The Game Theory Behind Bitcoin And Cryptocurrencies, Explained

Key Takeaways

• Game Theory helps understand choices in markets and Bitcoin’s role in strategic decision-making.
• Prisoner’s dilemma, or betrayal is a classic game theory scenario revealing self-interest vs. cooperation dynamics, relevant to Bitcoin.
• Pure Coordination unlike betrayal ensures mutual benefit and network integrity.
• Bitcoin’s status as a recognized, trusted cryptocurrency shapes its dominance and value and gives it its Schelling point.

What Is Game Theory?

Game Theory seeks to understand how individuals or entities make choices when their outcomes depend not only on their own decisions but also on the decisions of others. This theory helps with understanding price movements in markets, strategic decision-making in business and the psychology surrounding being an active participant or sitting on the sidelines.  

In this article, we delve into the game theory principles intertwined with Bitcoin and crypto, shedding light on concepts like Pure Coordination, Schelling Points, Network Effects, and the intriguing dynamics of a decentralized financial world.

Introduction Into The Prisoner’s Dilemma

Game theory cannot be explained without first understanding and delving into the prisoner’s dilemma. This hypothetical situation is called “ Prisoner’s Dilemma’ because it makes reference to the situation where two suspects are arrested for a crime and interrogated. 

Even though there’s enough evidence to convict both of the captives with a lesser charge, the police don’t have sufficient evidence to convict either on the primary charge without a confession.

This results in a classic game theory scenario where two individuals face a choice being to cooperate with the police force or betray the other criminal in fear that they will be betrayed in an effort to get a better sentence for themselves. As a result, the following matrix of options presents itself.

The outcomes vary as follows: 

• One year sentence: If both prisoners stay silent and cooperate with each other, they both benefit by getting a one year sentence. 
• One prisoner goes free and the other serves three years: If prisoner A betrays prisoner B while the other cooperates, the betrayer gets let free and prisoner B gets three years in jail for remaining silent and vice versa.
• Both prisoners serve two years: If both prisoner A and prisoner B betray each other, they both suffer a two year sentence. 

In the Prisoner’s Dilemma, the Nash equilibrium, which is the term given to the predictable outcome, occurs when both criminals choose to betray. This is because, given the payoff structure of the dilemma, betraying is always the dominant strategy for each individual, regardless of what the other player does.

To understand why, let’s break down the choices for one prisoner (Prisoner A) based on what they think the other prisoner (Prisoner B) might do:

• If Prisoner A thinks Prisoner B will cooperate (stay silent): A’s best move is to betray. By doing so, A goes free (0 years) while if A were to cooperate, they would both get short sentences (e.g., 1 year).
• If Prisoner A thinks Prisoner B will betray (confess): A’s best move is still to betray. By doing so, they both serve medium-length sentences (e.g., 2 years). If A were to cooperate while B betrays, A would get the longest sentence (e.g., 3 years).

Real World Analysis And Application Of The Prisoner’s Dilemma

Analysts believe that in the real world, one cannot rely on implicit trust or cooperation but only competition. Therefore, both prisoners will likely betray each other because that will ensure that they do not get a prison term of three years. By betraying the other, they have some chance of either getting released from prison or serving two years in prison.

Had they chosen the route of staying silent, they would have each served only one year in prison. However, in a world of competition this strategy is inherently risky.

The above scenario illustrates the tension between self-interest and collective benefit in the decision-making process of rational individuals, pursuing self-interest, often making choices that lead to suboptimal outcomes when cooperation is required for the best outcome.

Understanding Pure Coordination Concept And How It Varies Compared To The Prisoner’s Dilemma

Pure coordination is a concept that represents situations where individuals or entities seek to align their actions and choices to achieve a common goal without any conflicting interests or risks of betrayal. Unlike the prisoner’s dilemma, where the likely scenario is to betray one another to seek an advantageous result for the self. 

In pure coordination scenarios, all participants have a shared interest in cooperating, as it leads to the best outcome for everyone involved. This concept is often used in game theory to describe situations where cooperation and consensus are highly beneficial and where participants can trust each other to act in harmony to achieve a desired outcome. 

In the context of Bitcoin, pure coordination is essential for maintaining network security and integrity, as all participants must follow the same rules and validate transactions consistently to ensure the cryptocurrency’s reliable operation. It is also in the interest of all holders of Bitcoin to hold the coin at advantageous moments to see price appreciation because the Bitcoin blockchains underlying technology is scarce in nature which drives the price of the asset upwards over time.

What Are Schelling Points And How They Link To Value Communication

Schelling Points, or focal points, play an important role in Bitcoin’s value communication. Named after Thomas Schelling, a schelling point is a natural solution in situations where multiple parties must make decisions without direct communication. These solutions are intuitively obvious, often relying on shared expectations or common knowledge.

A prime real-world example of a Schelling point in the US is the practice of driving on the right-hand side of the road, in contrast to the left-hand side. This convention acts as a Schelling point due to its widespread recognition in the US and establishment, ensuring smooth traffic flow and reducing accidents. While there isn’t an inherently “correct” side to drive on, adhering to one consistent convention there is inherent value that can be taken to ensure traffic safety and coordination. 

The value communication hence refers to the process of conveying or expressing values, beliefs, or principles to others. Bitcoin’s value communication may refer to the way users and participants in the network communicate the value of the cryptocurrency. This can include discussions about its potential as a store of value, medium of exchange, or investment. Its protocol serves to benefit users when compared to the current financial system in place.

How Can Bitcoin Be Considered A Schelling Point? 

Bitcoin can be considered a Schelling point in the world of cryptocurrencies and digital assets for several reasons due to its fundamentals:

• Recognition and establishment: Bitcoin is the first cryptocurrency and has gained widespread recognition and establishment in the world of digital finance. It serves as a reference point for many people when they think of cryptocurrencies.
• Network effects: Bitcoin has a large and growing user base, contributing to its increasing network effect. The more people use Bitcoin, the more valuable it becomes, making it a natural focal point for individuals entering the cryptocurrency space.
• Market dominance: Bitcoin has consistently held the largest market capitalization among all cryptocurrencies. Its dominant position in terms of market share and value makes it a clear Schelling point for investors and traders.
• Decentralization and security: Bitcoin’s decentralized nature and robust security measures have established it as a trustworthy and reliable digital asset. Many users consider it a safe store of value and a medium of exchange.
• Liquidity: Bitcoin is highly liquid, meaning it can be easily bought, sold, and traded on various cryptocurrency exchanges. Its liquidity further reinforces its role as a Schelling point for individuals looking to enter the cryptocurrency market.
• Media attention: Bitcoin has received significant media coverage over the years, contributing to its recognition and establishment as a Schelling point in the cryptocurrency world. It often serves as the reference point in discussions about cryptocurrencies.
• Brand recognition: Bitcoin’s name and brand are widely known, making it the default choice for those seeking to invest in or use cryptocurrencies.

Overall, Bitcoin’s early adoption, network effects, market dominance, trustworthiness, and brand recognition have collectively established it as a prominent and widely recognized Schelling point in the world of cryptocurrencies. This status makes it a natural choice for individuals and institutions entering the cryptocurrency space, contributing to its continued success and influence.

Understanding The Game Theory Behind Bitcoin’s Shelling Point Narrative

Bitcoin’s role as a Schelling point is closely linked to concepts from game theory and pure coordination, and understanding this connection sheds light on how Bitcoin has gained prominence and trust within the cryptocurrency ecosystem over the last fourteen years.

Game Theory Behind Bitcoin Being A Schelling Point

Bitcoin is a prime example of a coordination game within the cryptocurrency space. Participants recognize that adopting Bitcoin as a common medium of exchange and store of value leads to a network effect where everyone benefits. This recognition makes Bitcoin a Schelling point because it’s the natural choice for individuals entering the cryptocurrency ecosystem due to its widespread acceptance.

In game theory, a Nash equilibrium is a situation where no player has an incentive to unilaterally change their strategy, given the strategies chosen by others. Bitcoin’s status as a Schelling point creates a Nash equilibrium where users and investors are inclined to hold and transact in Bitcoin because it is widely adopted. Switching to an alternative cryptocurrency, in most cases, would not improve their outcomes. This equilibrium reinforces Bitcoin’s dominance.

Bitcoin Pure Coordination Narrative

In the context of Bitcoin, the cryptocurrency community shares a common interest in believing in Bitcoins trajectory and its success as a decentralized, secure, and reliable digital asset. This shared interest drives users, miners, and developers to coordinate their actions to maintain the network’s integrity, security, and value.

The pure coordination relies on trust among participants, and Bitcoin’s design emphasizes the importance of this trust. Participants trust the system because they share the goal of maintaining the integrity and value of Bitcoin. This trust is reinforced by the decentralized nature of the network, the predictability of its monetary policy, and its robust security measures. 

Case Study: Bitcoin (BTC) Vs Bitcoin Cash (BCH) Game Theory 

In 2017, the Bitcoin community faced a decision surrounding how to address scalability issues. This situation touched on the concepts of Schelling points, pure coordination, and game theory in the world of cryptocurrencies as stakeholders had to pick a side to follow.

Schelling Point

In this case, a natural solution in situations where multiple parties must make decisions without direct communication was required whereby stakeholders namely, miners, developers and participants chose between two solutions for Bitcoin’s scalability:

• Big block solution: Advocated for increasing block sizes to reduce transaction fees which would be the Bitcoin Cash way.
• Segregated witness (SegWit): Proposed a different solution to enhance scalability without altering block sizes which meant stakeholders decided against the big block increase and advocated a Bitcoin soft fork.

Pure Coordination And Game Theory

The game theory aspect of this hard fork of Bitcoin resembled a coordination game, like the famous Prisoner’s Dilemma:

• Cooperation: If all players agreed on one solution, either to adjust the layer 1 protocol and introduce big blocks or to soft fork the protocol with SegWit, then the chain would remain united and strong, which in this case was Bitcoin. 
• Defection (Fork): If one group supported a hard fork to create Bitcoin Cash (BCH), they could pursue their preferred solution.

Incentives And Actions

• Mining incentives: Miners, driven by economic interests, were pivotal. They supported the chain they believed would be more profitable and that was Bitcoin.
• User and market sentiment: The broader community influenced the outcome through their preferences and support and in this case they also supported BTC and not BCH. 

The Outcome

In August 2017, the hard fork occurred, leading to the creation of Bitcoin Cash (BCH). Advocates of larger blocks chose to defect to BCH to pursue their vision of scalability. The Nash equilibrium of the hard fork was for stakeholders to inevitably continue to see Bitcoin as a protocol for money due to its many characteristics and hence classified it as the focal point or the Schelling point. 

How The Schelling Point Ties To The Lindy Effect And Sunken Costs

The Lindy effect and the concept of sunk costs are intertwined in the context of technology and communication protocols. The Lindy effect suggests that the longer a technology or protocol has been in existence, the longer its future life expectancy is likely to be. This idea relates to the notion that as a technology ages and accumulates a track record, it becomes more resilient and entrenched.

The Lindy effect suggests that the longer Bitcoin remains in existence the greater society’s confidence that it will continue to exist long into the future. The median age of a human is thirty years old, which means Bitcoin has been around for nearly 30% of the average human life. If Bitcoin exists for 20 years, there will be near-universal confidence that it will be available forever, much as people believe the Internet is a permanent feature of the modern world. 

Incorporating the idea of sunken costs into this framework, individuals may understand how the Lindy effect reinforces Bitcoins dominance as a resilient network with a future. As participants invest time, effort, and resources into a specific technology or protocol over an extended period, these become sunk costs, essentially costs that cannot be recovered if they switch to an alternative. One of the most visually appealing charts that summarizes the energy put into Bitcoin to date is the hashrate which has grown steadily throughout the course of Bitcoins life.

In the context of changing or switching away from Bitcoin, there can be several types of sunken costs:

• Investment costs: These are the expenses associated with acquiring and holding Bitcoin. They include the initial purchase price of Bitcoin, transaction fees, and any costs incurred in securing and managing your Bitcoin holdings, such as hardware wallets or security measures.
• Learning costs: Learning about Bitcoin, its technology, and how to use it effectively requires time and effort. People invest time in understanding the technology, its potential, and how to navigate the cryptocurrency space.
• Network effects: Bitcoin’s value is partly driven by its network effects—the more people and businesses that use it, the more valuable it becomes. If you’ve invested in building relationships within the Bitcoin community or integrated Bitcoin into your business, changing to a different cryptocurrency would entail losing these network benefits.
• Psychological costs: People may have emotional or psychological attachments to Bitcoin. They may have followed its development, become Bitcoin advocates, or have strong beliefs about its potential as “digital gold.” Changing to another cryptocurrency may mean letting go of these beliefs and sentiments.
• Tax implications: Depending on your country’s tax regulations, changing from Bitcoin to another cryptocurrency or asset can have tax consequences. Realizing capital gains or losses may result in tax liabilities that are based on your initial investment.
• Operational costs: If you’re a business that accepts Bitcoin payments, switching to another cryptocurrency may involve changing your payment processing systems, accounting procedures, and even marketing efforts. These changes can be costly in terms of time, resources, and potential disruption to your operations.
• Cultural and community costs: Bitcoin has a distinct culture and community associated with it. Changing to another cryptocurrency means leaving behind this culture and potentially adapting to a new one, which can be challenging and may involve additional learning costs.
• Loss of potential gains: If Bitcoin’s price appreciates significantly after your initial investment, switching away from it means missing out on potential future gains.

Conclusion

The Bitcoin Cash fork showcases how Schelling points, pure coordination, and game theory played out in the cryptocurrency world. Conflicting interests and a lack of consensus led to a split, with rational actors making choices based on their perceived self-interest and the future they envisioned for digital currency. 

This event serves as a lesson in the power of decentralized decision-making in the world of cryptocurrencies, where game theory dynamics can lead to unexpected outcomes. Today, the Lindy effect and sunken costs associated with Bitcoin shape the Schelling point narrative for stakeholders supporting the Bitcoin network.

The world’s game with Bitcoin adoption is multifaceted and dynamic. It involves coordination, trust, regulation, speculation, network effects, development, security, and institutional involvement. The ultimate outcome of this game is still evolving, with Bitcoin’s role in the global financial system continuing to develop and adapt as various stakeholders make strategic decisions based on their interests and expectations. 

As the price of Bitcoin continues to increase along with its widespread adoption, the choice that individuals must make is between being an active or non-active participant in this space or to sit on the sideline completely in case Bitcoin fails. So long as Bitcoin does not fail, its Lindy effect grows and those that choose to participate will benefit as a collective unit and those that sit on the sideline will find it increasingly difficult to create wealth for themselves by holding Bitcoin. 

It seems like the best way to finish this article is to quote Michael Saylor, CEO of Microstrategy, 

“Everybody gets Bitcoin at the price they deserve”.

FAQs

What role does Game Theory play in understanding Bitcoin’s dynamics? 

Game Theory helps us analyze Bitcoin’s market behavior, strategic decisions, and the psychology of participants, shedding light on concepts like Schelling Points and Network Effects.

How does the Prisoner’s Dilemma relate to Bitcoin? 

The Prisoner’s Dilemma illustrates the conflict between self-interest and cooperation, a concept applicable to Bitcoin’s decentralized ecosystem where participants must decide to cooperate with the network or act in their self-interest and choose to not be a part of the network.

What’s the significance of Pure Coordination in the context of Bitcoin? 

Pure Coordination represents harmonious cooperation, a stark contrast to the Prisoner’s Dilemma. In Bitcoin, it’s crucial for network security, consensus, and trust among participants. 

How does Bitcoin function as a Schelling Point in the cryptocurrency world? 

Bitcoin serves as a prominent Schelling Point due to its recognition, network effects, market dominance, decentralization, and liquidity, making it a natural choice for cryptocurrency participants.