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Game Theory And Its Application in the Cryptomarket

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Game Theory And Its Application in the Cryptomarket
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Game theory is a branch of mathematics that examines one’s behavior in decision-making in certain situations whereby individuals or a certain firm have to communicate with each other. Not long ago, game theory was introduced and applied in the crypto market which is known for its high volatility and unpredictability.

In this article, we will explore what game theory is and how it’s applied in the crypto market. We will also take a look at the history of game theory. Additionally, we will  provide a survey of game theory in the crypto market. By the end of this article, we will be able to understand what game theory is and how investors can make wise decisions in the market.

What Is Game Theory?

As highlighted earlier, game theory is a branch of mathematics that deals with one’s behavior of how he/she will make a decision in a situation where one person’s decision depends on the decisions that others make. It requires a person to consider the decisions that are made by other participants and predict their possible results. Theoretically, this is used in social science, economics, political science and a number of other fields to determine how to make decisions in certain scenarios.

When it comes to cryptocurrencies, game theory models are used in designing a trustless and secured ecosystem. As a result of game theory, a harmonious collaboration between game theory and cryptography created the Byzantine fault tolerant (BFT) system through bitcoin.

For instance the emergence of the cryptoeconomics idea was a result of game theory within the context of cryptocurrencies. But, what is cryptoeconomics? Cryptoeconomics is essentially the examination of the economic aspects of blockchain protocols and the potential consequences arising from the incentives embedded within these agreements. The resulting outcomes are shaped by the behaviors of participants in the system. Additionally, it considers the actions of “independent investment advisors” who might not be intrinsic to the ecosystem, but could potentially disrupt the network upon entering.

In essence, cryptoeconomics governs the behavior of network nodes in response to the incentives provided by the protocol. It delves into understanding the rational and probable choices that participants are likely to make.

What is the History Behind Game Theory? 

Game Theory, as a discipline, originated in 1920. Initially, the focus of the games was on scenarios involving two players where the outcome was winner-takes-all. During the 19th century, these types of games were commonly referred to as zero-sum games. It wasn’t until the 1950s that John Nash further refined and formalized game theory. He introduced the concept of Nash equilibrium, which ultimately earned him a Nobel Prize in Economics for his groundbreaking contributions to the field.

How Does Nash Equilibrium Work?

Prison dilemma. 

Let’s consider an illustrative scenario involving two convicts, Paul and David, placed in solitary confinement without any means of communication. A police officer approaches David, lacking evidence of their joint crime. The prosecutor offers David a choice: betray Paul by confessing to the crime, or remain silent. The same choice is given to Paul. If they both betray each other, they each receive a 6-year sentence. If David betrays Paul and Paul remains silent, David goes free while Paul receives a 12-year sentence. Alternatively, if both remain silent, they each serve a 1-year sentence. This situation highlights the concept of Nash equilibrium in game theory.

Nash equilibrium is a pivotal term in game theory, encompassing various other key elements and notions:

  • Payoffs: These represent the motivations sought by players in the game.
  • Players: Participants who make decisions within the game.
  • Outcome: The result stemming from the collective decisions of the players.
  • Actions: The moves that players take during the game.
  • Strategy: A planned course of action based on potential decisions.
  • Information: The awareness both players have of the available actions.

These elements collectively shape the interactions and decisions within a game, leading to outcomes that form the foundation of game theory analysis, such as the Nash equilibrium in the case of Paul and David’s dilemma.

Application Of Game Theory in the Context of Cryptocurrencies

Game theory plays a significant role in guiding cryptocurrency miners towards making informed decisions in various scenarios. In this article, we delve into the application of the prisoner’s dilemma method in the context of crypto mining. The prisoner’s dilemma provides a framework for miners to choose between self-interest and the collective benefit of the entire network. In the realm of mining, factors such as energy consumption and computational power are crucial considerations. Miners who successfully solve complex mathematical equations are rewarded with new units of cryptocurrency, like Bitcoin (BTC).

In the prisoner’s dilemma scenario, two miners, represented as miner X and miner Y, face a critical decision. Their options are to collaborate or work independently within the mining pool.

If both miners, X and Y, choose to cooperate, they mutually reap the rewards and share the profits evenly, resulting in a positive outcome for both.

Alternatively, if miner X decides to prioritize their own gain and “rat out” miner Y, miner X secures a larger share of the mining profit while miner Y receives a smaller portion – and vice versa.

If both miners opt to betray each other, they each receive diminished shares of the profits, leading to a suboptimal outcome for both parties.

The relevance of game theory extends to the world of cryptocurrencies, offering insights into consensus models and the construction of distributed systems that can effectively fend off cyberattacks from malicious entities. By employing game theory principles, the cryptocurrency community can enhance its understanding of how various decisions impact the ecosystem, leading to the development of robust and secure networks.

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