Elementary Bitcoin Economics: Analysis of Production, Transaction Demand, and Value

1. Introduction

Bitcoin represents a unique socio-economic experiment, combining a distributed ledger with a market-driven incentive structure for security (mining). This paper provides an elementary economic analysis focusing on the interplay between the supply of hashrate by miners (production) and the demand for Bitcoin for conducting transactions. The core motivation is to understand the fundamental drivers of Bitcoin's value, especially as the network transitions from block reward subsidies to a fee-driven model, and to assess the hypothesis regarding the absence of economic fundamentals for its price.

2. Core Economic Framework

The Bitcoin economy is modeled through two primary agents: miners (producers) and users/consumers.

2.1 Miner Supply & Cost of Production

Miners provide computational power (hashrate, $H$) to secure the network and process transactions. Their output is measured in hashes per second. The supply of hashrate is driven by profit maximization, where revenue comes from block rewards ($R$) and transaction fees ($F$), and costs include capital expenditure (equipment) and operational expenditure (energy, labor). Under perfect competition, the marginal cost of producing one unit of hashrate equals the expected marginal revenue. A foundational cost of production model, as referenced from Hayes (2015), suggests a relationship between Bitcoin price ($P$), hashrate ($H$), and energy cost ($E$).

2.2 Consumer Transaction Demand

Consumers demand Bitcoin primarily to facilitate transactions on its network. The paper initially considers a simplified model where demand is purely for transactions, excluding the significant effects of hoarding (store of value) and speculation. Transaction demand ($D_T$) is postulated to be a function of the Bitcoin price and the volume of desired economic activity on-chain.

3. Market Equilibrium Analysis

3.1 Indeterminate Price Thesis

The paper's central argument is that the market equilibrium condition—where the transaction demand for Bitcoin equals the "supply" of Bitcoin liquidity facilitated by miners—is insufficient to determine a unique exchange rate ($P$). The cost of production model determines the supply of hashrate for a given price, not the price itself. Therefore, within this elementary framework that excludes hoarding, the Bitcoin price lacks a fundamental economic anchor and is free to fluctuate based on speculative sentiment.

3.2 Role of Halving & Fees

The analysis projects the impact of the periodic "halving" events, which reduce the block reward. It argues that the direct effect on price may be muted. The critical implication is the forced transition towards transaction fees constituting a larger share of miner revenue. The paper warns that rising fees could impair Bitcoin's competitiveness (e.g., against Ethereum) and that declining miner revenue could negatively impact the perception of Bitcoin as a secure store of value, indirectly affecting its price.

4. Technical Model & Formulas

The economic logic is underpinned by key mathematical relationships:

Miner Profit ($\pi$): $\pi = (R + F) \cdot \frac{H_i}{H_{total}} - C(H_i)$ where $H_i$ is individual hashrate, $H_{total}$ is network hashrate, and $C$ is cost function.
Marginal Cost Condition (Competitive Equilibrium): Under competition, miners enter/exit until profit is zero. This implies the average cost per hash equals the expected reward per hash: $\frac{C(H)}{H} \approx \frac{R+F}{H_{total}} \cdot P$. This can be rearranged to show hashrate supply as a function of price: $H_{supply} = f(P, R, F, E)$.
Equilibrium Condition: The model posits an equilibrium where the dollar value of Bitcoin demanded for transactions equals the dollar value of rewards earned by miners (simplified): $D_T(P) \cdot P = (R + F) \cdot P$. This equation, however, often simplifies in a way that cancels $P$, leading to the indeterminate price conclusion.

5. Empirical Context & Prior Research

The paper situates itself within a contested empirical landscape. It cites studies like Hayes (2016, 2019) and Abbatemarco et al. (2018) that found correlation between Bitcoin price and a cost-of-production model. Conversely, it notes the work of Baldan and Zen (2020) which found no such connection, attributing discrepancies to different time frames and market states (equilibrium vs. disequilibrium, bubbles). The author's contribution is the theoretical argument that these models determine supply, not price, and equilibrium may be fleeting or non-unique.

6. Critical Analyst Perspective

6.1 Core Insight

This paper delivers a crucial, sobering dose of reality: Bitcoin's price, in a pure utility-transaction model, is fundamentally unanchored. Forget the "digital gold" narrative for a moment; if people only used BTC to pay for things, its value would be purely speculative, dictated by sentiment, not cost bases. This directly challenges the foundational belief of many investors who point to mining costs as a price floor. The author isn't just modeling; they're exposing a potential existential vulnerability.

6.2 Logical Flow

The argument is elegantly simple and devastating. 1) Miners supply hashrate based on expected revenue (a function of price). 2) Users demand BTC for its transaction utility. 3) In equilibrium, the dollar value of transaction demand must match miner revenue. But here's the kicker: in a simple formulation, the price variable ($P$) cancels out from both sides of this equilibrium equation. The system determines the level of economic activity (hashrate, transaction volume), but not the unit price of the asset facilitating it. The price is a free variable, opening the door to the wild volatility we observe.

6.3 Strengths & Flaws

Strength: The paper's greatest strength is its razor-sharp focus on first principles. By stripping away the noise of speculation and hoarding, it isolates the core transaction utility economics and reveals its insufficiency. The warning about fee-driven security and competition with Ethereum is prescient and aligns with current Layer-2 and fee market debates.
Critical Flaw: The model's fatal simplification is its initial exclusion of hoarding/store-of-value demand. This is like analyzing gold's economics while ignoring its role as a reserve asset. As noted by the Bank for International Settlements (BIS) in their work on cryptocurrency valuations, the dominant driver of crypto asset prices is speculative and investment demand, not transactional utility. The "indeterminate price" conclusion is almost a tautology once you remove the primary demand driver. However, this flaw is partially acknowledged and becomes the paper's bridge to reality: the price is set by the very factors (hoarding/speculation) the model initially excludes.

6.4 Actionable Insights

For investors: Stop relying on "mining cost" as a hard floor. It's a dynamic equilibrium outcome, not an independent input. A sustained price drop can and will push hashrate offline, recalibrating the cost base lower.
For network developers/advocates: The paper sounds a five-alarm fire on the fee transition. Relying on high fees to secure a multi-trillion dollar network is a dangerous game that cedes the payments narrative to competitors. The focus must be on scaling solutions (like the innovations seen in Ethereum's rollup-centric roadmap) that keep fees low while securing value through other means (e.g., staking, restaking).
For researchers: Test the model's implications during different regimes. Does price become more correlated with on-chain utility metrics (e.g., NVT Ratio) and less with hashrate during bear markets when speculation recedes? This could validate the core insight.

7. Analysis Framework: A Simple Case

Scenario: Assume a simplified period where block reward $R = 6.25$ BTC, average fee $F = 0.1$ BTC/block, and global energy cost $E = \$0.05$ per kWh. The cost of production model might imply a network hashrate $H$ that is economically sustainable at a given Bitcoin price $P_1$.
Equilibrium Check: If user transaction demand, valued in dollars, is $D_T = \$10$ million per day, and total daily miner revenue in dollars is $(6.25 + 0.1) \cdot P_1 \cdot 144 \approx 914.4 \cdot P_1$, the equilibrium condition $10,000,000 = 914.4 \cdot P_1$ would suggest $P_1 \approx \$10,940$. However, if speculative demand evaporates and the price falls to $P_2 = \$5,000$, the model shows miners will become unprofitable, hashrate $H$ will drop until a new, lower-cost equilibrium is found. The transaction demand equation $10,000,000 = 914.4 \cdot P_2$ no longer holds, revealing that the original "equilibrium" price was contingent on a level of economic activity that itself depends on the price. This circularity illustrates the indeterminacy.

8. Future Outlook & Challenges

The future of Bitcoin's economics hinges on resolving the tension identified in the paper:

The Security Budget Dilemma: As block rewards diminish, sourcing sufficient security (hashrate) from fees alone is a major challenge. High fees are antithetical to its use as a peer-to-peer electronic cash system.
Competition with Smart Contract Platforms: As noted, Ethereum and other chains offer more versatile utility, potentially attracting fee revenue and developer mindshare. Bitcoin's future may depend on robust Layer 2 ecosystems (Lightning Network, sidechains) that batch transactions, keeping base-layer fees low while enabling high-volume use cases.
Evolution of Demand Drivers: The store-of-value narrative must solidify to provide the price stability and appreciation that incentivizes mining without exorbitant fees. This involves broader institutional adoption, regulatory clarity, and integration into traditional finance.
Technological Adaptation: Innovations in mining efficiency (e.g., next-generation ASICs, use of stranded energy) can lower the cost curve, helping secure the network at lower price points.

The long-term trajectory will be determined by whether Bitcoin can successfully transition from a subsidy-driven security model to a sustainable, fee-based or alternative incentive model without compromising decentralization or security—a transition no major monetary system has had to engineer in real-time.

9. References

Perepelitsa, M. (2022). Elementary Bitcoin economics: from production and transaction demand to values. arXiv:2211.07035.
Hayes, A. (2015). Cost of Production and Bitcoin Price. SSRN.
Hayes, A. (2019). Bitcoin Price and its Marginal Cost of Production: Support for a Fundamental Value. Applied Economics Letters.
Baldan, F., & Zen, F. (2020). The Cost of Production of Bitcoin and its Relation with its Price. Finance Research Letters.
Garcia, D., et al. (2014). The digital traces of bubbles: feedback cycles between socio-economic signals in the Bitcoin economy. Journal of the Royal Society Interface.
Cheah, E.-T., & Fry, J. (2015). Speculative bubbles in Bitcoin markets? An empirical investigation into the fundamental value of Bitcoin. Economics Letters.
Bank for International Settlements (BIS). (2022). Annual Economic Report. Chapter III: The future monetary system.
Abbatemarco, N., et al. (2018). Bitcoin: an empirical study on the relationship between price, hashrate and energy consumption.