How Bitcoin Works, Featuring Nash Equilibrium
Bitcoin, a decentralized cryptocurrency released in 2009, has rapidly gained public interest and directly challenged fiat currency as countries like El Salvador adopt the digital currency. However, despite the popularity of the crypto, the intricacies of the network remain convoluted to most. I will attempt to explain how the technology works, its benefits, and how game theory has incentivized miners to protect the network against malicious actors.
To start, Bitcoin is a purely digital currency stored on a computer. Anyone with access to the Internet may create a Bitcoin wallet and seamlessly send/receive Bitcoin worldwide. The Bitcoin network operates using “blockchain” technology. A public ledger is distributed to computers on the network, containing a record of all network transactions, and these records are called “blocks”. As Bitcoin transactions occur, blocks are strung together on the ledger, forming a “chain” of blocks. The ledger of transactions is fully public, and anyone can see the wallet addresses involved in any transaction at any point.
To update the ledger, Bitcoin “miners” use special software to compute solutions to complex cryptographic problems. Solving these math problems takes time and electricity to power processors. If a miner solves the problem, their mining software groups various transactions together, forming or “mining” a block. Other computers on the network then validate the solution to the problem.
If the solution is valid, each computer on the network adds the block (group of transactions) to its own copy of the blockchain. As a reward for supporting the network, the miner receives Bitcoin plus transaction fees paid for by the senders of BTC. If the solution is invalid, the block submission is rejected, and the miner will not be rewarded. The reward will go to another miner who successfully solves the problem. Eventually, legitimate blocks are added to every miner’s copy of the blockchain.
Kendra Staggs, a writer for saltlending.com, displays a payoff table showing the incentive for competing miners to contribute to the network. Here, 1 represents a miner receiving BTC for maintaining the ledger, and 0 represents no reward.
| Miner 2 Dishonest | Miner 2 Honest | |
| Miner 1 Dishonest | 0, 0 | 0, 1 |
| Miner 1 Honest | 1, 0 | 1, 1 |
The Nash equilibrium suggests that both miners submit legitimate blocks to the network in order to recieve a reward. By incentivizing miners to join its network, Bitcoin increases its security. More miners means more copies of the public ledger and more auditors of other miners’ solutions. The Nash equilibrium benefits both miners and the security of the network, which in turn attracts more miners to join its network.