How is the Price of Bitcoin Determined?
Modeling price of Bitcoin with supply and demand
Laszlo Hanyecz, a Florida-based programmer & crypto-enthusiast made what is considered to be the first purchase using Bitcoin (BTC). On May 22, 2010, he bought two pizzas for 10,000 BTC (valued at around 30 USD at that time); making this week a celebration of Bitcoin Pizza Day’s ten-year anniversary. At the price of Bitcoin today, those two pizzas cost him 92,056,200 USD.
Despite the fact that Laszlo bought what are now the most expensive pizzas ever sold — he doesn’t regret it.
“I’d like to think that what I did helped. But I think if it wasn’t me, somebody else would have come along. And maybe it wouldn’t have been pizza,” Hanyecz explained in May 2018.
In fact, earlier in February 2018, he bought two pizzas using Bitcoin again. This time he only paid 0.00649 BTC (valued at around 68 USD at that time). In 10 years, 10,000 BTC went from being worth 30 USD to over 92 million USD. This naturally begs the question: How is the price of Bitcoin determined?
The answer lies in the understanding of how the price of that pizza was determined in the first place.
Let us consider that you are a pizza seller. You decide to set an initial price to 60 USD per pizza. You go to the market and set up a stall. But no one wants to buy your pizza; certainly, they don’t want to buy it for 60 USD because they value 60USD more than the pizza, or others are offering pizza at a lower price. As a result, there is no transaction. Naturally, you realize you have to drop the price to sell it. Now when you try to sell it for 30 USD, people are willing to buy because they value the pizza more than 30 USD. Thus, you have a transaction.
This is called the law of demand. When the price goes up, people buy less; when the price goes down, people buy more. This can be shown by the demand curve.
On the other hand, if the price of pizza goes up, you have the incentive to produce more pizza. But if the price goes down, you don’t want to produce more pizzas. This is called the law of supply and shown by the supply curve.
Surplus and Shortage
If you think about the dynamics of the market, the price will fluctuate in order to bring supply into line with demand. If the supply is higher than demand, then there are pizzas going unsold. This mismatch is called surplus. Eventually, you would be willing to lower your price to sell those pizzas. And when the price comes down, that will cause the demand to actually go up.
Similarly, if demand is higher than supply, that means that there are people who want to get your pizza but can’t get them because there aren’t enough pizzas around. Again, there is a mismatch — this time called shortage. People will have to bid more, because of competition for that limited supply of your pizzas. So, if the demand is higher than the supply, the result is that price will go up. And when the price goes up, demand will come back down.
In this way, market price fluctuates pulling supply and demand to converge to a point, an equilibrium point where supply meets demand. The price at this point is called the equilibrium price and this is exactly how the price of anything is determined — both Pizzas and Bitcoins.
Supply and Demand in Bitcoin
The supply of bitcoins is the supply of Bitcoins that are in circulation. Currently, of course, there’s a fixed number of Bitcoins in circulation. At the time of this writing, it’s about 18.5 million. And the rules of Bitcoin, as they currently stand, say that this number will slowly go up and hit a limit of 21 million eventually.
Let’s now look at demand. There are really two main sources of demand for bitcoins:
1. Demand for mediating fiat-currency transactions
2. Demand for investment
First, let’s look at mediating fiat-currency transactions. Imagine that Alice wants to buy something from Bob or wants to pay some money to Bob. And Alice and Bob want to transfer a certain number of dollars. But they find it convenient to use Bitcoin to do this transfer. Perhaps they’re at a distance, Alice wants to be able to email the money to Bob. Perhaps they like the fact that they can have very low (or no) transaction fees in Bitcoin; certainly, lower than some other service.
So, Alice buys Bitcoins for dollars. Alice then sends those Bitcoins to Bob as a Bitcoin transaction. Once that transaction is confirmed to Bob’s satisfaction, Bob will sell those Bitcoins for dollars and get the dollars back. So, Alice starts by putting in dollars, Bob ends by getting out dollars.
But the key thing to understand is that while mediating this transaction some Bitcoins have to be taken out of circulation and they’re devoted to serving this transaction. This creates a demand for those Bitcoins. If there are a lot of people who want to mediate transactions like this, that will generate demand for bitcoins. So, that’s the first source of demand.
The second source of demand is that bitcoin is sometimes demanded as an investment. That is somebody wants to buy bitcoins and hold them in the hope that the price of bitcoins will go up in the future and that they’ll be able to sell them. So, to the extent that people are buying and holding those bitcoins, those bitcoins are out of circulation.
Model To Predict the Price of Bitcoin
Now we can try building a simple model to predict the price of Bitcoin based on the effect of transaction mediation demand. Let us assume:
- T is the total transaction value that’s going to be mediated via Bitcoins by everyone who’s participating in the market. And that’s going to be measured in dollars per second.
- D is the duration of time that Bitcoins need to be held out of circulations in order to mediate a transaction. That’s the time from when the payer buys the bitcoins to when the receiver is able to sell them back into the market, and we’ll measure that in seconds.
- S is the supply of Bitcoins that are available for this purchase.
- P is the price of Bitcoin per dollar measured in BTC/USD. Therefore, 1 USD = ( 1 / P ) BTC.
As of this writing P = 0.00011, i.e. 1 BTC= 9,198.83 USD.
Calculation
Now we can do some calculations to determine the equilibrium price by equating demand and supply.
- Bitcoins needed to mediate transaction per second = Bitcoins available to mediate transactions per second
- Total transaction Value (T) / Price (P) = Supply (S) / Duration needed for transaction (D)
- Therefore, Price (P) = (T * D ) / S
Now if you think about it, D the duration does not change. Similarly, the total supply will max out at 21 million BTC, making it constant. Therefore, the price is going to be proportional to the demand for transaction mediation as measured in dollars. So, if demand for transaction mediation in dollars doubles, then the price of Bitcoins should double. In fact, we could graph the price of Bitcoin against some estimate of the demand for transaction mediation and see if they match up. And when we do this, they tend to match up pretty well.
This is not a full model of the market by any means. In order to have a full model, we need to consider the activities of investors. We need to bear in mind that investors will demand bitcoins when they believe that the price will be higher in the future. So, we need to think about investors’ expectations, and investors’ expectations, of course, have something to do with what is the expected total transaction value demand in the future.
Ultimately, what determines the value of pizza is exactly what determines the price of Bitcoin; whether people demand it. Predicting the future price of Bitcoin is impossible. But we can sure ponder upon if the Bitcoin price would continue to rise steeply enough for users to remain willing to pay ever-higher transaction fees? Or will there eventually be a “death spiral” triggered by falling prices as users leave the system in mass, followed by miners giving up as collapsing transaction volumes force fees down to zero?
