Game theory is fundamental to the development of cryptocurrencies and is one of the reasons why Bitcoin was able to prosper for more than a decade, despite all attempts to destroy its network.
What is Game Theory?
Essentially, game theory is an applied mathematics method used to study human behavior based on decisions made rationally. The “game” is designed as an interactive environment, so players tend to act rationally when responding to the rules of the game or the influence of other participants.
The concept was originally created in economics to investigate behavioral patterns in business, markets and consumers, but is now extensively applied in other fields of study. Therefore, theoretical games can be used as a tool to examine the potential behavior of interacting agents, and the possible outcomes of their actions, under certain circumstances. The models are also applied in wide-ranging studies of politics, psychology, and philosophy.
The Prisoner's Dilemma
The prisoner's dilemma is the most popular example of the game theory model. It illustrates a scenario where 2 criminals (A and B) are being interrogated after being arrested. Each is interrogated in separate rooms and is not allowed to interact with each other.
The prosecutor tries to convince each criminal to testify against his partner in order to reduce their sentences. If A testifies against B, he goes free and B goes to prison for 3 years (and vice versa). However, if both testify against each other, they will be imprisoned for 2 years each. Finally, if they decide not to confess and remain silent, they are sentenced to 1 year in prison due to lack of evidence.
Therefore, we would have the possible results (based on each person's individual decisions):
Clearly, the best scenario for A (or B) is to cheat on their partner and be released, but this requires one of them to remain silent and there is no way to predict what decision the other would make. When faced with an advantageous reward, many rational prisoners would likely choose to act in their own self-interest and betray their partner. But if they both committed treason, they would spend two years in prison and that is not the best option. So, the best solution for both of them, as a pair, would be to remain silent and only get 1 year in prison instead of 2.
The prisoners' dilemma has many variations, but this simple story illustrates the idea of using game theory to investigate human behavior and possible outcomes based on their decision-making processes.
Game Theory and Cryptocurrencies
When applied to cryptocurrencies, the game theory model has an important role in being used to develop a safe and reliable economic system, such as Bitcoin. The creation of it as a Byzantine Fault Tolerance (BFT) system is the result of a harmonious mix between cryptography and game theory.
The use of game theory in the context of cryptocurrencies gave rise to the concept of cryptoeconomics, which is basically the study of the economy in Blockchain protocols and the potential consequences that the design of these protocols can present – as a result of the behavior of their participants. It also considers the way of acting of “external agents” who are not part of the ecosystem, but may eventually enter the network just to try to cause internal damage.
In other words, cryptoeconomics examines the behavior of nodes in a network, based on the incentives provided by the protocol, considering the most probable and rational decisions.
Since the Bitcoin Blockchain is designed as a distributed system – with multiple nodes in different locations – it needs to rely on the agreement of these nodes when it comes to validating new blocks and transactions. However, these nodes are not able to trust each other. So how can such a system prevent malicious activities? How can a Blockchain protect itself from rogue nodes?
One of the most important features of the Bitcoin network that protects the system from malicious activities is the Proof of Work (PoW) consensus algorithm. It applies cryptographic techniques that make the mining process very expensive and demanding, creating a very competitive environment. Therefore, the architecture of PoW-based cryptocurrencies encourages miners to act honestly (so that they do not risk losing the resources invested). In contrast, any malicious activity is discouraged and quickly punished. Mining nodes that exhibit malicious behavior will likely lose a lot of money and be kicked out of the network. Consequently, the most likely and rational decision to be made by a miner is to act honestly and keep the network secure.
Conclusion
The common application of game theory is to model and examine how human beings behave and make decisions based on their rational minds. Therefore, game theory models should always be considered when designing distributed network systems, as is usual in most cryptocurrencies.
Thanks to a balanced combination of cryptography and game theory, the PoW consensus algorithm was able to make the Bitcoin Blockchain a decentralized system, being highly resistant to attacks. The same goes for other cryptocurrencies, remembering that the concept of game theory can also be applied to Blockchain networks that use the Proof of Stake (PoS) consensus algorithm. The main difference between the two is the way PoS-based networks organize their transactions and block validations.
Keep in mind, however, that the level of security and trust that a Blockchain has depends largely on its protocol and is directly related to the number of participants in it. Large distributed networks are more reliable than smaller ones.
