Game Theory For Cryptocurrency

To understand how game theory works within the sphere of Cryptocurrency we need to get through the basics first. To know more about game theory and how it’s used in cryptoeconomics keep reading on.

Let’s first get a feel for Game theory. It is essentially the study of logical decision making made by players within the clear parameters of a classification (game, scenario, etc). It uses mathematical models and can be applied to economics, psychology, logic, computer science, distributed systems, and more. Game theory can be seen as a microcosm of human behaviour under set conditions wherein certain inducement structures and mechanisms can lead to predictable and honest behaviour by players.

In a archetypal game theory scenario, there are 3 primary components: Players, Strategies, Outcomes.

Players are the users that make decisions. Strategies are the manoeuvres that players make while simultaneously taking into account possible strategies of other players. The conclusions are the result of the players’ moves inside the system, and with the right incentive mechanisms, can be motivated to a certain route or played out recurrently with similar results.

Game Theory in Cryptocurrencies

Cryptoeconomics can be well-defined as the amalgamation of cryptography, economics, and game theory incentive models merged into distributed blockchain protocols in order to create a secure, stable, and sustainable system.

It is a very new concept, but when you really dig deep into the functionality of cryptocurrency platforms, you will see how important it is to justifying malevolent actors and endorsing honest, trust less behaviour across the network.

The best example to understand the role of game theory and cryptoeconomics in cryptocurrency platforms is Bitcoin. In order for dispersed blockchain networks like Bitcoin to remain secure and have the ability to reach the essential consensus on the blockchain, they need to remain Byzantine Fault Tolerant.

For the system to remain Byzantine Fault Tolerant, the decentralized nodes have to come to a majority agreement on the current state of the blockchain without trusting each other. This is very difficult to accomplish and is outside of the scope of the employed cryptography, which is used to cryptographically link each block of the blockchain, not determine whether the transactions contained within the blocks are valid or which of 2 competing chains is the valid one.

Bitcoin solves this problem through its Proof-of-Work consensus model. The model works where miners need to solve computationally intensive mathematical problems in order to win the reward for mining the next block.

This solution needs to be verified by the other miners and the inherent cost of the process is electricity, a real-world asset with a financial value. The resulting chain becomes secure and very costly to manipulate or attack. The larger and more decentralized the network becomes, the increased difficulty in accomplishing an internal or external attack.

Incentive structures predicated on game theory mechanisms come into play in order to encourage the players (users and miners) in the system to act honestly. Additionally, some abstract concepts within game theory work subtly in the background.

Starting with miners, the obvious economic incentive stems from the block reward if they solve the next round of mining for the next block. The reward in Bitcoin is currently 12.5 BTC. This is important because since the miners are receiving the reward in Bitcoin, it is in their best interest for the value of Bitcoin to increase and the network to remain valid and secure.

They actively spend resources (electricity) to have a chance to win the block and thus, their efforts will be a sunk cost if they use malicious actions to attack the network and jeopardize the value of the reward. It becomes increasingly more costly to act dishonestly than it does to act honestly within the system. This creates a positive feedback loop where miners have a consistent positive incentive to maintain the valid blockchain and mitigate against malicious actors, resulting in a secure network.

Miners can act malevolently in a number of ways, counting adding invalid transactions into blocks or mining on top of invalid blocks to gain more BTC. However, this is where game theory mechanics come to the rescue. Invalid blocks will be rejected by the majority of miners in a coordination game format where it is in the best interest financially of miners to remain with the majority and not attempt to create invalid blocks due to the inherent and increasing cost associated with doing so.

The resulting conclusion from this is that the Bitcoin blockchain is constantly in a self-reinforcing Nash Equilibrium state. The system is Byzantine Fault Tolerant due to the majority of miners working in coordination to achieve and maintain the most stable state of the network at all times.

With regards to users, their preference for the longest chain (and the most secure) is a result of a concept known as Bounded Rationality. Essentially, users are acquainted with the main chain and switching chains creates unnecessary complications. Maybe reckless, but most users assume that incentive devices are working correctly to keep miners’ power in check.

Game theory dynamics in cryptocurrencies will endure to develop and should become one of the most captivating concepts within the industry. Their role in security, rationality, and viability cannot be modest and their eventual success or demise within decentralized networks will unfold in real-time as novel platforms go live and incorporate larger numbers of users.

The field of crypto economics is just commencement, with insinuations not solely referred to cryptocurrency platforms, but to the larger progress of game theory process themselves.