Bursting the Bitcoin Bubble: Assessing the Fundamental Value and Social Costs of Bitcoin

Abstract

This paper develops a microeconomic model of bitcoin production to analyze the economic effects of the Bitcoin protocol. I view the bitcoin as a tradable commodity that is produced by miners and whose supply is managed by the protocol. I show that bitcoin's volatile price path and inefficiency are related, and that both are a consequence of the protocol's system of supply management. I characterize the fundamental value of a bitcoin and demonstrate that the return on bitcoin appreciates proportionally to the rate of increase in the level of difficulty. In the model, where the price of a bitcoin is based on marginal production costs, successive positive demand shocks result in a rapidly increasing price path that may be mistaken for a bubble. I use the generalized supremum augmented Dickey-Fuller (GSADF) test to demonstrate that the model is able to account for the explosive behavior in the bitcoin price path, providing strong evidence that bitcoin is not a bubble. I also show that the difficulty adjustment mechanism results in social welfare losses from 17 March 2014 to 13 January 2019 of 323.8 million USD, which is about 9.3% of the miners' total electricity costs during this time period.