Bitcoin as a Master Piece: Game Theory and Incentives
Game theory studies the process of strategic interactions between two or more players in a situation where the outcome for each participant depends on the action of all.
In practice, if you are a player in such a game you must take into account the choices of others when contemplating your strategy. Thinking about their choices, you should also be aware that they are thinking about yours.
Game theory is based on the assumption that all participants are rational actors and are trying to maximise their gains from the game.
The study of game theory is characterised by the following elements:
- Game: Any set of circumstances that has a result dependent on the actions of two of more decision-makers (players).
- Players: A strategic decision-maker within the context of the game.
- Strategy: A complete plan of action a player will take given the set of circumstances that might arise within the game.
- Payoff: The payout a player receives from arriving at a particular outcome. The payout can be in any quantifiable form.
- Information set: The information available at a given point in the game. The term information set is most usually applied when the game has a sequential component.
- Equilibrium: The point in a game where both players have made their decisions and an outcome is reached.
Game theory is especially applied in social situations, where there is no black or white. That is because, when interacting with each other, human beings are highly complex. Predicting one behaviour might be as complex as predicting the future, as it is the result of the interaction of their strategies, payoffs and information sets.
Let us have an exemplificatory example, inspired by the movie a Beautiful Mind, the history of John Nash, that significantly contributed to the field of Game Theory and even won a Nobel Price for it:
You are in a bar with your 3 friends and you see 4 girls at the bar counter. One of them is a 10, one of them a 7 and two are 5s. Most likely, all of your friends will focus on the 10, as she is deemed to be the “most beautiful”, the highest payout they can get from the situation. If you go for the 10, you must assume that all of your friends will to, and if all of you go for the 10, she will probably be annoyed and her friends too. The result of your strategy will be a flop and none of you will get a girl. Unless she showed interest to one of your friends, then all the others should leave her alone and focus on the 7 and the two 5s. With this situation, your payoff will be maximised and you would have reached the so-called Nash Equilibrium. That is, a situation when the strategies of all players are consistent and where each one chooses the best response to the choices of others.
What Satoshi Nakamoto, the creator of Bitcoin, did was to find the missing piece of the puzzle: how to ensure that all the actors of a decentralized network behave correctly without trusting each other, an issue that is commonly known as the Byzantine Generals problem.
In simple terms, it is a problem of coordination. The Byzantines are trying to conquer a city, but the attack will only be successful if all generals coordinate and attack together. The problem is how to ensure that all generals will follow the plan, even if they are located in different places and do not trust each other.
How does Bitcoin solve the problem?
The players in the Bitcoin blockchain are the users of the network and the miners that maintain it. Since Bitcoin is a distributed network, the miners are essential for the network to work correctly as they approve and validate transactions and agree on the correct version of the ledger.
In simple words, Bitcoin uses game theory and a system of material incentives to make sure that rational actors behave in a certain manner by aligning their interests. In particular, they been used to influence the interactions and the behaviour of the miners of the network.
First of all, it is important to lay forward that an agreement on the correct version of the ledger within the Bitcoin network is reached using a Proof-of-Work algorithm: miners have to run computationally expensive operations to mine Bitcoins, incurring in significant electric costs. This makes computation expensive, to ensure that miners do not deviate from the rules of the network.
To encourage miners to behave in an honest manner, Bitcoin provides an incentive mechanism, to make sure their self-interest is linked to the network functioning well.
Published at Sat, 06 Jul 2019 05:35:14 +0000
