Pitfalls of Bitcoin’s Proof-of-Work: R&D Arms Race and Mining Centralization
44 Pages Posted: 2 Nov 2018 Last revised: 5 Feb 2020
Date Written: February 4, 2020
Does Bitcoin's proof-of-work (PoW) protocol serve its intended purpose of enabling and supporting a decentralized payment system? To address this question, we develop a game theoretical model where firms invest in research and development (R&D) before competing in a Bitcoin mining game. We show that firms fail to capture the surplus created from their research, because higher research expenditures induce a more aggressive mining game. Promoting R&D spillovers not only reduces wasteful R&D duplication and increases firms' profits, but may also raise the security of the Bitcoin system. We calibrate our model to rewards and operational costs of the Bitcoin system, and quantitatively demonstrate that the mining industry has a tendency towards centralization, against the core principles of cryptocurrencies.
Keywords: Bitcoin, proof-of-work, mining, arms race, centralization
JEL Classification: C70, G2, D43, L13
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