Bitcoin is perhaps the greatest innovations in economic design. I’m glad to see that despite the early predictions by many economists the currency is yet to die. The value of Bitcoin has hovered around $550-$650 (USD) for a while and I remain confident that its value will stay close to the present marginal cost of mining Bitcoin. In a previous post I identified scale economies in the Bitcoin mining protocol and predicted that this will eventually become a major issue. Recently, the mining pool Ghash.io which is administered by the presumably Russian owned CEX.io achieved 54% of computational power amongst all Bitcoin miners. The plurality lasted for a few hours and caused a great deal of `weeping and gnashing of teeth’ in the Bitcoin community. You see, anyone controlling more than 50% of mining power exercises complete control over the recording of Bitcoin transactions.
It is not surprising that a mining pool will occasionally achieve more than 50% of mining power, after all there are economies of scale that are built into the cryptographic mining contests in the Bitcoin protocol. But there are additional aspects of the Bitcoin protocol that will ensure that no persistent monopoly can emerge in Bitcoin mining. The protocol has democracy in built into it, and the plurality rule in the system combined with the fact that mining is costly ensures that we will not see a persistent monopoly. Indeed, given the economies of scale in the mining protocol I predict that the eventual stable market structure for Bitcoin mining will be two large mining pools of equal size. By equal size I mean two mining consortiums that will each frequently cross the 50% computational power line and have temporary control of the recording of Bitcoin transactions. And that, unlike a persistent monopoly, need not be a bad thing for the longevity of the currency.
The relationship between two-party systems and majority-rule elections is called “Duverger’s law” in political science. In a theory paper that I wrote some time ago (before the release of Bitcoin) with Martin Osborne, we identified economies of scale in a plurality-rule election system as one possible explanation for “Duverger’s law.” My thinking now is that the argument in that paper is rather compelling for predicting the eventual agglomeration that we will see in Bitcoin mining. Simply, because of economies of scale a stable outcome cannot involve more than two miners: there is always an incentive for miners to agglomerate into a pool with more than 50% computational power. Now it is also clear that a persistent monopolist is not a stable outcome. as the monopolist will have an incentive to reduce mining cost by remaining at just over 50% of computational power. After all, by way of market power there is no difference between having 51% of power and 52% of computational power. The non-monopolist, on the other hand, will have an incentive to increase their mining power or simply drop out (49% with a persistent monopoly is the same as having %0). Of course, there is another possibility: no miners. But that is also not possible, as in the absence of miners anyone can use the computational power of a smart watch to mine Bitcoin, just for fun.