Public Blockchains as the 3rd Equilibrium Solution to the Prisoner’s dilemma in Economic Trade

This is an important but under-appreciated feature of Bitcoin and ,indeed, many public blockchains. Before we dive into this thesis, let us take a minute to refresh our understanding of what the prisoner’s dilemma represents in the context of economic interaction and cooperation. The prisoner’s dilemma is an important concept in game theory that underlines why two rational individuals may not cooperate with each other despite it seeming to be in their best interests to do so. In its basic design, a prisoner’s dilemma arises when the optimal outcome for each party and overall (that each individually cooperate in good faith) is not achieved because each party individually would be worse off if it cooperated whilst the other party reneged. As neither party can be certain that the other party will cooperate, both decide not to cooperate resulting in both a sub-optimal macro and individual economic outcome. Looking back across millennia of human trade and interaction, there have only ever been two known solutions to this problem.
The first solution is reputation. Throughout history leading up to the industrial age (and beyond), certain close knit communities have used reputation as expressed through coordinated community sanction as an instrument of deterrence to renegement by bad actors within the community, thereby breaking through the prisoner’s dilemma and enabling economic exchange to take place. Even today, within certain close-knit, homogeneous business communities such as Orthodox Jewish diamond traders in Antwerp or Marwari Hindu businessmen in Kolkata, trade worth millions of USD is executed on the basis of hand-shakes with minimal paperwork with the full confidence that the threat of community ostracism deters bad behavior. The limitation of this approach was that it was a local solution, not a global one.
The 2nd solution, which has undergirded global trade for the last century, is currency. The creation of currency systems allowed participants to more easily coordinate with each in the economic sphere. It was also in the collective self-interest of all economic parties at a whole that the currency retained its value and was not manipulated. Even so, it was in everybody’s individual self-interest to print more currency or “double-spend” it, especially if everyone else was following the rules and optimizing for collective welfare. The individual incentive to cheat led to the introduction of a 3rd party enforcer who ensures that the rules are followed by all and penalizes bad actors. This 3rd party enforcer goes by different names, ranging from Central Bank or American Express to a broker or intermediary. Due to the centrality of a 3rd party enforcer, the 2nd solution to the prisoner’s dilemma in economic cooperation is characterized by a centralised network architecture or geometry, as the following graph illustrates.

Centralized-Networks

The key innovation in Bitcoin at a technical level is that it is a solution to an important problem in distributed systems called the Byzantine General’s problem. This represents a 3rd solution to the prisoner’s dilemma in global trade as it allows the distribution of trust away from a single 3rd party enforcement layer to a distributed network of supercomputers called miners that jointly execute the instruction set or protocol governing the economic interaction. Miners validate and audit all economic activity within the network, and secure the network from bad actors. While the blockchain is a working solution to the prisoner’s dilemma just like the other two solutions, it represents a fundamentally different market or network geometry, as below illustrated.

Distributed-Networks

Under a blockchain network architecture, the rules governing all economic activity within it are enshrined within a protocol or instruction set that is created and maintained by its legislature, which is composed of a team of core developers that support it. This instruction set is replicated and distributed to a network of mining nodes which execute and protect the protocol from corruption and ensure that the protocol is observed by all market participants or users. In return for their work contribution, the miners are rewarded with the native tokens of the network, which have real-world monetary value and act like a form of equity-based compensation. The key insight here is that this market geometry is a significant improvement on the 2nd solution which has been the dominant paradigm in economic trade for the last hundred years. There is no single point of failure. Miners can leave and join the network permissionlessly. If participants are dissatisfied with the protocol or governance paradigm of a given network, they can “fork” themselves a new network with the protocol features they desire. The only factor determining the quantum of economic activity within a blockchain-based network is the utility provided by the network to all participants, including developers, users and miners. Consequently, the distributed market network geometry naturally lends itself to greater resiliency, stability and robustness at a system level. Therefore, the core innovation behind Bitcoin can therefore best be summarized as a movement from the closed network architecture on the left to the open one on the right with greater trust, security and reliability.

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