Game Theory and Cryptocurrency

Game theory is the study of mathematical models of strategic interaction among rational decision-makers. It has applications in cryptocurrency as well.

To explore game theory in cryptocurrency we must talk about fiat currency first — the money declared by the Reserve Bank of India or any Central or Federal Bank as the legal tender, like INR or USD. How is our money maintained and stored? No matter who you are or how much money you have, your money is going to be stored in a centralised location i.e. a bank. The problem with the system is that you’re giving money to a financial institution and like every other, it is at the risk of being compromised because of the simple fact that it is run by human beings and human beings are corruptible. The blockchain was developed as a solution to this problem by being completely decentralised and internally corruption-free. This was achieved by using cryptography and game theory.

A lot of us must remember the movie ‘A Beautiful Mind’ starring Russell Crowe. The character he plays in the film, John Nash, was the American mathematician who was foundational to fleshing out some important ideas within game theory in 1950. Game theory is the study of mathematical models of strategic interaction among rational decision-makers. It has applications wherever human beings collaborate — fields of social science, logic, systems science, computer science and especially blockchain, as it operates on a peer-to-peer network. It is fundamental to the development of cryptocurrency and one of the reasons why it has managed to survive over a decade, despite attempts to break into the network.

Let’s take an example. Pritish goes to his grocer every morning to buy a packet of milk. While he waits for the shopkeeper to find the desired commodity, he can easily slip in a couple of bananas from the table with no one looking. But Pritish won’t do that, since the result of being caught stealing would be much greater than the cost of two bananas. This is a simple instance, but a similar principle is applied to economics to predict human behaviour and ensure a system with incentives and disincentives in place to discourage people from straying from the ethical course.

Miners on the blockchain have power in the system and if they choose to cheat, they can wreak havoc on the system. The way to mitigate the risks is by having punishments in place for misbehaviour. If you break a rule within the algorithm’s systems, there are consequences that far outweigh the gain.

For example, if a miner decides to attempt to tamper with a hash or double-spend a transaction, the block will become “orphaned”, or left out of the blockchain. If a miner attempts to do this, they will also end up devaluing their mining investment. They lose their mined Bitcoins and are denied the reward for completing transactions. And as such, the most probable and rational decision to make for a miner would be to act honestly and keep their blockchain secure. This is the essence of game theory.

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