Game theory is at the heart of cryptocurrency development and is one of the reasons Bitcoin has thrived for over a decade despite numerous attempts to bring down the network.

What is game theory?

Basically, game theory is a method of applied mathematics used to study human behavior based on rational decision-making. The "game" is designed as an interactive environment, so players tend to act rationally, responding to the rules of the game or the influence of other players.

This concept was originally developed in economics to study the behavior of businesses, markets, and consumers, but today it is widely used in other fields of research. Thus, game theory models can be used as a tool to study the potential behavior of interacting agents and the possible outcomes of their actions under predetermined circumstances. Models can also be applied in the broad study of politics, sociology, psychology and philosophy.

Prisoner's dilemma

The prisoner's dilemma is one of the most popular examples of the game theory model. It illustrates a scenario in which 2 criminals (A and B) are interrogated after being arrested. Each criminal is interrogated in a separate room and cannot communicate with others.

The prosecutor tries to convince the criminals to testify against each other in order to reduce their liability. If criminal A testifies against criminal B, he is released and criminal B is arrested for 3 years (and vice versa). However, if they both betray and testify against each other, they will both be arrested for 2 years. Finally, if criminals A and B choose not to betray and remain silent, they will only be sentenced to 1 year in prison due to lack of sufficient evidence.

So we will have the following possible outcomes (based on their individual solutions):

Of course, the best-case scenario for criminal A (or B) is to betray and be released, but that would require the other's silence, and it's impossible to predict what the other's decision will be. Given the opportunity to break free, many rational prisoners would likely choose to act out of self-interest and betray another. But if both criminal A and criminal B cheat, they will remain in prison for 2 years, which is not the best outcome. Therefore, the best option for them, as a couple, will be to remain silent and receive only 1 year instead of two.

There are many solutions to the prisoner's dilemma, but this simple story illustrates the idea of ​​using game theory models to study human behavior and possible outcomes based on their rational decision-making process.

Game theory and cryptocurrency

In cryptocurrencies, game theory models play an important role in the development of a secure "trustless" economic system such as Bitcoin. The creation of Bitcoin as a Byzantine Fault Tolerant (BFT) system is the result of a harmonious combination of cryptography and game theory.

The use of game theory in the context of cryptocurrencies is what gave birth to the concept of cryptoeconomics, which is largely the study of the economics of blockchain protocols and the potential consequences that the development of these protocols may have as a result of the behavior of its participants. This concept also considers the behavior of external agents who are not actually part of the ecosystem but may eventually join the network only to try to disrupt it from within.

In other words, cryptoeconomics examines the behavior of network nodes based on the incentives provided by the protocol, considering the most rational and probable solutions.

Because the Bitcoin blockchain is designed as a distributed system with many nodes in different locations, it must rely on the agreement of these nodes to verify transactions and blocks. However, in reality these nodes cannot trust each other. So how can such a system avoid malicious activity? How can blockchain prevent disruption by rogue nodes?

One of the most important features of the Bitcoin network that protects it from malicious activity is the Proof of Work consensus algorithm. It uses cryptographic techniques that make the mining process very expensive and demanding, creating a highly competitive mining environment. Therefore, the architecture of cryptocurrencies based on PoW incentivizes mining nodes to act honestly (thanks to this, they do not risk losing invested resources). Conversely, any malicious activity is discouraged and swiftly punished. Mining nodes that exhibit dishonest behavior are likely to lose a lot of money and be banned from the network. Therefore, the most likely and rational decision a miner can make is to act honestly and ensure the security of the blockchain.

Results

A common application of game theory is to model and study how people behave and make decisions based on their rational minds. Therefore, game theory models should always be considered when designing distributed systems such as cryptocurrencies.

Thanks to a balanced combination of cryptography and game theory, the Proof of Work consensus algorithm was able to create the Bitcoin blockchain as a decentralized economic system that is highly resistant to attacks. Likewise with other cryptocurrencies – game theory concepts also apply to PoS blockchains. The main difference here is how the Proof of Stake blockchain processes transactions and verifies blocks.

However, keep in mind that the degree of security and stability of the blockchain depends on its protocol and is directly related to the number of network participants. Large distributed networks are more reliable than smaller ones.