Bitcoins have been much in the news lately. Against the background of renewed concerns about the integrity of the euro zone and the imposition of capital controls in Cyprus, the price of a bitcoin has tripled over the last month and reached more than $141 for 1 BTC.Are we witnessing the spontaneous emergence of an alternative virtual medium of exchange, as some would put it? This article offers an answer to this question by considering three aspects of the economy of bitcoins: their production process, their demand factors, and their capacity to compete with physical media of exchange.
The Production of Bitcoins
A bitcoin is a unit of a nonmaterial virtual currency, also called crypto-currency, by the same name. They are stored in anonymous “electronic wallets,” described by a series of about 33 letters and numbers. Bitcoins can travel from a wallet to a wallet, by means of an online peer-to-peer network transaction. Any inter-wallet transfer is registered in the code of the bitcoin, so that the record of its entire transaction history clearly identifies its owner at any single moment, thereby preventing potential ownership conflicts. Bitcoins can be further divided into increments as small as one 100 millionth of a bitcoin. The current outstanding volume of bitcoins is above 10 million and is projected to reach 21 million in the year 2140.
This brings us to the truly fascinating production process of the bitcoins. They are “mined” based on a pre-defined mathematical algorithm, and come in a bundle, currently of 25 units, as a reward for carrying out a large number of computational operations that aim at discovering the solution to what could be described as a randomized mathematical puzzle.
The role of the algorithm is to ensure a declining progression of the overall stock of bitcoins, by halving the reward every four years. Thus, somewhere in the beginning of 2017, the reward bundle will consist of 12.5 units only. Also, the more bitcoins are produced, the harder are the randomized mathematical puzzles to be solved.
Bitcoins come about as the uncertain pay-off for an energy—and hardware—-consuming process that is extended through time. The per-time pay-off varies, based on the efficiency and sophistication of the more-or-less specific hardware used for the mining. Individual miners have started to pool their efforts, and this cooperation has tremendously reduced the uncertainty that each individual miner bears.
Due to this costly production process, bitcoins, although virtual, are constrained by scarcity.
While a bitcoin has no material shape or content, the algorithm that generates it has been designed to replicate the competitive production of a scarce good. First, entry in the business of producing bitcoins is open to anybody. Second, the production process is capital and labor intensive, extended through time, and also uncertain. Third, production is subject to decreasing returns, thereby conforming to the generalized scarcity faced by acting individuals in the better-known physical world. Thus, bitcoins turn out to be the exact opposite of the “Linden dollars” of the Second Life “virtual world.” The latter are produced by a monopolist central authority, out of thin air, and without any other limitation but the very discretion of that same monopolist authority.
However, it is not their costs of production that bestow on bitcoins the status of an economic good. After all, scarcity is not rooted in the absolute quantitative limitation of something; it comes from the insufficiency of the stock of that something, perceived as useful in some regard, relative to the individuals’ needs. Hence, we must ask ourselves how bitcoins have come to be valued at all. This leads us to an analysis of their demand.
The Demand for Bitcoins
At their inception, bitcoins were created and first held within a “crypto-punk” community. It could then be safely assumed that they served the purpose of conveying a specific antiestablishment worldview. The first demand factor, initially for producing bitcoins, and then unavoidably but only indirectly for holding them, was rooted in their capacity to project a certain point of view. In a sense, bitcoins were comparable to an artistic medium of expression, such as music, literature, and painting.
Thanks to that initial source of value, bitcoins had a reference point that positioned them relative to other goods and services. From there onward, the technological features that characterize them led to an expansion of their demand. Bitcoins are imperishable. Storage and protection against theft or accidental loss come at a very low cost, as these are accessory services rendered by standard antivirus and back-up software. Marginal transaction costs are also practically zero, once the fixed cost of establishing and maintaining a network connection has been accounted for. All these aspects are common to real wealth assets. Thus, the second demand factor for bitcoins is explained by their capacity to store wealth at a low cost. From the status of a good which, as a “worldview-conveyor,” was largely used for personal enjoyment (and hence consumption), bitcoins evolved into an investment good that has become attractive well beyond its original crypto-punk community.
The growing investment demand also spurred the development of intermediary dealers in bitcoins. There are a number of exchanges where bitcoins can be bought and sold against currencies. Specialized online storage, presumably with increased security, has also been made available. Intermediation, though open to free entry, is likely to remain rather monopolistic, given the very low margins associated with transacting in and with bitcoins.
This latter aspect, namely the intrinsically low transaction fee, contributes to a third demand factor for bitcoins, namely as a means of payment. A number of online vendors, who are mostly specialized in web-related services and online sales of rather exotic items, accept final payment in bitcoins, not the least because of the guarantee for almost absolute anonymity.
This last component of the demand for bitcoins is still nascent. After all, a very limited set of items can be purchased with bitcoins, and sellers still price their goods in dollars, euros, etc.
The price is then converted into bitcoins, according to the prevailing exchange rate, at the final stage of finalizing the payment method of the transaction. Thus, while bitcoins do appear to serve as a means of payment, they are definitely not used yet for business calculation. This is most certainly attributable to their still very limited demand to hold as a means of exchange. Nevertheless, couldn’t they become full-fledged money in the foreseeable future?
