Game theory is fundamental to the development of cryptocurrencies, and is one of the reasons Bitcoin has thrived for over a decade despite numerous attempts to disrupt the network.
What is Game Theory?
Essentially, game theory is a method of applied mathematics that is 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 to the influence of other players.
The original concept was developed in economics to study the behavior of businesses, markets, and consumers, but is now widely applied in the field of education. Therefore, game theory models can be used as a tool to study the potential behavior of interacting agents, and the possible outcomes of their actions, in predetermined circumstances. The 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 a game theory model. The dilemma illustrates a scenario where two criminals (A and B) are being interrogated after being arrested. Each criminal is interrogated in a separate room and is not allowed to communicate with the other.
The prosecutor tries to convince the criminals to testify against each other to make their conviction easier. If A testifies against B, he is released and B is jailed for 3 years (and vice versa). However, if they both testify and testify against each other, they will both be jailed for 2 years. Finally, if A and B decide not to testify, they will only be sentenced to one year in prison, due to lack of evidence.
Therefore, we have the following possible results (based on their individual decision):
Clearly, the best case scenario for A (or B) is to testify and go free, but that would require the other to remain silent, and there is no way to predict what the other will decide. In the face of a reward, many rational prisoners would probably choose to act in their self-interest and betray the other. But if B and A testify, they will remain in prison for 2 years, and that is not the best outcome. So the best option for them as a couple would be to remain silent and only get 1 year instead of 2.
The Prisoner's Dilemma has many different variations, but this simple story illustrates the idea of using a game theory model to explore human behavior and possible outcomes based on their rational decision making process.
Game Theory and Cryptocurrencies
When applied to cryptocurrencies, game theory models play an important role during the development of a secure and trustless economic system such as Bitcoin. The creation of Bitcoin as a Byzantine Fault Tolerance (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 basically studies the economics of blockchain protocols and the possible potential consequences that the design of these protocols may present as a result of participant behavior. It also looks at the behavior of “external agents” who are not actually part of the ecosystem, but may end up joining the network only to try to disrupt it from within.
In other words, cryptoeconomics studies the behavior of network nodes based on the incentives provided by the protocol, taking into account the most rational and probable decisions.
Since the Bitcoin blockchain is designed as a distributed system with many nodes distributed across different locations, it must rely on the agreement of these nodes to verify (validate) transactions and blocks. However, these nodes cannot trust each other. So how can such a system avoid malicious activity? How can a blockchain prevent fraudulent nodes from disrupting it?
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 PoW-based architecture of the cryptocurrency incentivizes mining nodes to act honestly (so they do not risk losing their invested resources). On the contrary, any malicious activity is discouraged and quickly punished. Mining nodes that behave dishonestly are likely to lose a lot of money and be kicked from the network. Therefore, the most likely and rational decision a miner should make is to act honestly and ensure the security of the blockchain.
Conclusion
A common application of game theory is to model and study how people behave and make decisions based on their rational thinking. Therefore, game theory models should always be considered when designing distributed systems such as cryptocurrencies.
With 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. The same is true for other cryptocurrencies, and game theory concepts also apply to PoS blockchains. The main difference here is how the Proof of Stake blockchain processes transactions and validates blocks.
Keep in mind that the degree of security and fault tolerance that a blockchain has depends on its protocol and is directly related to the number of network participants. Large distributed networks are more reliable than small ones.