• Market Cap: $244b

  • May 22, 2019

Chapter 1.4

What Determines The Value of Bitcoin?

Bitcoins, as well as all cryptocurrencies at large, are ‘digital money’ at the end of the day.

What Determines The Value of Bitcoin?

Bitcoins, as well as all cryptocurrencies at large, are ‘digital money’ at the end of the day. While they don’t function in the same manner as fiat currency, they are still tied to some rules of economics. Demand and Supply, which are the two governing forces that regulate the prices of many day to day commodities, also have a major impact on the price of Bitcoins.

The concepts of economics that apply to fiat currency don’t necessarily apply to Bitcoins. However, there are some concepts which overlap. The best way to understand how the price of Bitcoins is determined by comparing it to a real world commodity is by comparing it with Gold.

While Bitcoins are an alternative to fiat currency, they are best comparable with Gold. This is because Bitcoins too, like Gold are exhaustive. Eventually there will be a day when all the gold under the surface of the earth will be mined and exhausted. Similarly, Bitcoins too, are finite in number and one day Bitcoins too, will be exhausted. While one cannot accurately predict how much gold is yet to be mined, we know for sure that there are 21 Million Bitcoins in all, out of which 16 Million have been mined.

The Economics Behind Bitcoin Price

Let us take a quick look at the real-world economic concepts that apply to the world of Bitcoins:

  • Utility: One of the biggest reasons why Bitcoin has any price in the first place is that it has a utility. With time many merchants have begun to accept Bitcoins and this number is all set to grow as the awareness of Bitcoins surges.

  • Scarcity: As stated above, the scarcity of Bitcoins (similar to gold) is what gives it such a high value. However, it’s not just it’s scarcity, but it is scarcity combined with utility. Not only are Bitcoins limited in number, but they are also useful.

Moreover, similar to Gold, 1 Bitcoin is similar to the other. Both of them carry the same value. 1 gram of gold that you own carries the exact same value as the 1 gram of gold that I own - same goes with Bitcoins.

The similarities with Gold don’t just end there. Bitcoin, like gold, is divisible in nature. If you have one gram of gold and you want to liquidate some portion of it, you can have 100mg of it sold while the rest can still be with you. Similarly with Bitcoins, divisibility is quite easy. A bitcoin can be broken down to 0.00000001 BTC. This is the smallest divisible unit of a Bitcoin. 0.00000001 BTC = 1 Satoshi. It has been named after the creator of Bitcoins, Satoshi Nakamoto.

Getting back to utility, Bitcoins currently have the highest utility compared to other cryptocurrencies which emerged after it came around. There are many cryptocurrencies which have been created for a single purpose. However, Bitcoin is a multipurpose currency which, while still far away from mainstream acceptance, is still the most usable cryptocurrency. It is unlikely that any other cryptocurrency will compete at the level Bitcoin functions, at least in the short run.

Utility increases with acceptance. As more and more users start making use of Bitcoins, the utility will increase as a number of merchants will begin accepting it.

How Demand and Supply Affect The Price of Bitcoins

The biggest influencers on the price of any commodity are Demand and Supply. This is a universally applicable law, which is applicable beyond just the monetary system. This is something which applies in various walks of life. The law of demand governs the economy of Bitcoins.

Let us take a simple look at it:

  • In today’s world, people see Bitcoins as a great investment opportunity

  • More and more people are investing into Bitcoins, thereby ‘backing’ it with their investment.

  • As more and more people keep buying Bitcoins, the value keeps surging.

Here’s where the law of demand comes into play though.

The law of demand states that when the price of a commodity increases, the demand for it falls. Basically, this means that people would rather not buy Bitcoins when it is on a surge and wait for a dip in the graph.

This ‘dip in the graph’ comes when people start selling Bitcoins. This can be for a number of reasons. The price of Bitcoins is also affected by market sentiments. Market sentiments tend to fluctuate based on many external factors. Reports of Bitcoin Exchanges being banned in China saw a major panic in the markets and the price fell from $4500 to $2900 in a very short span.

However, once the markets gained confidence, the prices started to surge and it went from $2900 to $7000 - resulting in the biggest economic recovery in its history. This surge in the prices was aided by the upcoming Fork which is all set to give rise to Bitcoin Gold.

Market sentiments, combined with the laws of economics are what govern the markets and the price of Bitcoins.

Similar to this, there are other events - when BTC-E, a popular exchange was shut down, a major fluctuation in the price of Bitcoins was noticed. Similarly, when the Silk Route, a website where drug trade was being financed by cryptocurrencies was shut down, the value of Bitcoins again fell.

Government policies too affect the price. If the US government were to some day outlaw Bitcoins, it would see a large number of people selling their coins and liquidating them in rapid succession - crashing the entire Bitcoin economy.

Conclusion: Is Bitcoin A Bubble?

Anything with such a rapid rise in price is always looked upon with a deep sense of speculations. Ever since the first rise in the price of Bitcoins, it has been termed a ‘bubble’ by many economists and market experts. Even the likes of Warren Buffett had advised investors to stay away from Bitcoins back in 2014.

Bitcoin does show one major characteristic of being a ‘bubble’. People who don’t even know what Bitcoins are, how they function, and how the Bitcoin economy works have begun to invest into it as they are attracted by the massive profits. This carries an eerie similarity to the dot com bubble where many people who weren’t even aware of what they are investing in were throwing in their money, eyeing the major profits.

The best answer to this question comes from Bitcoin.org itself:

A fast rise in price does not constitute a bubble. An artificial over-valuation that will lead to a sudden downward correction constitutes a bubble. Choices based on individual human action by hundreds of thousands of market participants is the cause for bitcoin's price to fluctuate as the market seeks price discovery. Reasons for changes in sentiment may include a loss of confidence in Bitcoin, a large difference between value and price not based on the fundamentals of the Bitcoin economy, increased press coverage stimulating speculative demand, fear of uncertainty, and old-fashioned irrational exuberance and greed.

Questions will always be asked and fingers will always be pointed at Bitcoins every time the price falls or rises. However, for now, it is indeed a good opportunity to invest. It is however, critical to know what you are investing into and we hope this guide on Cryptocurrencies helps you know it better!

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