Breaking Satoshi

Bitcoin's Laffer Curve

January 31, 2020·Deryk Makgill

Arthur Laffer and his famous curve.
Arthur Laffer and his famous curve.

The Laffer Curve is an illustration by Arthur Laffer which describes the negative effects of tax increases on total tax revenue.

It is based on the economic understanding that individuals will change their behavior when the incentives around them change.

In the case of taxes, the Laffer Curve shows us that there exists some difficult to determine tax rate threshold at which maximum revenue is collected, beyond which people will simply reduce the amount of their taxed behavior, like work and investment, causing tax revenue to drop to lower levels than before the tax increase.

It’s surprisingly simple, but it explains why so many central planning regimes fail. They don’t consider the incentives created by their policies! They think they can raise taxes forever and people will continue acting exactly as they did before.

But people don’t do that.

The Makgill Curve

We need a Laffer Curve for Bitcoin. For fun, let’s call it…The Makgill Curve!

Makgill curve.
The Makgill Curve...simplistic illustration. Obviously fees wouldn't be in the middle

The Makgill Curve states that increases to the cost of transaction fees on the Biticoin Network have a diminishing return on total fee revenue collected by miners. This is because a threshold exists beyond which people won’t use Bitcoin to transact as much.

The Makgill Curve helps explain Bitcoin BTC’s artifical demand cap. It is an answer to the shallow jokes about ‘pulling out the champaign’ made by certain Bitcoin developers celebrating when Bitcoin fees rise due the Bitcoin blocks being full.

They do not understand that fees can only rise so high before people or businesses drop off the network entirely, causing miners to collect less total revenue than they could have collected if fees were lower but more people used the network.

Putting it into practice with unbounded blocks

The Makgill Curve won’t tell us the ‘ideal’ fee cost or the maximum miner revenue. It only tells us that there exists some point at which the highest possible fee revenue can be collected by miners.

Obviously a 0% fee would mean that, after the subsidy, miners collect no revenue. Obviously a 100% fee would mean that nobody could use the network at all. Somewhere between that the Makgill Curve says is the right number for both miners and users.

But how do we figure out what the maximimum possible revenue for miners is?

Well, artificial limits like the kind that exist on the BTC chain make it difficult for miners and users to negotiate the right cost of fees on the network. They force miners into a sort of procrustean business model. High fees or the highway. At a certain point, users and businesses drop off, so there is a limit on total possible revenue as the Makgill Curve predicts, and maybe even a reduction in revenue because users and businesses don’t necessarily return when the prices drop as demand calms.

We need unbounded block sizes to answer this question.

Unbounded blocks allow the miner who wants to maximize profit to set whatever block size allows them to process the right number of transactions at the right fee level. They create a real market for transacting on the network in which miners and users choose, not developers who think they know better than them.

Like most businesses, miners will likely find that economies of scale in transaction fees, pure volume, allow them to be more profitable than high fees, but let’s let them figure it out, like the BCH and BSV forks of Bitcoin are trying to do.

The Makgill Curve, or whatever you want to call it, demands this of us.

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