Bitcoin mining is a complex game of reward and risk, driven by what is probably the most free-market incentive mechanism in the world. In this article, I will go in the game theory of bitcoin mining, examining how individual miners make decisions that impact their success and some of the innovations that are taking place to make Bitcoin mining more efficient.
The Game Theory Of Bitcoin Mining
Understanding the game theory of Bitcoin mining is possibly one of the most important parts of understanding Bitcoin because it’s what drives Bitcoin to become more and more efficient over time. Without the incentive to constantly minimize overhead and costs, it’s possible that bitcoin mining wouldn’t adapt or change much. The game theory of bitcoin mining isn’t quite as simple as you vs. them or even you vs. yourself. There are multiple things to consider when understanding all of the different ways that miners compete against each other as well as simply increasing their own energy efficiency.
Game theory attempts to determine optimal strategies for maximizing rewards or minimizing losses in various competitive situations, such as in economics, political science, social psychology, and evolutionary biology. Game theory is also applied in understanding and predicting outcomes of various games, whether they are board games, card games, sports, and even bitcoin mining.
Since Bitcoin mining is a competition, Bitcoin miners do everything that is physically possible to eliminate all unnecessary energy expenditure and maximize all economic output in pursuit of the block reward. Without this game theoretical incentive, it’s possible that Bitcoin wouldn’t function at all. The game theory of Bitcoin mining is a beautiful system balanced by the purest free-market incentives and rewards in the world today.
It’s also important to understand that the game theory of Bitcoin mining is both competitive and cooperative. No matter who wins the block reward, miners all cooperate to add blocks to the same blockchain which makes every block (and everyone’s bitcoin transactions) more secure against block reorgs. I like to call it more of a co-op-etition and it’s one of the most beautiful parts of how Bitcoin works. In spite of some miners winning the entire block reward and all of the others losing, they are all working together on building the same network and bury every single bitcoin transaction under millions of dollars worth of energy and make every transaction immutable. All of that being said, here’s how the game theory of bitcoin mining plays out.
Hitting Multiple Moving Targets
Since the focus of this article is the game theory of bitcoin mining, it only makes sense that I refer to Bitcoin mining as a sort of game. Anyone can play. The same exact rules apply to everyone and if you play well, you win some newly mined bitcoin as a reward. There is really only one single rule to the game. You have to find a number that produces a hash that meets the current mining difficulty requirements. That’s it. That’s the only rule. To the human eye, this hash is just a 64 digit number that begins with a certain number of zeros but mathematically it’s the result of doing a LOT of systematic guessing to find the winning number.
To find this winning number, bitcoin miners have to hit a number of moving targets. If they can hit enough of these moving targets efficiently, they will win the block reward (newly mined bitcoin + miner fees). If a miner is efficient, they will win enough bitcoin to pay for all of their expenses and have some left over.
This is where the game theory gets really interesting because miners literally go to the edge of the world to innovate and find the most efficient way possible to find this winning number. Now, let’s look at all of these moving targets that they have to hit in order to win.
The Price Of Bitcoin
The price of bitcoin is the first of all of the moving targets that Bitcoin miners have to be aware of. Mining bitcoin is ultimately buying bitcoin but with several steps involved instead of just trading a fiat currency for bitcoin in a single step. The price of bitcoin is the intersection of the supply and demand for bitcoin but mining is the intersection of supply and demand for multiple different things. When a bitcoin miner decides to dedicate resources to mine bitcoin, they are ultimately attempting to devote fewer resources to buy bitcoin than if they just bought them from an exchange. If they are successful, then they are rewarded with more bitcoin than if they just bought them. If they are unsuccessful, then they will have less bitcoin than if they just decided to buy from an exchange. Everything that happens in between is what drives bitcoin mining to become more and more efficient over time because miners have an incentive to do everything possible to reduce their overhead costs. The lower their costs, the greater their potential profit.
The starting point for every Bitcoin miner in the world needs to be a realization that the price of bitcoin is a moving target and that all miners are trying to mine new bitcoin by expending fewer resources than it would cost just to buy bitcoin. Once you understand this very basic concept, you can begin to truly understand the game theory of bitcoin mining and what every bitcoin miner in the world is ultimately aiming for.
Just like any rational individual or business wants to accumulate bitcoin at the lowest possible price and spend or sell it at the highest possible price, the same is true for bitcoin mining. The greater the difference between your “mined” price and your spend/sell price, the greater the benefit that you get from bitcoin. Hitting this single moving target is easy to calculate if you just buy bitcoin but if you decide to mine, the price is only the beginning.
Electricity & Hardware
In order to sustain mining operations for as long as possible, bitcoin miners need two things and once again, they are both moving targets.
1. The cheapest electricity possible
2. The most efficient mining hardware possible
That means that not only are bitcoin miners constantly upgrading to the most efficient mining hardware available, they are also searching for the cheapest electricity they can find. Whoever has the combination of the most computational hashes relative to their electricity consumption costs will be able to mine profitably for the longest amount of time.
Bitcoin miners may choose to seek out cheap electricity first and then once they have found it, invest in the most efficient mining hardware they have access to.
OR…they may decide to do it the other way around.
They might decide to buy the most efficient mining hardware that they can possibly afford and mine with their local electricity as they seek out the cheaper electricity.
The most efficient bitcoin miners on the planet are always in the process of chasing both. They are constantly searching for cheaper electricity and more efficient mining hardware so they can widen the gap between their costs and their revenue which produces the largest profit. This never ending search for both cheaper electricity and more efficient hardware is the driving force behind what pushes Bitcoin to become more and more efficient over time.
The Cost Of Electricity
The cost of electricity is one of the most important elements of the game theory of bitcoin mining because it is the fuel that Bitcoin miner’s use to produce computational hashes and what determines a miner’s costs over time. Even if a miner has access to incredibly cheap or efficient mining hardware, the cost of electricity is what determines the cost of each hash that hardware produces. In order for any given miner to gain a competitive advantage, they need to find electricity that is as close to $0.00 so that they are able to run their mining hardware for a longer duration than any other miner in the world.
This is where the most exciting innovation in Bitcoin mining is taking place because the cheaper the electricity that bitcoin miners can find, the greater their profit margin and the longer they can sustain their mining operations. If a miner can find electricity that costs $0.00, they can theoretically mine forever regardless of how efficient their mining hardware is.
This substantial financial incentive drives miners to develop some incredibly innovative methods to find and utilize electricity that is otherwise stranded, unused, and wasted. This intense game theoretical incentive is also what will drive the cost of energy production down over the next century and effectively subsidize an energy renaissance.
Here are some of the energy sources that bitcoin miners are currently using to mine bitcoin for as close to $0.00 as possible.
– On-grid electricity where electricity is just cheaper and more abundant (Kazakstan, Iran, Iceland)
– Mining bitcoin with solar energy (Spain, Nevada)
– Mining bitcoin with wind energy (England, Denmark)
– Mining bitcoin with hydro energy (Washington, Norway, California, DRC)
– Mining bitcoin with geothermal energy (Iceland, El Salvador, Tonga)
– Mining bitcoin with flared gas from oil wells (Alberta, Texas, Wyoming)
– Mining with curtailed electricity from solar, wind, and hydroelectric power plants
– Mining bitcoin with methane from animal waste (Ireland)
– Mining bitcoin with used cooking oil (Guatemala)
Since many of these sources of energy are incredibly cheap, often unused, and even wasted, they have a market price that is as close to $0.00 per kilowatt hour as is currently possible. Bitcoin miners are energy scavengers who are all racing to find all of that stranded, unused, and wasted energy and put it to use mining bitcoin.
The miners that find the cheapest electricity on the planet will be able to mine for the longest period of time with their respective mining hardware.
Mining Hardware Efficiency
Another important part of understanding the game theory of bitcoin mining is mining hardware efficiency. This is the amount of electricity that is consumed to produce computational hashes used to mine bitcoin. Mining hardware efficiency is a critical factor when it comes to determining the profitability of a mining rig.
The greater the hash rate produced per kilowatt hour of electricity consumption, the more bitcoin it will earn and is considered to be more efficient. This means that if two mining rigs consume the same amount of electricity but one is more efficient, it will produce more hashes and earn a larger percentage of the block reward when a new block is mined. Bitcoin miners have a financial incentive to always seek out the most efficient mining hardware possible so they can continue to mine longer into the future than other miners and increase the odds of sustained profitability.
If a miner has access to cheap electricity but not the most efficient hardware, they may be able to compete effectively against more efficient mining hardware that is using more expensive electricity.
Bitcoin Mining Difficulty
Possibly the most important element of the game theory of bitcoin mining is the difficulty adjustment or “retargeting”. If the mining difficulty never adjusted, the supply of new bitcoin would be prematurely exhausted as more and more miners come online around the world. The difficulty adjustment is the primary mechanism that ensures that bitcoin blocks are mined approximately every 10 minutes no matter how much more hash power comes online.
What’s equally important is that when the least efficient miners are forced to shut down their operations because their overhead has become greater than their revenue, the total hashrate decreases and the mining difficulty decreases with it. Only miners that are able to mine efficiently are able to continue running their hardware.
Without the difficulty adjustment, it’s possible that bitcoin would not be able to function at all because blocks would be mined too quickly for all of the nodes to be able to update their own record of the blockchain and there would be too many conflicting copies which would cause chain splits, block reorgs, and compromise the overall trust in Bitcoin. By adjusting the difficulty of bitcoin mining, the production of new bitcoin blocks stays constant so that no single entity with access to lots of electricity can gain an unfair advantage.
The Price Of Bitcoin…Again
After a new block has been mined it’s possible that the winning miner needs to sell some of their bitcoin in order to recoup at least some of the costs to pay for the electricity that was expended to find that particular block. In order for miners to be able to mine profitable and stay online, they need to be able to sell their bitcoin for the highest rate possible.
If any miner is able to find a way to sell their bitcoin above market rate, then they might be able to gain an advantage over other miners. Since there is demand for newly mined bitcoin, it’s possible that some services will surface specifically to sell newly mined bitcoin for older bitcoin that is already in circulation for a premium. One open source tool that is working on this specific problem has named itself UTXO Dealership which aims to create a peer-to-peer marketplace for miners to sell newly mined bitcoin for old bitcoin for a premium. This could have huge implications for bitcoin miners looking to increase the profit margins by a few percent.
The bitcoin miners that are able to sell their bitcoin for the highest rate possible are able to increase the probability of mining at a profit for longer. Even if a miner is able to sell their bitcoin at 1% above the spot price, that might be all they need to be able to continue operating or even give them an edge over other miners.
Miner Fees
Miner fees are yet another important part of the game theory of bitcoin mining and they are an important part of understanding how to send bitcoin. Every time someone sends an on-chain transaction, the miner fee is like placing a bid to have their transaction added to the blockchain. The higher the fee rate, the sooner a miner will include that particular transaction in a block. If the fee rate is low, then the sender will have to wait until the mempool clears out and on-chain fees drop.
When the number of people sending on-chain transactions increases, the MemPool will bloat and fees will naturally rise as senders bid up the price of limited block space. Some miners may decide to quickly deploy less efficient miners during time of high demand to try to get some of the increased fee volume until the next difficulty adjustment. As fewer people send on-chain transactions, the mempool should clear out and the cost of sending transactions should decrease.
While there are multiple ways that Bitcoin is scaling, one of the ways that bitcoin payments are scaling is with the lightning network which relies on some different game theory to bid down the price of sending bitcoin.
Not only are miner fees incredibly important for miners as well as those sending bitcoin, they are one of the most important parts of how bitcoin operates because high fees means high demand for sending bitcoin which fuels innovation to find more efficient ways to send bitcoin.
The Diminishing Block Subsidy
Unlike all of the other moving targets mentioned above, the block subsidy is the slowest and most predictable moving target. While all of the other targets move and adjust based on a number of market dynamics that constantly shift up and down, the block subsidy only goes down and it does so on a predictable and fixed schedule of exactly 210,000 blocks in an event commonly called The Halving.
Even though the halving is predictable, it it still has an enormous impact on the game theory of bitcoin mining because it is what determines how many bitcoin miners are rewarded with for mining a new block. Without the halving, all of the bitcoin would have been mined in the first 8 years of Bitcoin’s existence. This is an incredibly important element of bitcoin because it ensures that there will be bitcoin to be mined for the next century. It is also an incredibly important part of ensuring that Bitcoin mining stays efficient as well as drives a lot of the hype cycle that pushes the price of bitcoin to new highs at least once every 210,000 blocks.
Jurisdictional Arbitrage
After everything mentioned above, bitcoin miners are left with some freshly mined bitcoin and an entire list of overhead expenses. Depending on which jurisdiction a bitcoin miner is operating in, there may be yet another cost that is not directly related to the game theory of bitcoin mining itself and that is taxes. This is where bitcoin mining gets political because if you have to pay various taxes on your mining earnings, you may be at a substantial disadvantage compared to miners operating in parts of the world where bitcoin mining operates on more of a free-market basis.
In order to maintain an advantage over other miners, it might make sense to set up a bitcoin mine in a part of the world where there is little to no regulation surrounding bitcoin mining. If you’re able to secure a location that is free from bitcoin mining regulation, it might serve as a substantial advantage over miners that are required to pay heavy taxes. This is yet another moving target because as political parties change, tax laws also tend to change with them. Finding a location that is a good fit for bitcoin mining is already competitive enough but finding a tax-friendly jurisdiction can also be an important factor in determining the best location to start a bitcoin mine.
Any miners that are able to avoid regulation or tax burden might be able to gain a substantial advantage over miners in regulated jurisdictions around the world.
Reducing Waste
Mining Bitcoin requires creativity, innovation, and dedication to gain any sort of an edge. Not only are entrepreneurs working constantly to maximize miner output but also working to reduce overhead in any way possible. Since mining produces heat and people often pay for heat, it only makes sense that miners attempt to find ways to put that heat to use.
Mining hardware is also incredibly expensive so miners are also looking for creative ways to sell off old hardware as efficiently as possible to invest in newer hardware or maybe just to boost their overall revenue.
Using Bitcoin Mining Heat
As the game theory of bitcoin mining heats up, so do the innovative methods that miners are coming up with to reduce operating costs. Since bitcoin miners generate heat as a byproduct, it only makes sense that bitcoin miners utilize surplus heat to do things like heat homes, water, and more. Any surplus bitcoin mining heat energy that gets put to work helps to offset the overall costs of bitcoin mining by reducing expenses elsewhere. Entrepreneurs, engineers, businesses, home miners, and even governments are all looking for ways to put surplus mining heat to good use to lower operating costs and even find ways to help the environment.
There are a multitude of applications for Bitcoin’s low-grade heat from simple space heaters all the way to fully integrated residential heating systems. Any bitcoin miners that can find a way to use wasted heat energy from mining hardware may be able to offset heating expenses somewhere else and drive down their overall expenses.
Selling “Old” Mining Hardware
Once a miner has come to the realization that there is simply no way for hardware to mine profitably any longer, it may make the most sense to sell the hardware for as much as possible and invest that revenue in more efficient mining hardware. What might be considered “obsolete” hardware for one miner might be a great learning opportunity for a new miner. There are a number of resale groups, websites, and communities who are all dedicate to selling old hardware as well as helping onboard new miners.
Some miners sell perfectly useable hardware just so they can purchase new hardware while others may decide to refurbish unusable hardware from multiple machines in order to make a single machine that works. Some miners even sell-off old hardware for parts for niche projects like making bitcoin art.
Winners & Losers
As is often the case with game theory, there are winners and losers.
In relation to the game theory of bitcoin mining, the winning miners are the ones who produce the most hashes relative to their costs and the losing miners are the ones who produce the least amount of hashes relative to their costs. In the event that any miner’s revenue falls below their operating costs, they will be mining at a loss and would be getting more bitcoin if they just bought bitcoin with the money they are spending on electricity to mine. For these inefficient miners, it makes the most sense for them to shut down and relocate to another part of the world with access to cheaper electricity. If that’s not an option for them, they can either choose to continue mining at a loss or face the inevitable reality that their costs are too high relative to their returns and they need to sell their mining hardware for whatever price they can get for it.
If these losing miners were only mining to get more fiat, then it makes the most sense for them to shut down until the difficulty adjusts downward and they can mine efficiently again (not likely as long as the hashrate keeps climbing). If the losers are mining because they actually want more bitcoin, then it makes the most sense for them to find ways to cut costs or divert the money they’re spending on electricity toward buying bitcoin.
For the miners that decide to shut down and divert their resources to buy bitcoin rather than mining at a loss, they will not only get more bitcoin but they are also part of what helps to push the bitcoin price to new highs once every halving cycle. With the supply of new bitcoin now cut in half, all of the resources that were previously dedicated to mining bitcoin from these inefficient miners is now being dedicated to buying bitcoin which puts upward pressure on the price of bitcoin and supports remaining miners as well as every bitcoin hodler in the world.
Final Thoughts
If you hadn’t already spent a good bit of time thinking about the game theory of bitcoin mining, hopefully this article has helped to shed some light on the subject. It’s not as simple as one miner vs another miner or even you vs yourself. Gaining any sort of an advantage and hitting any of these moving targets more efficiently may prove to be crucial in determining the profitability and sustainability of a bitcoin miner.
The highly competitive nature of mining bitcoin shows just how important it is to constantly innovate to find any sort of advantage. Getting the cheapest electricity possible, the most efficient mining hardware, the constantly changing difficulty of the hashrate, and the fluctuating price of bitcoin are all layers that bitcoin miners are constantly looking for any sort of an advantage.
Furthermore, there’s a strong incentive to utilize surplus heat from bitcoin miners to offset the costs of heating something else as well as a political incentive to move bitcoin miners to parts of the world where bitcoin mining revenue is not taxed so as to gain any sort of an advantage over the competition.
With bitcoin mining being one of the most competitive industries in the world, understanding the game theory of bitcoin mining can help miners to make the most educated decisions to reduce overhead and maintain profitability as long into the future as possible. More importantly, it pushes Bitcoin to become increasingly efficient over time as miners constantly innovate, reduce waste, maximize hash power, and gravitate to parts of the world where they are needed most.
At the end of the day, the miners who produce the least amount of hashpower relative to their electricity consumption costs will eventually go out of business as new miners enter the market, the hashrate increases, electricity costs fluctuate, the difficulty adjusts upward, and the block subsidy is cut in half every 210,000 blocks.
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