Bitcoin mining is probably the closest the world has ever come to a perfectly competitive market. Everybody is free to use whatever resources they can access and compete. There is no entity that can stop them, short of identifying their location and physically disabling their equipment. There are no barriers to entering or exiting the market. The rules are the same for everybody, your payout is directly proportional to the percentage of the hashing power you assign to the the task. Perfectly competitive markets do not make ‘abnormal’ profits over the long term.
In economic terms, normal profits are the minimum level of profit required to keep the factors of production in use for the long term, taking into account the opportunity cost of the funds required to finance the business. Abnormal profits are any profits in excess of normal profit.
Mining’s variable difficulty level, designed to average out the time between blocks found, means that the number of bitcoins created stays relatively constant, no matter how many miners are working. If too much hashing power comes online then the block rewards are shared among more people. This reduced income will put some less efficient miners below normal profits. The only rational behaviour is therefore for them to stop mining. The reverse is also true, if hashing power is reduced, causing short term abnormal profits, new miners will come online, competing away the abnormal profits until they are normal again. The averagely efficient miner will continue to make normal profits over the long term and is therefore sufficiently incentivised to continue mining. So the question you need to ask is will you be at least averagely efficient over the long term; or can you maintain a competitive advantage long enough in the short term to cover the set up and shut down costs?
What does it mean to be averagely efficient?
Averagely efficient means taking into account all variables, both known and unknown, will you produce your hashing power at a price which is the mean of everyone else. Of course, you will never actually know the average cost of production until it is too late. The input variables will include:
- cost of hardware
- cost of electricity
- staffing costs
- research costs
The need to continually achieve the average cost, plus the desire for abnormal profits, means that mining is incredibly competitive. If you are not competitive then you’re out of business. The average cost of producing hashing power is constantly pushed downwards through economies of scale, technological advances, and even dishonest means.
Electricity costs differ per location, as well as the variable costs of generating electricity, in some countries it’s taxed, whilst in others it is subsidised. If you live in an area with cheap electricity, or you have a large enough operation that you can locate to a cheaper location, then great; if not, you will need to make up for this lack of efficiency somewhere else.
It is not enough for your hardware costs to be average today. They must be at least average throughout the entire life of their operation. If new more efficient hardware becomes available in three months, new investment will be attracted by the short term abnormal profits, buying the new hardware and reducing the average cost of production.
Historically many miners have been accused of using dishonest means to reduce their costs. For example, it was not uncommon for people to buy new ASIC mining hardware, mine with it for a month or two, then reset everything and resell it as new, effectively making their hardware costs nil. On a larger scale, at least a couple of large hardware manufacturers were accused of delaying the delivery of pre-ordered ASICs so that they could mine with them first. It may be dishonest, but it reduces the average cost of hardware.
If after taking everything into consideration you decide that you can be at least average, that you can stay competitive, then great. If not, maybe you would consider cloud mining. The argument for cloud mining is that through economies of scale you can reduce your costs. Either through locating in an area with cheaper rent and electricity, negotiating on hardware purchases, or even attracting better management; which may cost more in nominal terms, but may well offer better value.
The obvious downside is that the cloud mining company’s profit margin, marketing activities, and risk of non-payment become another cost that need to be considered, pushing up your average cost of production. You need to consider whether the savings through economies of scale will be enough to make up for this and still return a profit.
Predicting the future
The majority of the factors that will help you decide whether to start mining can be known in advance, but the most important one cannot! You can predict the cost of your hardware, electricity, staffing and research costs. You can know what hash rate you will produce, you can even factor in percentages for unforeseen circumstances, such as premature hardware failure. What you cannot reliably predict is the difficulty, because the difficulty is determined by the overall average cost of everybody’s hash power. You can know your own costs, but you cannot know everybody else’s.
What is needed is a reliable futures market that allows you to lock in today’s difficulty level for the life of your hardware. In much the same way that a farmer can use a futures market to lock in the price of grain today, allowing him to make large capital investments to harvest more efficiently, without having to worry that the market price (something he cannot reliably predict) will collapse before his harvest is ready to sell. Of course, the cost of buying a future contract adds to the miners cost of production, which may make his operation uneconomical. However, it is likely that the majority of large mining operations would follow suit as it would mean they could concentrate on what they are good at, creating hashing power, and leave the difficulty speculation to the speculators. One would also expect financing costs will be reduced as a result of a more predictable business model.
This week saw the launch of a bitcoin derivative market, allowing traders the ability to hedge the price of bitcoins with forward contracts, maybe a difficulty forward contract should be their next product.