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Back-of-the-envelope calculations for marginal cost of transactions

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MarginalTransactionCost.md
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Motivation

This gist tries to come up with a back-of-the-envelope estimate for how much it costs a miner to create larger, rather than smaller, blocks. An economically rational miner will only include transactions with enough fees to cover the cost to the miner of processing the transaction.

I hope this analysis helps solo miners and mining pool operators to reason about their transaction fee policies, and helps them estimate their 'charity cost' if they decide to include fee-free transactions in the blocks they create to promote more use of Bitcoin.

Uncertain numbers in this document are rounded to one digit of precision; this is meant to be an order-of-magnitude estimate; when I say that 100K of free transactions costs about $1, you should assume that the real number might be anywhere between 10 cents and 10 dollars.

Executive summary

The dominanting cost for a miner to include more transactions in their blocks is the risk that larger blocks are more likely to be orphaned. I estimate a current-worst-case "orphan cost" of an average 250-byte transaction is 0.0008 BTC, or, at today's $500/BTC price, $0.41 (forty-one cents).

Therefore, a rational miner should demand at fee of at least $0.41 per transaction. The default fee-per-kilobyte for the reference implementation is 0.0001 BTC/kb (5 cents).

Estimating current marginal transaction cost

Direct bandwidth, disk, and CPU costs to process a typical 250-byte transaction are negligible; the most expensive operation is checking the transaction input's ECDSA signature(s). Assuming it takes 0.002 CPU-seconds (2ms) to validate a transaction, and a server uses $0.03 per CPU-hour in electricity, validating one transaction takes 1.6 microdollars (millionths of a dollar).

A much bigger cost to the miner is the risk that by making their blocks larger they will take longer to be sent to other nodes, validated, and accepted; if another (smaller, faster propagating) block is found in that time, the miner's block will be orphaned and they will lose the 25BTC block subsidy and all transaction fees.

Given the 10-minute-per-block generation rate, the chance that a block will be found in the next X seconds is: 1 - e^(-(1/600)X)

According to measurements from Christin Decker and Roger Wattenhofer: "each kilobyte in size costs an additional 80ms delay until a majority knows about the block."

An 80ms delay increases the chances that the miner's block will be orphaned by 1-e^(-(1/600) x 0.080) = 0.00013. Multiply that by the 25BTC block subsidy, and we get the estimate that a typical 250-byte transaction must have a fee of at least 25 x 0.00013 x 250/1000 = 0.0008 BTC or its potential "orphan cost" outweighs the fee.

Discussion

It would be nice to get real-word metrics on how long it actually takes smaller and larger blocks to propagate to miners; I suspect that most hashing power is not directly connected, but is protected behind "network facing" relay nodes.

It would also be nice to get real-world metrics on how quickly transactions propagate; if most of the network has already validated a transaction, then validating it is much faster (TODO: how fast is validation if the ECDSA signature is already cached? Its inputs must still be checked for double-spend when the block is created...)

Future work

As far as I know, miners are not doing much to minimize their orphan cost beyond trying to be well-connected so their blocks are seen by the network quickly. In the future, they might do things like prefer to relay marginal-fee transactions but not include them in their blocks until enough time has passed that they are certain most of the network has validated them.

Are there strategies miners might use to try to maximize their rival's orphan costs? (beyond the DDoS attacks we have already seen)

A question that is often asked is "what incentive do miners have to relay transactions? Why don't greedy miners simply keep high-fee transactions to themselves?" Under what conditions does the benefit of (trying to) keep the larger fee transaction outweigh the increased orphan cost?

If we imagine there is no limit to blocksize, and the block subsidy is zero, what is the transaction fee equilibrium? Every transaction with a fee added to the block increases the amount lost if the block is orphaned, and (slightly) increases the chances that it will be orphaned.

Does bandwidth eventually become a bottleneck or will CPU/validation time dominate? We should assume that miners will include only "pre-validated" transactions in their blocks, and that new block announcements consist of just the block header (with proof-of-work, merkle root, etc), the coinbase transaction, and then the list of already-broadcast-and-validated transaction ids. In that case, the maximum number of transactions that the network can support will be determined by either the bandwidth to broadcast the transaction data, or CPU power to keep up with validating them.

Given current trends, bandwidth will likely be the eventual limiting factor: http://www.nngroup.com/articles/nielsens-law-of-internet-bandwidth/

Consider two miners in the far future where the block reward subsidy has dropped to zero: A large miner that has 20% of network hashing power, and a small one that has 0.1% of network hashing power. The large miner will pay the cost of validating 5 transactions to be rewarded with 1 transaction fee. The small miner will have to validate 1,000 transactions to be rewarded with 1 transaction fee. What are the dynamics of that system? Will the small miner be driven out of business, or would it only validate/include higher-fee transactions in its blocks? Or will this simply never be an issue because the direct cost of validating a transaction is so small (and will become smaller, assuming computers/networks continue to get faster)?

We should assume that miners will include only "pre-validated" transactions in their blocks, and that new block announcements consist of just the block header

Why make that assumption? I would expect the opposite case to be true as the cost of running a relay node increases, particularly for small miners. Right now transactions get relayed very freely because operating a relay node has such low cost that hundreds if not thousands do so for no return. That won't be true in the future, so relay nodes will either charge for their services, and/or clients connect directly to miners to submit transactions. The latter implies miners now start advertising their services on the blockchain, likely as a URL to connect to in the coinbase header, and clients connect to the advertised miners in parallel.

But then comes the next step: for a miner, particularly a large one, you are better off if you're block propagates to less than 100% of the network; some fraction of your competitors are now uselessly spinning their wheels solving an already solved block, and that fraction is sorted by whoever can afford the least bandwidth and computational power to validate blocks quickly. Now you have a reason to offer lower fees, provided the sender promises not to submit the transaction to any other miner. Because your competitors don't already have the transactions, it takes them longer to validate the block, and thus they are spending more time working on the previous block. (remember they have to find two blocks in a row to beat you) There are plenty of applications like settlement where waiting a little longer in exchange for the lower fees makes sense.

If we imagine there is no limit to blocksize, and the block subsidy is zero, what is the transaction fee equilibrium? Every transaction with a fee added to the block increases the amount lost if the block is orphaned, and (slightly) increases the chances that it will be orphaned.

Among other things if there is no limit to blocksize among other things you can profitably run UTXO bloating services such as backing up files in the UTXO set and timestamping. (1) These have the additional advantage of continually increasing the fixed overhead required to be a miner, gradually driving your competition out of business.

You also get to reduce the number of copies of the UTXO set out there, and eventually those who hold those copies can get together and dictate hard-fork rule changes as they wish, demanding that users upgrade to accept the new rules. What are you going to do after all? Without the UTXO set you can't process transactions, end of story. If there are only a few dozen miners out there they have a lot of incentive to get together and change the inflation schedule for instance.

1) https://bitcointalk.org/index.php?topic=152167.msg1619469#msg1619469

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