Tag Archives: Transaction Cost

The Transaction Cost of Bitcoin

Bitcoin and other cryptocurrencies have create a new monetary system that relies privacy and pseudonymity to conduct economic transactions, rather than governmental laws and regulations. This monetary structure has several distinct advantages over fiat money that makes cryptocurrencies fundamentally superior to all fiat money.

The current economic paradigm using fiat money creates a system in which transaction costs shall always be higher than those found within the bitcoin ecosystem. This is due to the costs that are associated with the creation, maintenance, and enforcement of laws within the fiat currency system that allows it to function. The privacy and anonymity functions of bitcoin allows for it to function as a money system, while not needing to pay for the legal structure, or enforcement cost of normal money systems.

What Creates Transaction Cost?

According to Ron Coase, who originally theorize about transaction costs in his work the Theory of the Firm, there are three types of transaction cost:

1) Search and information cost

2) Bargaining and decision cost

3) Policing and enforcement cost

These are features that all transactions have and are built into the cost of the transaction. For example you want to buy a loaf of bread, first you need to know where to buy bread (search and information cost). Then you need to decided what a reasonable cost is, and to see if you can get bread at that cost (bargaining and decision cost). And finally you need something to pay for that loaf of bread (policing and enforcement).

Now all three of the above features are ‘cost’ that are associated with any kind of exchange; legal or illegal. The largest key difference with illegal transactions is that third type of transaction cost (policing and enforcement) is replaced with evasion and extralegal cost.

Evasion cost substitutes the policing and enforcement cost. So if one wanted to avoid paying $25,000 in taxes, they could pay a lawyer $10,000 to save $25,000 in taxes. So part of the $25,000 is going towards paying the policing and enforcement cost, where as $10,000 is the alternative evasion cost that one can pay to assure they get away with their full $25,000. So if one pays the evasion cost of $10,000, they will save $15,000 in total.

This $15,000 is a special type of profit because it is derived directly from NOT paying the full transaction cost. This is called risk profit and is only experienced when one takes on evasion cost, or the cost of doing illegal business.

All transactions consists of the three above associated cost. What crypto-currencies offer is a fundamentally different paradigm for how to deal with legal and enforcement cost. Instead of needing violence to enforce the rules of the money system (like fiat money), bitcoin embeds ‘the legal system’ directly in cryptography, merging law and mathematics. This allows for an economy to be built directly on top of the non-aggression principal. Cryptocurrencies have no policing and enforcement cost whatsoever, which shall always create a lower transaction cost.

The Law and what it offers

Today, the law is what offers us financial protection within our current economic system. This is why you can challenge or dispute transactions that you do not recognize on your credit card or debit card. This is also why the Department of Homeland Security can seize your banking accounts and all of your money without notice. Both of these situations arise because of the laws that govern the current economic system. Though laws offer a distinct way of protecting actors within their economic system, and are sometimes of great necessity, it can also be at great expense to the general populous, and to the determent of the economy on a whole. Police stole more goods than all burglaries combine in 2014–if you haven’t already, it might be time to rethink the majesty of the law, and what it means to be governed.

Detriments of the Law

Utilizing laws as a bases to create an economy system has two distinct detriments: The cost that is needed to create and enforce laws, and biases of those involved in the legal system.

When we look at the cost of legal economic enforcement, we must look at all aspects of the law and the expenses associated with them. Breaking down these cost is almost impossible when we look at the breadth of lawsuits, permitting procedures, various licensing, taxation, and various government entities that are funded through taxation. These cost are rolled into all economic transactions that one does within a fiat economy, as the burden of police and enforcement cost are forced on to the consumer, producer, and the sum total of society. Thus, through simply having laws that must be enforced, the transaction cost associated with that money will increase.

Legal bias

Another hidden expense that comes from a economic legal system is the inherent bias that those involved within the legal and political system are going to have towards themselves. Or in another word, corruption.

Those who are closes to the centers of power are the ones that will benefit the most from the law, or the corruption of the laws. This is why the most profitable investment that can be made is lobbying. This is also why no criminal charges have been brought to those responsible for the 2008 financial crisis, no charges for the NSA spying scandal, and why the average congressperson is a millionaire. This is because of the corruption of the legal framework that they operate within and control, and the way that they allow for the corruption of the legal system to favor themselves and their cronies.

The corruption of our legal system is not an error, but occurs by design. Those who are closest to the centers of power are also the ones with the most agency within this system. They have varying degrees of control within the legal system that correlates with how close to the center of power they are. Thus, the closer to the center of power, the higher degree of agency they have within this legal system, which creates the conditions for manipulation and corruption of the legal system. This creates a two-tiered legal system in which those who are closer to the center of power shall have more economic opportunity than those more removed from it.

Over the last century, the corruption of the legal, economic, and political system has resulted in the economic state we are in today: a broken political system that is beholden to the interest of bankers, oligarchs, capitalist, and members of the legal system before all others. This not only is unethical and morally reprehensible, it is also very, very expensive.

Free Markets and Their Functions

People enter into economic agreements because they are just that: agreements. These are natural transactions that occur because of our own subjective interests for ourselves.  This is why we enter into social contracts in the first place; because we freely and naturally agree with the stipulations of the contract and proactively make the choice to be part of the contract. A transaction like this does not need anyone to enforce anything–both parties are willingly entering into a transaction because they both are getting something they desire from the transaction. Both actors have utilized free-choice to choose to enter into this agreement. This is the natural state of economic affairs, and there is no actual need for policing and enforcement cost in transactions that are entered into within free agreements. Thus, for voluntary agreements, there is not need to pay for policing and enforcement cost, which in turns creates a lower total transaction cost within a monetary system.

With bitcoin, people are making exchanges via the internet where there is no need for a legal enforcer to ensure that transactions are conducted fairly–that is what the bitcoin software does. Because of this feature–where bitcoin can allow for private individuals to preform economic transactions without needing a centralized enforcer–means that bitcoin does not have to pay policing and enforcement cost. This means that if we are to look at the economic cost of transactions within a monetary system, fiat currencies will always have a higher total transaction cost because of the need to pay for a policing and enforcement cost.

Conclusion

When observing any contemporary economy system we can see that there are three types of transaction cost: search and information cost, bargaining and decision cost, policing and enforcement cost. Because bitcoin uses software to create a secure form of money, there is no policing and enforcement cost that are associated with bitcoin. This means that when we look at the total transaction cost across an economy, an economy using bitcoin (or another digital currency) will always have a lower transaction cost than a fiat economy that must pay for policing and enforcement cost.

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Next: Bitcoin and Liquidity Preference

The Intrinsic Value of Bitcoin

gold_mining_rocker_boxThere are several features that create the intrinsic value of bitcoin, but the primary one is its production cost. Bitcoin is a commodity money like gold, sliver, or copper which means that the energy cost to extract these raw materials creates their base value. The actual exchange between two people is totally subjective, as the subjective theory of value shows us, but we can assume that practically no one would sell their commodities for a price below what it cost them to extract the commodity. Today, the cost of mining bitcoin is getting to be quite difficult, which is part of the reason for the increase in price we have seen.

The Base Value of Bitcoin

Let us take a moment to think about how mining for bitcoin is similar to mining for gold. If you go into your backyard and try to see how much gold you are going to find, you’ll probably come away empty handed. That’s because you are using a pick and shovel, and it is no longer the 1850s–someone else got that gold (if it was there) long ago.

That just like how bitcoin mining is today–well more like 95 years ago when gold was about $20 to the ounce. Check and see how many bitcoins you could make with this mining calculator. Most likely it’s not a lot. This is because just like with gold mining, someone developed a better way to mine for bitcoins, making mining with a normal computer unprofitable today. This is because the newest bitcoin miners use energy more efficiently to mine bitcoin.

Keep in mind that the commodity value is just the base amount–that is just the production cost. Bitcoin, like gold, is a special commodity–it’s a commodity AND money at the same time. These special commodities are appropriately called commodity money. Commodity monies are special in that they have an inherent value by being a commodity, but because of their traits, they make great money too.

It is this secondary value of being good form of money that creates the secondary social value of bitcoin and other commodity monies. It is both the production cost of bitcoin, along with the properties of good money that it exudes which creates the total value of bitcoin.

Commodity money creates a secondary value as a mode of exchange through the base production value. It is because of this trait of being made from a real commodity that commodity-monies can ‘bootstrap’ their way into becoming a mode of exchange. Once this happens it allows for market mechanisms to decide on the price of the commodity money beyond its production value. This is how commodity monies become more than just commodities, and become modes of exchanges and in some cases a storage of wealth. This is why gold became the most sought after commodity during the mercantilism era: it met the four qualities of good money better than any other object in the world, and was by far the best storage of wealth. This was not because it was shinny, but because it was incredibly rare. This is also why gold and silver have 3,000 years of history as being used as money and a storage of wealth–due to the intrinsic qualities they hold because of their scarcity.

The Value of Fiat Money

Where Fiat money eventually ends up: An arm full of Zimbabwe money that is worth nothing.

So than why is fiat money valued at all? Fiat currencies are not independent, nor is there any value contained in the money itself–it’s just paper. So how do these worthless pieces of paper have value?

Through the governments guarantee that it will accept fiat currency as legal tender, and that all transactions within its economy will meet this basic minimum standard of the law. This is what allows the government to bring violence to anyone who challenges the legitimacy of government’s monopoly on money. The power of fiat money is derived from the government’s legitimacy–that is why they can just make new money up out of thin air.

Statists argue that seigniorage from the state is not only needed, but is desired. For the State is the law, and the law is a means to an end in itself–that is why the state has the legitimacy of violence to decide if a person deserves to live or die. It is through this power of that the State can redistribute, protect, or harm their own citizens–for the benefit of all, or for a few. It is from this base of power that states create the laws to conduct economic transactions within their sphere of influence. This is why fiat money is only valid within particular nation-states own sphere of influence, and not that of other nation-states.

Philosophy of Value

The intrinsic value of bitcoin far beyond its commodity value. What creates its real value is the mathematical assurance that the bitcoin ecosystem cannot be predicated upon force, unlike fiat money. This is because of the cryptography that bitcoin is built on top of allow for two very distinct things:

For this to work, a robber would need to know all of the wallets that you have, and the amounts you have in them.

1. It assures that the vast majority of transactions within the bitcoin economy are based upon voluntary participation, which in turn ensures:

2. Almost all transactions must be non-violent, unlike state-based currencies, where the legitimacy of the currency comes from the state’s ability to bring violence to you for not complying with their laws or legal structure.

These qualities result from the privacy function of Bitcoin. Privacy, within the context of an economy is what allows for a fair, voluntary economic system to be created. Bitcoin exchanges ‘the protection’ of the law, for the mathematical assurance of cryptography.

Bitcoin has made a new economy in which the categorical imperative is not the law; but privacy. We prefer to have no laws, because privacy allows for us to build the voluntarily social contracts without the threat of violence from the state, or anyone else because our true identities are unknown. We understand voluntary transactions ultimately lead to a lower transaction cost for both parties because policing and enforcement does not have to be paid for.

Conclusion

In another age, fiat currencies and national governments were tools that we needed to evolve technologically. This economic mode was an excellent model for the growth and development of an advanced industrialized society, and all that came with it. Today however, both national governments and fiat currencies are anachronism that keeps greater humanity from advancing itself to its next stage of societal evolution: Anarchism.

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Next: Understanding The Economic Functions of Bitcoin