Proof-of-Work Cryptocurrencies: Does Mining Technology Undermine Decentralization?

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 in which 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.