculative bubble in 2014 and again in 2017.

Economist John Quiggin has been particularly vocal in his criticism of bitcoin, calling it the most demonstrably valueless financial asset ever created in 2013.

Nobel laureate Joseph Stiglitz has also expressed concerns about bitcoin, calling it a bubble that will eventually collapse and emphasizing its use by criminals.

Nobel laureate Paul Krugman has criticized bitcoin as a bubble wrapped in techno-mysticism, highlighting its lack of a "tether to reality".

Four Nobel laureates, including James Heckman, Thomas Sargent, Angus Deaton, and Oliver Hart, have characterized bitcoin as a bubble at a joint press conference in 2018.

Professor Nouriel Roubini of New York University has called bitcoin the "mother of all bubbles", highlighting the massive obstacles standing in the way of its adoption.

However, a research paper by the Asian Development Bank in 2019 concluded that there is a "strong evidence that bitcoin is not a bubble".

The opinions of economists on bitcoin are varied and often conflicting, reflecting the complexity and uncertainty of this new digital currency.

Warren Buffett, a renowned American investor, has been vocal about his skepticism towards bitcoin, calling it "a mirage" and "rat poison squared" in 2014 and 2018, respectively.

Buffett believes that bitcoin is a non-productive asset, and its value is based on the hope that someone will buy it for a higher price in the future.

Charlie Munger, Buffett's close associate, is even more direct in his disdain for bitcoin, calling it "worthless" and a "turd".

John Bogle, the founder of The Vanguard Group, advises investors to "avoid bitcoin like the plague", as there is no fundamental value behind it.

Gavin Andresen and Mike Hearn, two lead software developers of bitcoin, have also warned about the possibility of bubbles occurring in the cryptocurrency market.

Jamie Dimon, the CEO of JPMorgan Chase, initially referred to bitcoin as a "fraud" in 2017, but later expressed regrets about his statement and acknowledged the potential of blockchain technology.

Alibaba chairman Jack Ma has a nuanced view, stating that there is no bubble for blockchain, but a bitcoin bubble does exist.

Here's a summary of the views of these investors and executives on bitcoin:

Crypto-macroeconomics is a crucial aspect of the cryptocurrency economy, focusing on the regional, national, and international regulation of cryptocurrencies and DeFi transactions.

The Group of Seven governments' interest in cryptocurrencies became evident in August 2014, when the United Kingdom Treasury commissioned a study of cryptocurrencies and their potential role in the UK economy, and issued its final report in January 2021.

In June 2021, El Salvador became the first country to accept Bitcoin as legal tender, paving the way for other countries to follow suit. Cuba followed in August 2021 with a legal resolution to recognize and regulate cryptocurrencies like Bitcoin.

However, in September 2021, the government of China, the single largest market for cryptocurrency, declared all cryptocurrency transactions illegal, completing a crackdown on cryptocurrency that had previously banned the operation of intermediaries and miners within China. This move highlights the challenges and uncertainties that come with regulating cryptocurrencies at a national level.

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Economists have varying opinions on bitcoin, with some finding it an elegant solution to creating a digital currency. François R. Velde, Senior Economist at the Chicago Fed, has praised bitcoin for its innovative approach.

On the other hand, some economists have expressed skepticism about bitcoin's ability to act as a stable store of value. Paul Krugman and Brad DeLong have questioned why bitcoin should be considered a reliable store of value, and whether there's a floor on its value.

David Andolfatto, Vice President at the Federal Reserve Bank of St. Louis, has stated that bitcoin is a threat to the establishment, which he believes is a good thing for the Federal Reserve System and other central banks. This prompts these institutions to operate sound policies.

Some experts have criticized the lack of anonymity in bitcoin, calling for reformed development. Free software movement activist Richard Stallman has been vocal about this issue.

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Not all experts are negative, though. PayPal President David A. Marcus has called bitcoin a "great place to put assets", but notes that it won't be a currency until price volatility is reduced.

Interestingly, even some government officials have acknowledged the legitimate uses of bitcoin. In 2013, three US government officials testified at senate hearings that "Bitcoin has legitimate uses", and most other witnesses echoed those sentiments.

Here's a summary of the various opinions on bitcoin:

Financial institutions have been cautious about dealing with bitcoin companies due to concerns about illicit activity. Banks in Australia have been particularly wary, with some closing down accounts of businesses involved with the currency.

The National Australia Bank closed accounts of businesses with ties to bitcoin in 2014. HSBC also refused to serve a hedge fund with links to bitcoin.

Australian banks have been reported to close down bank accounts of operators of businesses involving the currency, sparking an investigation by the Australian Competition & Consumer Commission.

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Bitcoin's acceptance among major online retailers has declined, with only three of the top 500 U.S. online merchants accepting it in 2017 and 2018.

High transaction fees and long processing times make bitcoin impractical for small retail purchases, according to economist Kim Grauer. As a result, merchants often use payment service providers to convert bitcoin payments into conventional currencies.

The first recorded sale of a house in exchange for bitcoin happened in September 2017, and a first recorded sale of an apartment in the world was sold for bitcoin in November 2017 in the Czech Republic.

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Cryptocurrencies have struggled to establish a clear legal status due to their lack of government or private entity backing.

The U.S. dollar, on the other hand, is recognized and issued by the government as the official currency of the United States.

This difference is a major hurdle for cryptocurrencies, making it difficult for them to be recognized as legal tender.

Cryptocurrencies have primarily functioned outside most existing financial infrastructure, which doesn't help their case for legal status.

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In the United States, only three of the top 500 online merchants accepted bitcoin payments in 2017 and 2018, down from five in 2016, due to high transaction fees and long processing times.

Bitcoin is not practical for small retail purchases due to high price volatility and transaction fees, making it difficult for merchants to accept.

The largest 17 crypto merchant-processing services handled $69 million in June 2018, down from $411 million in September 2017, indicating a decline in merchant adoption.

Merchants that do accept bitcoin payments often use payment service providers like BitPay or Coinbase to convert the bitcoin into conventional currencies.

In 2017, a Texas real estate agency, Kuper Sotheby's International Realty, brokered a house sale in exchange for bitcoin using BitPay to process the payment, marking a significant milestone in merchant acceptance.

In the Czech Republic, a three-room apartment was sold for bitcoin in November 2017, marking the first recorded sale of an apartment in Europe paid for in bitcoin.

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Payment service providers like BitPay or Coinbase charge a fee of less than 1 percent to convert bitcoin into conventional currencies for merchants.

Regulatory agencies are slowly gaining ground in the industry, with the SEC regulating crypto exchanges and coin offerings, and the IRS treating cryptocurrencies as financial assets or property for tax purposes.

In Europe, cryptocurrencies are legal in the European Union. This means that individuals and businesses can use them freely.

Derivatives and other products that use cryptocurrencies must qualify as "financial instruments." To qualify, they must meet certain standards and regulations.

The European Commission's Markets in Crypto-Assets (MiCA) regulation went into effect in June 2023. This law sets safeguards and establishes rules for companies or vendors providing financial services using cryptocurrencies.

The MiCA regulation establishes rules for companies providing financial services using cryptocurrencies. This includes requirements for transparency, security, and consumer protection.

Companies that provide financial services using cryptocurrencies must comply with the MiCA regulation. This ensures that consumers are protected and that the market operates fairly.

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Investing in bitcoin can be a high-risk, high-reward proposition. Some Argentinians have bought bitcoins to protect their savings against high inflation or government confiscation.

Investing in bitcoin funds is another option, but it's essential to be aware of the risks. The first regulated bitcoin fund was established in Jersey in July 2014, and the price of bitcoin fell 15% in a few minutes when the SEC declined a bitcoin ETF in 2017.

The European Banking Authority and the Financial Industry Regulatory Authority (FINRA) warned that investing in bitcoins carries significant risks in 2013 and 2014. However, Forbes named bitcoin the best investment of 2013, and bitcoin topped Bloomberg's currency tables in 2015.

Bitcoin's price volatility is a significant concern for investors. The price of bitcoin fell from $67,000 to $15,000 in its longest bear market, but the hash rate continued to climb.

Here are some key risks associated with investing in cryptocurrencies:

Investing in cryptocurrency can be a high-risk, high-reward venture. The total market capitalization of cryptocurrencies has risen to about $2.4 trillion, with some investors creating substantial fortunes by taking on the risk of investing in early-stage cryptocurrencies.

However, the risks associated with cryptocurrency investments are numerous. About one-fifth of all bitcoins are now inaccessible due to lost passwords or incorrect sending addresses.

Investors should be aware of the following risks:

Some investors have used cryptocurrency as a safe haven during times of economic uncertainty. For example, some Argentinians have bought bitcoins to protect their savings against high inflation, and bitcoin purchases in Cyprus rose during the 2012–2013 financial crisis due to fears that savings accounts would be confiscated or taxed.

Bitcoin's security mechanism is based on proof-of-work, an energy-intensive process that secures the decentralized digital network. This process demands constant capital input, making it difficult for attackers to outcompete miners and forgo potential rewards.

The block subsidy, which supports miners with a reward for their computations or energy input, is a bootstrapping instrument for maintaining the blockchain's integrity. The current subsidy is 6.25 BTC, but its value has fluctuated between $93,000 and $400,000 per block.

The computing power competing for that reward is approximately 506,385,212 terahashes per second. This significant amount of computing power is a testament to the security of the Bitcoin network.

The block subsidy has been halved three times since its launch, but the hash rate has continued rising. As of the end of 2023, the hash rate has climbed 8000% since the 2016 halving and 394% since the 2020 halving.

Despite a 40% hash rate decline in 2021 following China's ban on Bitcoin mining, the hash rate has continued its climb. This shows that the Bitcoin network remains secure and resilient, even in the face of challenges.

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Bitcoin Mechanics is a complex system, but it's based on some simple principles.

The Bitcoin network is maintained by a decentralized network of computers, known as nodes, that work together to validate transactions and add them to the public ledger, called the blockchain.

Each node on the network has a copy of the blockchain, which is a record of all Bitcoin transactions ever made.

The blockchain is a ledger that is maintained by a network of nodes, rather than a single central authority.

Transactions are grouped together in batches called blocks, and each block is given a unique code called a hash.

A hash is a digital fingerprint that identifies a block of transactions.

The blockchain is a chain of blocks, each linked to the previous one through a unique hash.

A new block is added to the blockchain every 10 minutes, on average, through a process called mining.

Mining is the process of using powerful computers to solve complex mathematical problems in order to validate transactions and add a new block to the blockchain.

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