Proof-of-Work Cryptocurrencies: Does Mining Technology Undermine Decentralization?
54 Pages Posted: 29 Jun 2021 Last revised: 12 Sep 2022
Date Written: September 11, 2022
Does the proof-of-work consensus protocol serve its intended purpose of supporting decentralized cryptocurrency mining? To address this question, we develop a game-theoretical model where miners first invest in hardware to improve the efficiency of their operations, and then compete for mining rewards in a rent-seeking game. We show that centralization grows with heterogeneity in mining costs, but hardware capacity constraints prevent the most efficient miners from monopolizing the mining process. Investment leads to a more decentralized network unless larger miners have a significant comparative advantage in acquiring new hardware. Our model generates empirically supported implications: (i) mining centralization is countercyclical with respect to mining reward, and (ii) a change in mining reward leads to a less than proportional change in hash rates.
Keywords: proof of work, cryptocurrencies, mining technology, decentralization, rent-seeking game
JEL Classification: D47, D82, D43, D83, G14, G23
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