Bitcoins Explained_ Fungibility, Double Coincidence of Wants

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11/13/2014 Mrunal Bitcoins Explained: Fungibility, Double Coincidence of Wants

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- Mrunal - http://mrunal.org -

[Economy] Barter-Money-Bitcoin: Fungibility, Double

coincidence of wants, division of labour (Part 1)

Posted By On 24/12/2013 @ 9:27 pm In Economy | 105 Comments

1. Prologue2. Bitcoins overview3. Barter system

1. #1: Double coincidence of wants2. #2: Division of Labour3. #3: Divisibility of Value4. #4: Fungibility

4. Bitcoin and Fungibility5. Mock Questions

Prologue

Original plan was to write on Bitcoins. But for Bitcoin related MCQs, groupdiscussion (GD) and interview questions, one must know the basics of moneyitself. Only then you can see how Bitcoin is better or worse than the money we

use today- rupees, dollars or Euros. Hence a long series of articles.

1. In the first few of articles (total 3), well see why did people start usingtraditional money (Rupee, dollar), how is it better than bartering system.

And how is bitcoin better or worse, on those parameters?2. In the second batch of articles, well see evolution of money system: from

commodity money, metallic coins, fiduciary money, gold backed papercurrency, fiat money, bank money etc.-what were their advantages andlimitations. And how is bitcoin better or worse on those parameters.

3. And in the final articles, well see what is bitcoin exactly? from where does it

come? How does it operate? Advantages, limitations, future applicationsand regulatory issues etc.

Bitcoins overview

Bitcoin is a digital code. (Some) people use it as currency.Started in 2009 by Satoshi Nakomoto. He could be a man or a woman or agroup of people- real identity unknown.
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There are two ways to get Bitcoins:

#1: Mining #2: Exchange

Aluminum is hidden insidebauxite ore in earth.Similarly, Bitcoins are

hidden in data blocksdesigned by Satoshi andspread across theinternet.You can mineBitcoins bysolving those datablocksusing special computersoftwares.Reward for solving onedata block=25 bitcoins at

the moment.Total number of Bitcoinsin the system =~21million. Additional bitcoinscannot be created beyondthat.

If you dont want to mine bitcoins, then simplyfind someone who has already minedbitcoins. then

A. Offer him real money (rupee, dollar,euro) and get bitcoins in return.Websites that facilitate suchtransactions are called Bitcoinexchanges. OR

B. Sell him some goods/services, and earnBitcoins in return.

Once youve have bitcoins (BTC), you can use them to buy goods/service(But very few sellers accept bitcoins.)OR you can just wait for the BTC vs.$ exchange rate to rise then sell yourbitcoins to a third party.

But what about anonymity and terrorist angle? what about money laundering?what about inflation? isnt this a ponzi/MLM scheme? Well all those things indetail later on. I gave the overview right now, because for next 5-6 articles, atleast^this much knowledge of bitcoin topic is required before we start comparingBitcoin system with barter system and money system. Now lets start first article.

Barter system

People have been trading with each other even before the advent of money,coin, cash, currency, rupee, dollar, euro or Yuan.They simply exchanged goods and services with each other through bartersystem- 1 kg rice for a 200 gms tomatoes, 1 kg tomatoes for 50 gmalmonds and so on

Barter system: advantages


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1. Simplest form of exchange. Had all nations did foreign trade on bartersystem, there will be no headache of foreign exchange rates andassociated problems. Today if Dollar strengthens by some action of USfederal reserves (=American RBI), then it automatically becomes expensivefor India to import oil from Saudi=>everything else transported throughpetrol/diesel becomes expensive= inflation.

2. Less chances of overproduction, hoarding, profiteering etc. =less chances

of inflation. Although itll be wrong to say there will be no inflation in bartersystem- because war, famine and natural disasters can create mismatch insupply and demand even in a barter system => lead to inflation.

3. Difficult to concentrate wealth= Less inequality of income, and all the socialproblems associated with it.

4. Barter system ensures need based production. In money system, firmscreate products to create demand e.g. so many softdrinks and plasticbottles+ the subsequent harm to health and environment.

5. Barter system promotes personal contact among individuals, socialharmony, and healthy community life, joint families etc.

But Bartering system had many limitations, thats why people shifted to themoney system. So,

What are the limitations of Barter System?

#1: Double coincidence of wants

farmerI wantyou to cut my hairs just Amir Khan in Dhoom3. Ill give you 5kilos of rice

barberBut I already have 200 kilos of rice from previous customers. I dontwantrice anymore! Ill cut hairs only if you bring 1 kilo tomatoes aspayment.

Another case

MallyaMy son wantsto get admission in your coaching class. I can give you500 beer bottles as fees.

SirI dont drink at all! Although I do wantnew table and benches for my

classroom.

MallyaBut I dont know any carpenter in this area, and even if I find one,there is no guarantee hell accept beer bottles as payment for makingfurniture!

Thus, under barter system, the wants of two parties must coincide witheach other, otherwise they cannot trade with each other. This increases thetransaction cost as everyone will have to waste time and energy to findanother party with double coincidence of wants.Money system solves this problem. Farmer can sell his rice for money, use


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that money to get a haircut, and barber can use the same payment to buytomatoes from another farmer.Money thus facilitates the exchange of goods and services, lessens thetime and effort required to carry on trade.

What about Bitcoins?

Bitcoinalso serves the same purpose but with some caveats

Fiat money Bitcoins

Fiat money= money issued by thegovernment (or its central bank) exampleRupee, dollar, Yen, Yuan.

Bitcoins are not issuedby any government.Bitcoins are uniquepieces of digital codesthat (some) peopleaccept as digital

currency.

It is legally recognized money for settlingall payments and debts within theterritory.If you walk with a 5 rupee coin to a tea-vendor, he must serve tea, irrespective of

your race, religion, color, caste, age orgender.If he refuses to serve tea, hell be in legaltrouble.

An IT professional inBanglore may acceptbitcoin payment forcreating software forsome Americanbusinessman.But if the same techie

offers to pay house rentin bitcoins, the landlordis legally free to refusethis payment and caneven order him to vacatethe property.

Even better, you can get your rupeesexchanged in a foreign currency andimport any commodity from any part ofthe world to India. So a fiat money(rupee) removes the double coincidenceof wants for the trade within country andabroad.

Bitcoin removes thedouble coincidence ofwants ONLY for thepeople who believe inbitcoin system, and notfor everybodyeverywhere.

Lets make comparison table:


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FEATURES BARTER FIATMONEY

BITCOIN

trade can happen without doublecoincidence of wants?

No YesYes, if twoparties agree.

#2: Division of Labour

In the barter system, buying/selling/trade can only happen, when twoparties want each others stuff- the double coincidence of wantse.g.farmer wants haircut and barber wants rice from that farmer.But that doesnt always happen, so each household tries to produce all ofits daily requirements- from growing green tea, tomatoes, chilies in theirbackyard; raising cows and poultry for milk and eggs; even making pickles,paper andpapadfor entire year.

So is this good or bad?

Good from Gandhian principle of self-reliance.Food inflation is kept in check- because everyone is growing vegetables intheir backyard.

But overall bad because:

Everyone is wasting their time and energy to become jack of all trades,instead of becoming master of a single trade -medicine, engineering,construction, accounting, teaching, singing, painting etc.Thus, a bartering economy is less likely to produce specialists like

Alexander Graham Bell (telephone)=> Vin Serf (Internet)=> Sergey Brin(Google) because everybody busy growing vegetables in their backyardand trying to become self-reliant-jack-of-all-trades.

And even if there are talented specialists, they wont have the necessarycapital or resources to continue their research. Imagine how many partieswith Double coincidence of wants youll need, for assembling the parts ofa Large Hadron Collider or a ParamSupercomputer.Money system also facilitates savings to become investment for theentrepreneurs => more companies, more job, division of labor, optimal

usage of manpower, good for economic growth, R&D and internationaltrade.

And with the money thus earned, anyone can buy his daily necessities,doesnt need to grow vegetables or rear cows in the backyard.

What about Bitcoins?

Just like traditional money, Bitcoin also promotes division of labour, but it islimited by the factor that not everyone accepts Bitcoins- especially the local milk-veggie sellers. So if a software professional decides to live only on bitcoin, hell


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have to start growing vegetables and wheat in the backyard of his house,arrange a goat/cow for milk, and so on, we are back to square one- everyonetrying to become jack of all trades like in Barter system.

However, in future, Bitcoinmay promote Division of labour to a whole new level(when and if Bitcoin is accepted by a large population):

Imagine a laptop manufacturing company- owned and operated by an AI(or robot) that accepts bitcoin payment, robots make and pack the laptopsinto parcel, and drones deliver them at your door step.

AI uses these bitcoins for paying the cost of raw material, warehouse rent,electricity bill etc. to humans (or other AIs).

And whatever bitcoins left (=profit), are reinvested in buying more drones,bigger servers and so on.

This is not possible in the present money system because legally- an AI or Robotdoesnt meet the KYC norms for opening a bank account = impossible for

them to pay electricity bills through netbanking or creditcard!

Anyways, lets update the table:

Features barter fiat money(Rs./$)

Bitcoin

trade can happen without doublecoincidence of wants

No yesOnly if both partiesagree.

Promotes division of Labour? No YesYes, lotpossibilities in

future.

#3: Divisibility of Value


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barter-system-divisibility

Under the barter system

JKRowling

Give me a cup of tea, Ill give you two pages from the latest HarryPotter book.

chai-

walla I dont want just two pages, I want the whole book for my son!

Even if chai-walla continues serving tea to Ms. Rowling for 300-400 days,gets all the pages of Harry Potter book and staples them together => stillthat stapled book will not sell at the original value of a brand new Harrypotter book (which is say worth 30 kilos of rice).

Meaning:

You cannot always divide the valueYou cannot always re-unite the divided values.

Other scenarios:

1. Jeweler wants a matchstick box. But its not possible to divide gold to sucha micro-micro-micro quantity where gold becomes proportional to the valueof a matchbox.

2. Mallya wants to buy a pencil box for his son, offers 1 table-spoon of liquorfor 1 pencil box but stationary-walla will not accept because such low
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quantity of alcohol cannot give the kick.

3. To pay for a cup of tea, Picasso cannot cutout 1 mm2of canvass from hisoriginal painting.

Fiat Money system (and Bitcoins) dont suffer from this problem of divisibility,and hence facilitate the trade.

currency smallest unitRupee (Rs.) 1 paisa=0.01 Rupee (that is 10-2)

Bitcoin (BTC) 1 Satoshi= 0.00000001 Bitcoin. (that is 10-8)

You can see it is possible to divide 1 BTC into so many small parts, so evenif new bitcoins are not created, it can continue as mode of payment bylowering the corresponding values of commodities.e.g. if today MRP of 1 laptop =1 bitcoin then in 2050, MRP of 1 laptop mayadjust itself to 0.00165 Bitcoins, if there is shortage of bitcoins.

And still you can pay 0.00165 BTC to someone by simply typing thatspecific amount in your keyboard. Same thing is not possible with rupee ordollars because of the chillarshortage in real life.

#4: Fungibility

Even if items are divisible, their fungibility is a problem under barter system.

Fungible items = those items whose individual units have same uniform value andmutually exchangeable, inter-changeable. For example:

1. The value of first five pages of harry potter book= Not same as the value oflast five pages of the same book. Because in the last pages you get theclimax so theyre more precious= not fungible.

2. Value of one diamond of 100 carat = not equal to ten smaller diamonds of10 carat each. In this case, bigger the size, more precious. Even those 10carat diamonds are not mutually interchangeable because their individualvalue may vary depending on cut,color and clarity.= not fungible.

3. If Picassos painting was cut into nine equal square parts, then Central

Square will be more precious than others. So you cannot interchangethem. And if you glue these torn parts together= its total value will be farless than the original painting=not fungible.

4. Exception:Precious metal. Value of 1 kilo gold bar= Value of 100 goldcoins of 10 grams each. You can melt to reunite them, you can melt againto divide them. And those 100 gold coins will be interchangeable becausetheir individual value will be same.= fungible.

But by and large, goods are not fungible and this creates obstacle in bartertrade, when two commodities are not available in their standard weight/size. For


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example, Suppose the ongoing barter rate is 5 kilo salt = one live hen weighing500gms.

A poultry farm owner wants to buy 2.5 kilo salt. He gives the whole live hento shopkeeper.Common sense suggest that shopkeeper should give 2.5 kilo salt and cuthalf of the hen and return it.

But which half? In non-veg cooking, the legs of chicken are consideredmore valuable than its head and neck upper part. = dispute betweencustomer and shopkeeper.Overall, the customers in a barter-trade will end up buying more than whatthey really need. (e.g. 5 kilo salt even if he needs only 2.5 kilo.)=considerable wastage and sub-optimal use of resources.

Money system solves this via fungibility.

Rs.1000 note= can be exchanged for 20 notes of Rs.50 each. And each of

those 50 rupee notes have equal purchasing power. A 50 rupee note inyour pocket will buy as many ballpens, as the 50 rupee note in my pocket.(as long as ballpens are of same brand-model.)Similarly ten notes of Rs.100 can be exchange for a single note of Rs.1000and so on.But there is an exception: Someone might offer 1000 rupees for a single 10rupee note that has unique serial number like ABCD-123456789. butignoring such exception, currency notes are fungible.So, if you give Rs.100 note to shopkeeper to purchase a ten rupee worthballpen=> hell give you 10 rupee pen + one note of 50 Rs. + four notes of

10Rs.

Still Money system too has limitations:

You cannot pay Rs.149.75 through notes and coins because 25 paisa isout of circulation. (Although possible if you pay via credit card, debit cardor internet banking)Persistent shortage of chillar coins. And if you cut a ten rupee note into tenparts using a scissors, itll not become ten 1Rs. notes.Persistent looting by Shopping malls. Items priced @Rs.99, 499 or 999 often, cashier wont give you one rupee coin back but instead gives achocolate. (He is making additional profit because for him cost price of 1chocolate is less than 1 rupee.)

Bitcoin and Fungibility

Bitcoins (BTC) are fungible because

1. Individual units are identical. 1 BTC in Rajas Digital wallet will buy same


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amount of goods & services as 1 BTC from Kalmadis digital wallet. (Even iftheir unique digital codes are different.)

2. Mutual substitution possible. it doesnt increase or decrease the value. e.g.100 centibitcoins (cBTC)= 1 bitcoin (BTC).

As such chillar/change problem doesnt arise in Bitcoin because you can payexact amount to the seller. E.g. if a pen valued at 0.4 BTC. you can type 0.4 in

keyboard and eletronically transfer that amount to seller. Its not like you have togive him 1 Bitcoin(BTC) and he gives 1 pen + 0.6 BTC in return. This is a digitaltransaction after all.

But there is trouble brewing:

You may have read in newspapers that Bitcoin transactions are anonymousand hence can be used by terrorists, druglords and tax evaders.Therefore, some experts have came up with the idea of coin validation.Well see about that in a separate article later, but for the moment the gist

is:- Through coin validation software, you can separate GOOD BITCOINS(those earned through honest work) vs BAD BITCOINS(those earnedthrough hacking & other illegal activities) via analyzing their transactionhistory and origin.

This coin validationwill destroy the fungibility of bitcoins. How?

Because then most users will refuse to accept bad bitcoins.Some American users might even refuse to accept bitcoins originating frompeople of Cuba, Pakistan, Afghanistan, North Korea or Iran-for the fear that

later US authorities may persecute/harass them while hunting for BadBitcoins/Al-Qaeda/Terrorists.

Anyways lets update the table:

features barter Fiat money(Rs./$)

Bitcoin

trade can happen withoutdouble coincidence of wants

No YesYes, if both partiesagree.

Promotes division of Labour Hardly yesYes, but limited@the moment.

Divisible?Notalways

Yes but limitatione.g. Rs.14.199

Yes and lesslimitations than fiatmoney

Fungible?Notalways

Yes Yes, for now.

In the next article, well see more on Barter vs Money vs Bitcoin, with referenceto storing wealth, account keeping, deferred payment, circular flow of income


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etc. parameters. click me

Mock Questions

Assertion reasoning instructions: Each of the following questions contain aset of Assertion (A) and Reasoning (R) statements. Answer codes are asfollowing

A. Both A and R correct and R is the correct explanation for AB. Both A and R correct but R is not the correct explanation for AC. A is correct but R is wrongD. A is wrong but R is correct

Questions:

1. (A) Money brings down the cost of transaction in trade, compared to bartersystem. (R) Money promotes division of labour.

2. (A) A trader is free to refuse payment in Bitcoins. (R) Bitcoin is not a fiatcurrency.3. (A) A Barter economy is less likely to have to food inflation. (R) In Barter

system, trade can happen without double coincidence of wants.

MCQs

4. Correct Statement(s) about Bitcoins?a. It is a digital fiat currency without fungibility.b. It is not a fiat currency but has all the properties of a fiat currency.

c. Both A and Bd. Neither A nor B.

5. Find Incorrect Statement(s)a. One fiat currency can be exchanged with other fiat currency.b. Bitcoin cannot exchanged with fiat currency.c. Both A and Bd. Neither A nor B

6. Correct set of fungible pairs?a. One i-phone of 64 GB capacity vs Four Nexus phones of 16GB

capacity each

b. 1 Bitcoin vs 108Satoshisc. 1 Rupee vs 100 centsd. None of Above

Q7. Which of the following statement(s) is/are incorrect?

1. Bitcoin algorithm is designed to generate 21 million coins every year.2. There are two types of Bitcoins: mined bitcoins and exchanged bitcoins,

theyre not fungible among themselves.
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3. Smallest unit of Bitcoin is called Satoshi.

Choice

A. Only 1 and 2B. Only 2 and 3C. Only 1 and 3D. All of them.

Q8. Which of the following is/are the benefit(s) of barter system overmoney system?

1. Trade is possible without double coincidence of wants.2. It promotes division of labour3. Bartered commodities are always fungible.

Choice

A. Only 1 and 2B. Only 2 and 3C. Only 1 and 3D. None of Them.

Q9. If a Barter economy is transformed into Money economy, what will bethe consequences?

1. Increased Economic Efficiency2. Increased Transaction costs3. Increased specialization among workers

Choice

A. Only 1 and 2B. Only 2 and 3C. Only 1 and 3D. All of them

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