Bitcoin’s Marginal Cost Fallacy

Some proponents of the merits of holding money in bitcoin form argue that the increasing cost of mining new coins will make existing coins more valuable over time. This argument implies that prices are set with reference to marginal costs. But this is wrong.

Gold provides a useful parallel study. The amount of gold in existence is increasing in only very small increments – almost all the gold that is in circulation today was also in circulation several decades ago. Unlike other commodities such as oil, it is not used as part of economic activity (except in insignificant amounts in some industrial applications). The marginal cost of producing oil has a large bearing on the price that it fetches in the market since almost all that is produced is consumed.

In the case of gold, the marginal cost is a function of the gold price – since producers only mine what they can sell for more than it costs. And that price is set by speculation – the hope that someone else will pay more for something in the future. Therefore, marginal cost is not a support to the price; demand can easily collapse since people’s willingness to pay is not a function of how useful the good is.

The argument that bitcoin (priced in dollars) should keep rising rests on similar logic that the marginal cost of producing it keeps increasing over time. Bitcoins are “mined” using computing power. The required computing power and hence the cost of mining incremental units goes up with the quantity in existence (mining involves solving increasingly complex mathematical problems that a normal PC would not cope with). For a unit to be mined economically the cost of the computing power must be less than the price those additional units could be sold at.

But since the demand is nothing other than speculation there is no relative pricing argument in the way there is with oil – demand for oil is a function of the role it plays in other economic activity. If demand for bitcoin (or gold) falls below marginal cost, mining would stop. But even then anyone can buy in the secondary market should they wish.

If the appeal wanes the bottom could fall out of the secondary market too. The world could keep going as it is without gold and, quite obviously, without bitcoin. It could not keep going (in its current state) without oil.

Even if some people get rich speculating on bitcoin that does not mean others should try. There is nothing to sustain it other than an ephemeral sense that, when it comes to monetary policy, “we can do this better ourselves”.


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