Originally Posted by killer-x
I'm not quite sure exactly either, so take my response with a grain of salt.
From what I've gathered, the more people that are mining the coin (higher total hashrate), the higher the difficulty goes.
Higher difficulty means it's harder to mine coins. In theory, the price of the coin should go up as the difficulty rises, but I'm not sure about a coin that has just launched.
Originally Posted by RavenXBR
Hmmm, got it, pretty simple.
There is more to it than that though. Originally the expectation was price would not change according to diff. Since the same flow of coins is mined regardless of difficulty. However that was with the assumptions the same amount of people would be mining but with just faster hardware with no added users.
What tends to happen is the difficulty is also a indication that more people are using the coin and mining it. So price often scales up with difficulty. The truth should be somewhere in the middle. In a given year hardware should get faster therefore difficulty will go up regardless of new users adopting or using a coin (in this scenario the exchange rate shouldn't change much if there was no reward halving). But when the new users adopt the coin and want to buy it and use it this should cause coin to go up in value and therefore difficulty will increase to follow too fill in the gaps of profitability vs exchange rate.To answer the original question though how does difficulty increase work and why.
Its simple really. Each coin is designed to have confirmation at a certain time frame. Example Bitcoin is set to have a block every 10 min. Litecoin is set to have a block every 2.5 min. This will never change. Difficulty is set to pace the blockchain out so you have a block every 10 min (Which is a confirmation as well). So in a 10 day period for the most part there has always been the same about of blocks found. Weather there is only 100 people mining with CPU's or 500,000 people mining with ASIC's, it will always try to have 2016 blocks every 10 days which is every 10 min there should be a block (on average, with BTC).
Now if suddenly for what ever reason everyone mining bitcoin turned there machines off. And only 1000 CPU miners left there machines on mining. Then the difficulty would adjust really really low again to make calculations to find a block on average every 10 min again for those 1000 CPU miners collectively.
So that's the basic idea on how and why it works. Now you can look at any coin and they all work the same. Some coins retarget very quick, like every 10 blocks the difficulty will change to keep the pace of blocks the same. And some coins will have shorter block times like 40 seconds or a minute. As long as you know the block time and block retarget rate, you can get a good idea on how the difficulty will work for any given coin.
The original 2016 retarget is very long and any new coins coming out with 2016 block retargets should be avoided. The problem with these retargets on small coins is its very easy for them to get abandon. If it takes 2000 more blocks until the next retarget and only a few people are mining that coin it may never retarget and even the few guys left mining it will leave for something more profitable. Then you will not have any confirmations for any transaction and the coin is dead, because if no blocks are mining then no confirmations will be processed and you will not be able to send money to anyone.
So this is why you will mostly see new coins using short retargets. BTC and LTC don't have much to worry about in that arena since there well established value will make it easy to reach the next 2016 block retarget with ease.