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Question: How is the price of Bitcoin determined?
is it too expensive? - 0 (0%)
What is the value in use of Bitcoin? - 0 (0%)
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Author Topic: Valuation of Bitcoin  (Read 16 times)
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January 13, 2018, 08:23:08 AM

1. Introduction
Bitcoin is an electronic cash, potable, forgery-proof, and not issued by any national government. Its supply is limited by the architect and forgery-proof is guaranteed by block-chain technology. Its scarcity enables itself to function as an international currency, a medium of exchange. Compared to traditional currencies, it is far more convenient to carry, store, and wire-transfer.
It has also limitations in use. Currently, its transaction networks, nationally and internationally, are not well organized. In addition, most of the public including policy makers do not grasp the economic role of Bitcoin. As its price skyrockets, national governments began to regulate its transactions, even shut down Bitcoin trading centers. Without understanding the nature of Bitcoin, people’s fear of Bitcoin trading is rapidly mushrooming. One side tells that current Bitcoin price is just a bubble and soon it will go burst. So they say that Bitcoin trading should be strictly regulated or completely prohibited. But the other side tells that Bitcoin is a new electronic medium that can increase efficiency in all kinds of commercial trading.
I, as an economist, tries to elucidate price determination of Bitcoin and hope this work becomes a useful reference in reducing our fear of electronic currency.

2. How is the price of Bitcoin determined?
Bitcoin is just a scarce electronic resource whose supply B is strictly limited. In a market its price is determined where supply S(p) and demand D(p) meets. Since supply is limited, market price of Bitcoin is determined by demand as shown in the equations below. Why is Bitcoin price so high in Korea? Simply because demand there is so high for some reasons.
D(p* )=S(p* ), D(p* )=B
Bitcoin price is however also a price of a new electronic currency, which can function as an international currency. This implies that p* is also an exchange rate in international currency market. If Won/Bitcoin = 20,000,000 and $/Bitcoin = 14,000, then Bitcoin based exchange rate Won/$ = 1,428. Dollar (Won/$) exchange rate is roughly 1,070 in the Won-Dollar exchange market. There exists a wide gap between the two.
The gap between the two exchange rates implies that Bitcoin market is not well integrated with traditional financial market, which means that the gap will become narrower as Bitcoin market becomes more closely tied with traditional financial market. If Bitcoin market behaves irrationally, it is simply an evidence that it is isolated from the markets in general. As Bitcoin becomes a medium to buy goods, services, and international currencies, the relative price of Bitcoin will naturally converge to the traditional exchange rates between currencies.
Shutting down the trading centers of Bitcoin is a simple and bold measure but it also shut down the chance to develop an electronic medium for exchange, globally accepted and trusted, even more trusted than dollar.

3. Is it too expensive?
The relative price of Bitcoin will be constrained by arbitrage transactions and the gap between Bitcoin exchange rate and dollar exchange rate cannot exceed a certain level also because of arbitrage transactions. That is why absolute prices (denoted by national currencies) of Bitcoin in different countries are also closely linked and go in tandem as we observe in reality.
Then what determines absolute prices of Bitcoin? As stated in the previous section, its absolute price is determined solely by the demand of the market given that supply is fixed. Demand for a good, including Bitcoin, depends on its own price, prices of substitutes and complements, income, preferences, expectation and others. At this juncture, preferences and expectation seem to be major demand factors that drive increases in Bitcoin price.
Globally the amount of Bitcoin is limited, implying that without supply of substitutes its price is likely to increase. Many people point out that it has no value. Here “value” means value in use. They argue that its price cannot and should not be that high because it has no value in USE. This argument is the same as the famous water-diamond paradox. Diamond has almost no value in use and its value in use is far smaller than water’s. However, its value in exchange is far greater than water’s. What determines absolute price of a resource is its scarcity relative to demand.
If anyone believes that Bitcoin price is too high, no regulation is the solution. As Bitcoin price increases more substitutes will naturally appear globally.

4. What is the value in use of Bitcoin and who gets it?
The intrinsic value of Bitcoin resides in its forgery-proof nature and its scarcity. Block-chain technology protects Bitcoin from fraud, forgery, and hacking. In addition, it is not backed by a national government, so no national government can control its supply and harvest seigniorage, the profit a government obtains by issuing its currency. National governments can control only demand.
Who gets the seigniorage by issuing Bitcoin? Those who offer (mine) bitcoins initially get the seigniorage profit. Others purchasing bitcoins at the secondary market, as stock investors, can earn capital gains or experience economic loss. Bitcoin investors are no different from usual investors pursuing capital gains by purchasing whatever rare.

5. Who will be the losers?
National governments will be losers because their power of issuing national currency will be gradually eroded as people begin to use all kinds of bitcoins for economic transactions. In addition, they will lose seigniorage profit and a powerful economic policy tool, money supply.

6. Should we regulate the crypto-currencies?
At this juncture, bitcoin markets are not efficient and it is easy to observe volatile price changes in the market. Allowing and encouraging crypto-currency markets to be merged into traditional financial markets are likely to be a shortcut to reduce chaos currently occurring in crypto-currency markets.
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