Miner Business Model

Miners play a zero sum game within a positive sum economy.

As the utility of Bitcoin to people increases, both the fee level and exchange price necessarily increase. These increases both contribute to reward utility. However coin utility is not unbounded, it is decreased by rising fees and always limited by substitutes. Exchange rates are a measure of utility, including the capitalization of expectations.

Initially rising utility creates a higher rate of return on capital investment in hash rate. This creates an opportunity cost for not capturing the outsized return. This in turn causes an increase in capital investment and therefore hash rate from existing and/or new miners. The increase is eventually captured in a difficulty adjustment, returning average rate of return to market levels.

It has been argued that blocks mined in a period of rising price actually produce outsized returns for miners, at least until the adjustment. This is based on the classic failure to understand that market prices are not predictable. Investments dependent on price changes are always speculative. There is no reason to assume that Bitcoin speculation is any more or less effective than any other.

Bitcoin mining investment on the other hand is based on the predictable relationship between price, hash rate, difficulty, and competition over time. That relationship predicts that the average of all mining approaches the market rate of interest over time. As with all markets, shorter time periods are unpredictable in price and longer periods approach market returns. Ultimately time preference controls the market rate of investment return.

So how does a miner achieve outsized returns? It cannot be done with side fee agreements. There is only one way to make a higher-than-market rate of return, which is to have a below average cost of hash power for the coin. This is achieved by either taking advantage of pooling pressures or through superior operational efficiency. Because of the zero sum property, these are offset by lower-than-market rates of return by other miners.

However other miners will eventually exit as their capital seeks market returns. This would leave one miner bound to market returns. In other words, making outsized returns requires others from whom to capture those returns. The highest return that can be sustained is a function of the greatest opportunity cost others are willing to sustain. This is a function of differential reward utility, as discussed in Threat Level Paradox.

By limiting dividends to market rates of return and reinvesting all other reward, a miner can maintain a constant hash power and thereby obtain market returns against a capital base proportional to Bitcoin capitalization. Reinvesting dividends increases hash power and liquidation decreases it. Grinds are liquidated by reduction of reinvestment, taking each device offline as it becomes a net negative producer, or discounting those future returns by selling the mine.

There are no outsized returns in mining generally. Disproportionate returns do result from pooling pressures and relative operational efficiency, though the premium is limited for a miner above 50% hash rate and nonexistent at 100%. Merchants however are not financially affected by miner returns, disproportionate or otherwise. Merchants pay the average fee which is strictly a consequence of time preference.