The Economics of Bitcoin

The wide ride for the price of Bitcoin over the last few months has been very fun to watch.  Over the last six months, the digital currency has experienced a parabolic run from the $17 to $263 and a subsequent crash back to $50.  As you can see, the price has recovered somewhat in the last week and is now trading around $120.

Bitcoin is an all-digital currency which is widely used for anonymous transactions over the internet.  As such it is a common means for payment for all-digital goods in video games and also for illegal drugs also traded over the internet. Prior to March 16, 2013 that was basically all it was used for.  Then the world changed for Bitcoin (and nearly all bitcoin holders).

It is certainly possible that it is a coincidence, or a planned maneuver by some shrewd market manipulators in Bitcoin.  But the simple story is this:  On March 16, the ECB announced a bail-out plan for the Cyprus banking system that involved a 40% haircut of all deposits over 100,000 EUR (roughly $130,000) in order to fund the bail-out.  Obviously, this set off a panic in the Crypiot community.  The bank run was mitigated by a week long bank holiday, followed by restrictions on daily withdrawals in Cyprus.  This also seemed to set off a interest in holding money outside of the Euro and outside of a bank.

Enter, the massive appreciation of value of Bitcoin (BTC).

Now, I don't want to voice a prediction on whether or not BTC is a good store of value or not.  But what I think is particularly interesting here is that its very easy to apply the most common economic model to our situation.  The basic supply and demand curve:

A standard market for a good has a sloped demand curve and supply curve.  As you remember, as a product gets less expensive, more customers will want it and fewer suppliers will be willing to sell it at that price.  Conversely, as a price gets more expensive, fewer customers will want to buy it and there will be ample suppliers willing to sell it at the higher prices.  In a normal market, especially a capital market which is especially liquid, the supply and demand curves will respond to price actions and work to moderate the drastic movement of prices.

Bitcoin is a very interesting case though.  Because the supply of Bitcoin is fundamentally governed by a digital algorithm, the supply in the long run is entirely inelastic. The inelastic nature of the market is visualized in the near vertical supply curve above.  In some ways, the supply is fairly inelastic in the short run as well, because only a small number of Bitcoin are produced a day -- and the algorithm is designed to make it harder and harder (read more computing hours) to produce a bitcoin as there are more Bitcoin in existence. So, holders of existing Bitcoin are the only suppliers that provide any tilt to the supply curve at all.

So, as a small segment of the European banking system sets into a crisis, the demand for Bitcoin as an alternative haven pushes the demand curve upward (from Demand 1 to Demand 2).  Because the supply curve can't react, the price moves dramatically.  This doesn't predict that prices will go up sharply, as much as it just predicts that price movements are almost entirely driven my demand changes at this early stage in Bitcoin's liquidity maturity.

Certainly, all capital markets function in a somewhat restricted supply in the short run.  There won't be more Amazon.com stock tomorrow, just because the price goes up today.  And certainly there is only a fixed and predictable amount of oil or copper coming out of the ground any given day.  However in the long run most things do face some curve, where if the price goes up enough Amazon will certainly issue more stock or more people will get into the business of digging for oil and copper.  So in the short run, it's about incumbent holders of a commodity selling into the market.

Its in this newness of Bitcoin going from fringe payment mechanism to semi-legitimate capital market where the supply curve hasn't really figured out how to respond, and is shocked into an inelastic state.  I would expect that it will take about 6 months for the turnover in bitcoin to get into the hand of enough traders for the short-run supply curve to long like a fairly normal market.  However, until then... and then some point soon after Bitcoin will again feature the near vertical supply curve that drove the radical price movements of the last month.