Unit 5 Lecture Notes

A detailed explanation of the importance of mining to the Bitcoin network can be found in Chapter 8 of The Bitcoin Standard. The most relevant point for this discussion is that the energy expenditure is a key to the safety and security of the network, allowing it to maintain an honest record of transactions and a predetermined fixed credible monetary policy. Bitcoin allows anyone to validate (i.e. read) this shared ledger for themselves and, provided their computer can solve Proof of Work problems, will reward them with new coin production and transaction fees in exchange for committing (i.e. writing) transactions to its shared ledger. The nature of proof of work problems is that they require repetitive trial and error guesses by computers to solve, and the more computing power dedicated to these guesses, the faster a correct guess is made. As more machines come online to try to solve these problems, the speed by which they guess the answer increases, which increases the production of blocks, and thus increases the production of new coins. But bitcoin's algorithm has a difficulty adjustment every two weeks that adjusts how hard it is to solve these problems; this adjustment ensures that the time it takes to find a solution remains around ten minutes for the network as a whole. Regardless of how many more computers join the network to mine bitcoin, there is no increase in the supply of bitcoin, only an increase in the difficulty of mining it. This automatic adjustment is how bitcoin is uniquely different from all other monetary assets. If demand for any metal increases, the production of that metal will accelerate, and thus its supply will grow at a quicker rate than previously. But bitcoin mining is like a sports competition: there is only one trophy to be handed out, and even if more people compete, more trophies aren't made; winning the trophy just becomes harder. This effectively ensures that the cost invested in producing a bitcoin is roughly equal to the value of a bitcoin, which is what ensures bitcoin is hard money. If a miner could produce bitcoin cheaply, it would be so profitable that other miners would join, and the difficulty would rise, increasing the cost of production until the profit is eliminated, or preserved for only the miners with the lowest electricity cost.

I view the difficulty adjustment as the crucial ingredient missing from previous digital currency attempts that allowed bitcoin to succeed. It ensures that the cost of producing a bitcoin always trends close to its price, thus ensuring that bitcoin remains hard money. The difficulty adjustment is also what makes bitcoin escape the easy money trap I discuss in my book, and allows it to have the positive feedback loop of economic incentives which I believe is the only way to understand its quick rise in value.

Figure 1: Bitcoin's monetary uniqueness

Another consequence of the difficulty adjustment relevant to today's topic is that it ensures that mining is only profitable for the miners who have electricity rates significantly cheaper than average. An upward adjustment of mining difficulty as mining activity increases erodes the profitability of all but the most competitive miners. If you're mining bitcoin profitably at an electricity cost that is widely available worldwide, then many people will purchase mining equipment and begin to mine to make that profit. But as their entry raises the computational capacity of the network and blocks are found faster, a sufficiently large difficulty increase restores the original block intervals; unfortunately for those now mining at the margin (i.e. the worldwide average electricity cost), they're no longer profitable. The only miners that can stay in the game are the ones with access to cheaper energy sources, which by definition are not easily attainable worldwide.