Bitcoin Series 29: Why Do We Mine Bitcoins?

Credit:   Wikipedia

Credit: Wikipedia

A lot of people seem to think that the purpose of mining is to create Bitcoins (as if there was something special about creating Bitcoins that requires lots of computation, electricity and datacenter).   This is not correct.  The purpose of mining is to provide transaction security for the Bitcoin network by creating a competitive environment for recording transactions so that no one bookkeeper controls the ledger.  The Bitcoin rewards for mining a block are an incentive to provide that transaction security and that is it.

So, with this in mind, we are in a position to figure out what it means when miners "overinvest" and lose money mining.  

The first order effects are simple:

  • If miners overinvest and it costs them more to mine a block than they can earn from selling the Bitcoins earned all it means is that a user of the Bitcoin network gets extra security (extra protection from a 51% attack) for free.
  • And the miner who made the CapEx investment in mining equipment based on an incorrect assessment of 'how many other miners will be in the market simultaneously" and "what the price of a Bitcoin will be" will have a poor return on the capital invested.

It might be useful to reason by analogy.  

  • Let's say the strategic planning committees of all the world's steel producers see a bull market for steel and build out a lot of steel capacity (that would be profitable in isolation, but, in aggregate creates too much steel).  
  • The price of steels falls and certain steel manufacturers lose money.
  • This is bad for the steel producers but fantastic for steel customers.  When General Motors can buy cheaper steel procurement doesn't think "oh no, 'steel is dead' but hurrah I can get more steel for my money".    

The analogy in Bitcoin is that the Bitcoin user gets more transaction security than would logically be needed given the market capitalization of Bitcoin.   It is a boon to consumers of Bitcoin (network users) and a tough market for Bitcoin producers (miners).   That's all.

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Posted on January 17, 2015 .