game theory basics
Game theory is a fundamental mechanism underlying blockchain technology. it is what enables cryptocurrencies like bitcoin to manage and divert network outages and ensure the reliability of distributed databases.
so what is it? Broadly speaking, game theory uses mathematics to model human behavioral pathways within an interactive and dynamic environment. Put another way, game theory is the science of strategy that plots the best game path for agents to achieve a desired outcome or outcome. According to game theory, we see three core elements of any game:
Reading: Bitcoin game theory
- players: the strategic actors within a game
- strategy: a plan of action that a player will take given the circumstances that arise
- payout: the outcome or result a player receives after reaching a certain state. Please note that payments do not always have a dollar value, but can be in any quantifiable form
With these parameters, we can see that “games” are played out in a wide range of human activities, allowing game theory to be applied to military tactics, politics, economics, evolutionary biology, and computer science. Before employing a game theory view of cryptocurrencies, we will first look at how game theory can be applied in real life.
Related article: Crypto adoption for countries is a “high stakes” game
The prisoner’s dilemma is the most common scenario used to explain game-theoretic modeling. In this scenario, two criminals have been arrested by the police for a crime of which they are guilty. prosecutors interview criminals separately and offer each a reduced sentence in exchange for a confession against the other. in this example, none of the criminals have the means to communicate with each other.
If prisoner a betrays prisoner b, prisoner a is released and prisoner b is sentenced to 5 years. the same applies to prisoner b (vice versa). if both a and b betray each other, they each get 3 years. lastly, if a and b remain silent and cooperate with each other, each will serve only 1 year. the payoff matrix for this scenario looks like this:
The prisoner’s dilemma shows that if the prisoners pursue their own interests, the result is not optimal, since the best option is cooperation. however, since the potential consequence of cooperation is so high (5 years in prison), game theory tells us that a rational actor will choose to betray. this dynamic often plays out in real-world markets, where understanding the balance between competition and cooperation can lead to optimal outcomes that are mutually beneficial.
Cryptoeconomics combines game theory, economics, and cryptography to understand the incentive models underlying distributed blockchain protocols. A game-theoretic understanding of rational nodes interacting within a network improves the security and sustainability of distributed peer-to-peer systems.
Since the blockchain is a distributed synchronized database containing validated blocks (i.e. transactions), miners must come to a consensus on which block to validate. In the case of bitcoin, the validation of each new block is done by miners solving a computationally difficult problem. this is called a proof-of-work puzzle.
Consensus algorithms, such as proof-of-work, rely on game theory to support trustless cooperation. In a competitive mining environment where solving puzzles is resource-intensive, game theory tells us that rational actors have incentives to act honestly so as not to risk losing their investment.
Bad faith actors have no incentive to cheat, i.e. accept invalid transactions or ‘double spend’, as the consequence would normally involve a loss of resources.
Because of this, we can see mining as a repeated prisoner’s dilemma in which each node employs a strategy that aims to maximize its payout without taking into account the strategy of other players. Distributed networks encourage cooperation between nodes without relying on trust between players. it is the players who act in such a way to maximize their winnings that guarantees the stability and security of the network.
further reading: proof-of-work vs. proof-of-stake
In the proof-of-work consensus model, we see that distributed databases are based on the behavioral interactions of rational decision makers. that is, game theory enables platform security and trustless consensus protocols.
It is worth noting that a robust and resilient blockchain depends on its protocol and the number of nodes using the network. the more a distributed network grows, the more resistant it is to attacks.
Game theory allows us to understand the incentivization of consensus models and build attack-resistant decentralized systems. By analyzing strategic interactions, we can create a distributed game that: 1) incentivizes players toward desired outcomes; and 2) design a trust system based on code instead of human mediation.
We are approaching a future where blockchain technology and cryptocurrencies shape our everyday interactions at scale. a key element in the construction of that future is the underlying dynamics of game theory. game theory and cryptoeconomics as a field are in their infancy and there is still a lot of room for contribution in a variety of disciplines.
Blockchain and cryptocurrency are redefining our understanding of economic incentives and the way humans interact. With game theory as a strategic map, we will see how the social function of these technologies continues to grow.
further reading: blockchain: a social perspective