Inside the Black Box of Bitcoin Mining: A Theoretical Framework and Simulation Evidence

Abstract

The incentive compatibility of Bitcoin mining is vital for maintaining the network trustworthy and immutable - its empirical composition, however, remains widely opaque. This paper proposes a conceptual framework that leverages innovation-driven convergence to reconstruct market conditions and to study miners' behavior. The theoretical implications are corroborated with empirical evidence using numerical simulation and a set of 10,000 random samples. The results quantify large variation in miners' profits and costs but demonstrate that the observed behavior is consistent with the proposed theory. Lower bound estimates indicate that the fixed costs required for a majority of computing power and thus the ability to successfully attack the network can be astoundingly small (e.g., $2.55 million in May 2020) when adverse events coincide. This pronounces the relevance of cyclical patterns when assessing the stability of proof-of-work consensus.