The Divergence of Profit
The first years were more profitable than you could have dreamed.
But now, you avoid looking at the paper. You already know what it says.
You were one of the first into the latest generation of ASICs, getting in before the economic crash that sent supply chains reeling and markets crashing. At the time you were worried, but it only served to make you scrappier.
You feel the weight in your hand, somehow heavier than it had ever felt before, and the smile you’d been wearing like scaffolding begins to fade as you look out your office window. Six years of time and toil wash over you.
It was a hard business, mining, but you made it your own. From the spare bedroom to the shed out back and into the warehouse you were looking at now. You’d made and spent millions running those machines, scraping together every shelf, cord, cable, and computer you could see through the glass.
You scrounged up your own cheap power system, taking old, broken solar panels and battery systems and repairing them, learning as you went how to solder and design electrical systems. Your left hand still tingles from time to time in remembrance of the mistakes you’d made.
And when the economy bounced back, your investments soared in value.
It’s what made it possible to buy this warehouse and fill it with layer upon layer of money making machines. Back then, you were the one sitting, waiting and watching as a tired man looked out that window, listening to the dissatisfaction of fans, the constancy of which droned on even in dreams.
Where had it gone wrong?
You feel the weight of three pairs of eyes staring at you. You avoid looking up at them. You already know what they want.
Hash rates had skyrocketed over the past two years even as the halving approached. On chain fees weren’t materializing in any consistent fashion. Revenues were plummeting even as your costs began to mount. Old machines were failing, and new hardware was being released to the market at inflated prices.
The eyes across the desk were responsible for that.
A sudden urge fills you to throw up your hands and curse the monsters out of your sight, damned be the consequences!
But it passes, and you feel the weight in your hand.
There was no choice left to you. With three weeks until bankruptcy, these men will get their prize sooner or later. Pride alone cannot prevent that.
The fact is, you can no longer compete. Despite all your best efforts, there’s only so much water in a well, and your well has dried up. And it’s the men before you who made it happen.
They cracked the code. They found the niche. They took the opportunity.
With the largest hashing operation in the world, they built their own power plants, designed their own ASICs, and they make the most profit of anyone, pushing up difficulty and pricing out the competition.
And you can’t even be mad, because in their shoes, you’d have done the same. You had done the same.
You give in and look down at the pen in your hand, feeling its weight.
It was the same pen your predecessor used and left upon your desk when he sold his business to you, red bodied with a golden pattern on its tail end like a crown. You cherished it for your time. The Red Queen. For a time, you held the crown. No longer.
You set the tip to the page and begin the sweeping curves of your own name.
At the completion of the final stroke, you set the pen down upon the desk and you hardly have the strength left to shake the hands that are offered to you.
Ten minutes later you leave your former office for the last time, looking back at the desk for a final glance at the pen that still lay on its side, daring you to pick it up and strike a new line.
You close the door and leave the warehouse, looking back with tired longing. You know what’s within, and what you can never have again. But now the burden is light, the weight no longer yours to bear.
You breathe deep and set forth on what you hope to be a new and greater adventure.
Commentary
The story above is the inevitable conclusion of market forces in an industry designed to consolidate over time, where the bigger players are more efficient and have more opportunities, and the smaller players are priced out of the competition.
But not all markets end this way. What makes some markets consolidate while others remain accessible to all?
Some think it comes down to barriers to entry and a pure analysis of operational costs. However, this analysis is incomplete.
A business will continue to operate despite exorbitant costs if the revenues justify the expenditure. Profit, not costs alone, determines the willingness of a business to continue operations.
How, then, does a firm gain the economic advantages of sustained and sustainable profit margins? And how can a market sustain multiple competing firms, each of which remains profitable?
You hear the answer from entrepreneurs all the time. In fact, it is one of their driving purposes: find a niche, and own it.
Markets and Their Structures
Markets are squishy things. How we frame a market is as much a subjective operation as is the valuation of the goods and services within it.
The market for new Toyota Corollas is a monopoly, while the market for new mid-sized sedans includes dozens of global competitors. Even if a competitor were to copy the Toyota Corolla piece for piece, would that competitor have the same advantages as Toyota in the production of this vehicle? Could they produce the Corolla for the same costs, rely on the same brand perceptions, or distribute via the same global dealership network?
Toyota has filled the Corolla niche. There are other niches they have filled, too. Stepping into Toyota’s niches would be a costly endeavor, and as the incumbent player, Toyota has many advantages against the newcomer, even if that newcomer is already well established in the broader industry.
Like him or not, Elon Musk is an expert at finding a new niche, filling it, then expanding to service more niches with more mature technology.
The Cybertruck is a phenomenal example of his strategy.
By creating a vehicle so absurdly, comically divisive, he tapped into a market niche that no other company would dare enter. In doing so, he created a small market wherein Tesla could learn and innovate, enabling a more conservative later offering from the company to succeed where their first approach to an electric truck could not.
By seeking an untapped niche, Elon Musk expands the number of firms in an entrenched industry by one. He then uses his production processes to fill and own that niche. Then, as all businesses try to do, he expands his business to fill other niches that his production processes can be used to fill in a profitable manner.
Therein, we can see how markets structure themselves.
There is only one niche in the market for Toyota Corollas, or for Tesla Cybertrucks. If a competitor tries to fill these niches, they must overcome an entrenched, highly specialized opponent, the incumbent business.
Specialization comes at the cost of resources that might have been spent filling other niches, or in attempts to generalize production. Specialization, by its nature, requires making mutually exclusive investments, and these mutually exclusive investments generate efficiencies in some areas, and inefficiencies in other areas.
In the process of specialization, firms scale. Economies of scale result in greater efficiencies still. The largest, most specialized, and most monopolistic firms vertically integrate within the production structure of their niche, maximizing efficiency of the entire production process.
These efficient firms price out firms that are less efficient in that niche. They come to wholly own that niche.
This is the pattern of market consolidation. Only the firms who pursue a niche and own it survive. If a niche is not owned by a single firm, eventually, one winner will emerge and the rest will fail.
The only way markets resist consolidation is through the existence of many niches which require mutually exclusive investments to fill.
There is only one niche for Toyota Corollas, but many niches for mid-sized sedans, and many more for vehicles with four wheels. As such, the Corolla and the Cybertruck can coexist in the economy at once, and both Toyota and Tesla will remain in business despite the other’s existence.
Framing the market for automobiles in the right way tells us that it doesn’t matter that Toyota has a monopoly on Corollas, or that Ford’s F-150 is the incumbent truck in the market. If there is another niche to fill, another firm can compete, and their business can be viable.
Broader Market Examples
The concepts laid out here are general economic principles in the determination of market structures. As such, we may explore other markets wherein these principles apply to better understand them, and to test the viability of these theories. Once sufficiently established we may apply these principles to our own analysis of emerging markets.
For those interested, I have compiled resources on a number of other markets where these principles are relatively easy to see, and the niches held are largely obvious.
Potential differentiations between niches may include localization of goods and/or services such as store or service locations, price, qualitative tastes and preferences (i.e. flavor profiles, aesthetics, build quality), and objective comparisons (i.e. nutritional content, technical specifications, time to destination). Other differentiations may apply.
Low Niche Markets
PC Parts — CPUs
Market Participants: AMD (34.1%), Intel (65.8%)
https://www.cpubenchmark.net/market_share.html
PC Parts — GPUs
Discrete GPU Market Participants: AMD (19%), nVidia (81%)
All GPU Market Participants: AMD (16.65%), Intel (68.18%), nVidia (15.17%)
https://www.tomshardware.com/news/jpr-gpu-shipments-in-q1-2021-hit-119-million-units
Cream Cheese
Primary Market Participant: Kraft Foods — Philadelphia Cream Cheese (65% market share)
https://www.statista.com/topics/3109/cream-cheese-market/#dossierKeyfigures
Commercial Jets
Market Participants: Boeing (est. 54%, 2018), Airbus (est. 45.3%, 2018)
https://www.aerospace-technology.com/features/airbus-vs-boeing/
https://www.forbes.com/sites/greatspeculations/2020/01/06/how-airbus-has-grown-over-the-years-to-dethrone-boeing-as-the-largest-commercial-aircraft-maker/?sh=887f4713a59f
High Niche Markets
Fast Food
Notable Market Participants (2018 Market Share):
- McDonald’s (21.4%)
- Starbucks (7.52%)
- KFC (2.82%)
- Subway (2.8%)
- Domino’s Pizza (1.57%)
- Pizza Hut (1.24%)
- Burger King (1.16%)
- Tim Hortons (1.09%)
- Chipotle (1.02%)
https://www.t4.ai/industry/fast-food-market-share
https://www.zippia.com/advice/us-fast-food-industry-statistics/
Global Auto Manufacturing
Notable Market Participants (Market Share 2017):
- Toyota (10.8%)
- VW (10.7%)
- Hyundai (7.4%)
- GM (7.1%)
- Ford (6.6%)
- Nissan (6.0%)
- Honda (5.4%)
- Fiat (4.7%)
- Renault (4.3%)
- PSA (3.8%)
https://www.quest-trendmagazine.com/en/automobile-industry/internationalization/market-shares-automobile-manufacturers.html
https://www.goodcarbadcar.net/2019-u-s-auto-manufacturer-sales-figures/
https://www.goodcarbadcar.net/2022-us-auto-sales-figures-by-manufacturer/
Commercial Airlines
Notable Market Participants (Market Share, 2020):
- American (19.3%)
- Southwest (17.4%)
- Delta (15.5%)
- United (12.4%)
- Spirit (5.8%)
- Alaska (5.3%)
- JetBlue (4.7%)
- Frontier (3.6%)
- SkyWest (3.5%)
- Envoy Air (1.3%)
https://companiesmarketcap.com/airlines/largest-airlines-by-revenue/
https://www.zippia.com/advice/airline-industry-statistics/
The Bitcoin Mining Market
Bitcoin mining is still an emerging market, despite over a decade of development and experience. The production of mining equipment has, but for rare periods of time, lagged behind the appreciation of prices of the primary assets in the market. Miner’s revenues still outstrip operational expenditures by significant margins, except on older equipment.
In the Bitcoin mining market, miner’s revenues are derived from two sources:
- The coinbase subsidy
- Transaction fees
To earn the subsidy, only blocks must be produced. To earn the fees, blocks must be produced and fee paying transactions included within them.
How might miners compete over revenue? What niches are available for them to fill?
The first method is through the acquisition and operation of hashing machines. By acquiring hash power, miners can produce more blocks which in turn nets a greater percentage of the total coinbase subsidy. The more efficient this hash power is, the more profitable they will be.
Further, by mining more blocks, the miner has more opportunities to earn transaction fees, and makes it harder for other miners to orphan their blocks.
But even a miner with minimal hash power can earn greater revenues by including more transactions, or transactions paying greater fees, in their fewer blocks.
However, in analyzing this secondary mechanism for generating revenue, we encounter a hiccup. Some Bitcoin-derived chains have artificially limited the size of their blocks, creating an artificial limit on the number of transactions a miner might include in their blocks, the very purpose of which is to reduce the cost of validating transactions to a minimal amount, sustainable even by those not generating revenue by doing so.
How, then, can a miner compete over the acquisition of transaction fees?
They can’t.
In fact, revenue from transaction fees becomes indistinguishable from the coinbase subsidy, as the only way to earn more revenue from fees is to mine more blocks. This reduces all niches in the mining market to one: the efficiency of hash power available to a given miner.
The more efficient the miner, the greater their profits. The more their profits, the more hash power they can pay for. The more hash power they can pay for, the greater their share of total revenue, and the higher they push difficulty. The higher they push difficulty, the lower the revenue for other miners. The lower the revenue for other miners, the less profitable they become. The less profitable a miner becomes, the more likely they are to shut down. Sustained negative profitability forces shut down.
This is the real story, only the ending of which is told above.
In a small block system, rising difficulty meets equilibrium miner revenues, and these pressures begin to take effect. The divergence of profit between efficient and inefficient miners leads inefficient miners to die off, freeing resources for the efficient miners to gain more market share.
Only through continued price increases has Bitcoin of any variety so far avoided this fate, but no market has ever sustained price increases indefinitely, and no market will. The very concept of perpetual price appreciation is an absurdity uttered only by those ignorant of even the most common sense aspects of economics.
But what if blocks are not limited in size? What if it is costly to collect transactions and include them in your blocks? What if the types and sources of transactions are widely varied, and the investments miners make into which types and sources they seek to include in their blocks matters?
When it requires mutually exclusive investments to be the first to include certain kinds of transactions in a block on-chain, then miners can fill different niches.
A miner can have relatively low hash power, thereby creating efficiencies for themselves by reducing hashing costs, while including many transactions in their blocks that hashing focused miners couldn’t afford to process in time to include in their blocks.
Here there are at least two niches to fill:
- Efficient hashing
- Efficient transaction processing
But what if transactions themselves are unlimited? What if some transactions may be very small with high volume, while others are large and low volume? What if some transactions have complex scripts, while others merely contain lots of data? What if some transactions come from China, while others come from Europe, the USA, or Africa?
What if some transactions are used for layered services such as token platforms, the deep processing of which enables miners to provide additional ancillary services from which they might profit even if they’re not otherwise the most efficient miners?
What if some transactions are broadcast widely, while others are sourced through payment processors?
What if Bitcoin were unbounded, unlimited, and competitive?
Can the available niches in this unbounded market even be counted?
How many niches can the market sustain?
The inevitability of market consolidation will not be avoided entirely by the availability of many niches, but like so many markets before it, a large block system will allow miners to find their own niche and own it.
The market will consolidate around those niches it can sustain, and the firms that survive will be powerful market players, but like Toyota or Ford, they will not have the power to prevent a Tesla from forming a new niche, nor will they have the power to strong-arm all others to do as they will.
The large block system will remain truly decentralized with power distributed among many rival players, whereas small block systems will consolidate into a highly centralized, even monopolized power center and no number of raspberry pis will be able to prevent their collective insecurity.
This is not opinion, but the inevitability of economics.
