Basics the Game Theory in Cryptoeconomics

Basics of game theory

The game theory is one of the major models used in defining modern economic activities. When creating systems for organization, it is usually to structure social interactions that lead to social order and desirable outcomes. For this to be realized, there is a need for a framework for mentally approaching system design for humans. We all want to win in everything we do, and one way of doing this is through understanding human behavior, especially when it comes to the decision-making process.

Economists have been trying to approach this matter using different means. And over the past few decades, they have managed to assemble the arsenal of tools necessary for handling this issue. Today, different mathematical and theoretical approaches help us predict how people will act under certain circumstances. In making economic decisions, information is one of the main pillars that construct a good idea. With information, one can easily tell where to invest and where not to invest when looking to reap maximum profits. When, for instance, a company wishes to open a new branch in another region, they will need to first make a background check of the area by researching different consumption needs. If the market is good, they will go ahead and invest, and when things don't look very promising, they will move on to another area.

We all must make decisions in our daily lives. It is part of being human. The decisions that individual households make do not have much impact on the economy, but when many households refuse to consume a certain product simultaneously, it will have a huge impact on the market that produce it. In other words, the decisions of many individuals or firms always affect the real economy. For instance, if one rice farmer in a remote village in Indonesia changes the price of a kilo of rice, it will not impact the economy. However, if all villages from different parts of the country decide to raise the prices at once, it will greatly impact the general supply across the region.

But how do people make these decisions? And most importantly, how can one take advantage of this knowledge to help them make more informed decisions? This is where game theory can be very instrumental.

Game theory is simply the science of logical decision making in humans, animals, and computers. As a science, it seeks to answer some of the most important questions concerning how people make certain decisions under specific conditions. It has been used with different aspects of human life.

In public policy, game theory is applied when trying to predict how nations will act and react. In war, it has been used to predict the moves of the enemy. It has also been used in cryptography to predict potential cyberattacks. Game theory has also been applied in toke design to predict the possible actions of token holders as they respond to embedded incentives. Financial markets have not been left behind in applying game theory as it has been instrumental in predicting stock market decisions.

In simple terms, game theory has become a great asset in economic activities that lead to growth and development to major economies. All the prediction that comes from it results from human tendency to maximize benefits and minimize losses, hence are calculatable. Human beings are rational decision-makers, which explains why they will go for anything that proves a more profitable outcome than losses.

It is all about knowing how 'players' will act, or the next step they are most likely going to take, leading to the results of the 'game.' The outcome result is called the Dominant Strategy, which is used in predicting the player's decision.

How is the game theory used?

The best way is to understand how the game works, in which case, at all begins by specifying the players – as in prisoners dilemma, which has two prisoners, nuclear warfare, which involves two nations and labor relations which have worker and firm. And then we have to specify their strategies and the payoff.

In an example of nuclear warfare, the game theory can be arranged using the US and SU; strategy A is to attach and strategy B not to attach. The payoffs or {(A, A) (-1, -1)}, {(A, B) (4,0)}, {(B, A) (0,4)} and {(B, B) (2,2)}. This is the first step, which is specifying the players, strategies, and payoffs. This section is followed by creating a normal form game.

When using the game theory in academic literature, you will find players often abbreviated to i, strategy as s, and the payoffs to u.   One way of explaining the events in the game is: In any strategy profiles, each player receives a payoff ui(s), which relies on the entire vectors of the strategies within that profile.

Note also, that the payoff may be other different things. This many mean the satisfaction or the utility of an individual too, or perhaps a momentary reward that he/she receives. The reward may also be the expected value of monetary reward or utility under uncertainty.

The Nash Equilibrium

Now, if we want to predict the game's outcome, as the contact between the US and SU, above, the Nash Equilibrium of the game is necessary. This is an outcome where each player has no incentive to alter its behavior, considering the actions of each other participants in the game.

Consider this figure, noting that the rewards are arranged with the US coming first. We can use this to predict Nash's Equilibrium, in a simpler manner using different approaches as follows:

- Look on at the US's payoff if they attack, where we see -1 and 0. 0 is better, we draw a line under 0.

- The focus of the payoff of the US where they don't attach. Here we find 4, and 2.4, and highlight 4.

- We then move on a focus on the results of the SU if the attack. We find -1, and 0.0 (which is better, and highlight 0.

- Now focus on payoff when SU doesn't attach. There is also 4, and 2.4 is better; hence we highlight 4.

In this game, the dominant strategies are to attack, don't attach, or don't attack, attach. This example can be used in making real-life predictions in cryptocurrency.

Games classification

Another crucial aspect of understanding game theory is classifying games. This where we have to look at the following:

- Exposure to information. Does the player have full or equal information? In this case, we consider perfect and imperfect information. Imperfect information is present when the game has either external uncertainty or strategy uncertainty, and perfect information exists where there are no uncertainties. There is also incomplete information, where one player knows more than the other, and incomplete information where players have full or equal information.

- The players' interest. Are the players' interests in total conflict, or is there aa common line? One way to look at this is considering basic games – some games are considered a pure conflict, and others are pure common interest. For instance, traffic jam is an example of common interest since they seem to affect everyone in the same way. On the other hand, interactions like settling on the price of a good to be exchanged are considered a conflict. The tragedy of commons features here, where some game has both conflict and common interest. It is a common issue where one's Nash Equilibrium overwhelms the supply, and any attempt to consume and additional unit negatively affects the other. This happens when specific resources are set free to player of the game, which may lead to overfishing, air pollution, traffic on public roads, and many others.

The game theory has become an important model when looking for the best outcomes in people. In the world of cryptocurrency, this is not different.

Game theory and cryptoeconomics

Cryptoeconomics is an emerging aspect of economic coordination games in P2P networks secured by cryptography. This term was commonly linked to the developer of the community. Vlad Zamfir was the first to cite this subject in 2015, and his work was loosely formalized blogs that talk about Vitalik Buterin, and the academic community. However, the term has remained under-defined over the years, may be because it is applied under different contexts. In this section, we will not go into the details of describing cryptoeconomics due to the complexity that comes with it. Instead, we try to look at how the game theory has been used in economics’ trending field.

Cryptocurrency game theory

Cryptocurrency is one of the greatest innovations of the 21st century. It has taken traction across the globe, boosting the economy in various ways. It all began with the discovery of blockchain technology, which has become a big breakthrough today. Understanding this technology's impact requires one to look at the real world and how fiat currency is maintained and stored. Your money always ends up stored in a centralized place – the bank. This has been the most effective way of storing money, yet one with many issues. For instance, you give your money to a third party, which exposes it to a high risk of compromise following a variety of reasons, one of them being high transaction costs and lack of anonymity. Blockchain is completely decentralized and corruption-free internally. It achieves this by incorporating cryptography and game theory.

Before understanding this concept, it is prudent to go through some basics. We have already seen what the game theory is and how to use it. You also need to know what market structure is. Market structures are different based on several factors, including how many producers they have, control over prices, and entry barriers. There are four different types of market structures:

- Perfect competition. This is a market that has perfect information, and it is easy for anyone to enter. Individua sellers of firms don't have any power over the price of the price. A perfect market is also defined by perfect information. Think about mangoes; for instance, you only need to grow some to get into the market. And everyone knows the price of mangoes, selling them higher or lower only hurts your business.

- Monopoly. This is the exact opposite of perfect markets. The market is dominated by one firm and has high barriers to entry.

- This market has a lot of sellers, and barriers to entry are very low. The products may be similar, but they are not identical. A good example of a pizza delivery service. One service may have a slightly higher price than the other.

- Oligopoly. These are markets that are few, and entry barriers are high. Consider the Smartphone market, for instance. Like Samsung, Apple, and Huawei, there are just a few companies that dominate the market. The products are similar, but not identical. These companies cannot compete by changing prices, even though they are price makers. They use 'non-price' competition, where they change their products' style and look, offering a unique experience. They also advertise well to get the attention of many buyers.

Its competitions where various factors limit price-makers, producers add features to their products before increasing price. But then, buyers will only head over to the competition. So how can a firm advertise their products without losing customers? The Game Theory.

In blockchain and cryptocurrency, game theory has become a common application. Note that a block is a series of blocks which carry individual transactions, and each block has the hash of the previous one, linking them together.

Every block contains a scoring function: genesis block=0, block= parent block + proof of work. In the current state of the chain is the block with the highest reward. In a bitcoin blockchain, there are two players; users and miners. Users have two functions; send coins and receive coins, which they do use public and private keys.

Miners find bitcoin through the mining process. And in this case, they can cheat through different means, e.g., mining on top of invalid blocks to gain more BTC. Fortunately, the system has been designed with the game theory in mind to ensure such transactions are avoided. The game theory is also used to predict the decision of cryptocurrency holders.

Author: James Hamilton