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Economic design in cryptoeconomics_game theory_mechanism design_market design_v.1.0

  1. 1. Economic Design in Cryptoeconomics - Focus on Game Theory, Mechanism Design, Market Design Jongseung Kim SK telecom Blockchain Business Development Unit 2018. 9. 8
  2. 2. What is Cryptoeconomics?
  3. 3. Institutional Technology Information Technology + Two Characteristics of Blockchain Technology
  4. 4. Making Sense of ‘Cryptoeconomics’ “Crytoeconomicsis the practical science of using economic mechanisms to build distributed systems, where important properties of that system are guaranteed by financial incentives, and where the economic mechanisms are guaranteed by cryptography.”(JoshuaStark)* Cryptography Economics + <Source:https://medium.com/l4-media/making-sense-of-cryptoeconomics-5edea77e4e8d> Signatures Hash Functions Zero-Knowledge Proofs … Game Theory IncentiveDesigns InstitutionalDesigns …
  5. 5. Information and Incentives •Economicsystem structured to dealwith the twinproblems ofinformationand incentives •How can wecoordinateaction — make exchanges, buildrelationshipsand communities — inaworld of incompleteinformationandpotential rentseeking? •Wherecryptographers havefoundtheir solutionsinpublickeycryptography and proofof work mechanisms, economists have foundsolutionsinmarkets, regulation,andinstitutions. <Source:https://medium.com/cryptoeconomics-australia/byzantine-political-economy-de25bf8f047e> Byzantine Fault Tolerance Robust Political Economy Algorithmic Questions ßàConstitutional Questions
  6. 6. What is ‘Economic Design’? ü Game theory provides a structured language that helps in analyzing interactive situations; when several individuals have to make decisions, and the outcome depends on each person’s choice.* ü The generalpurpose of mechanism design is to design games in order to achieve specific outcomes. ü Market Design :Auctions and matching or assignment problemsare in fact special cases of mechanism design. <Source:GuillaumeHaeringer, <Market Design :Auction andMatching>TheMITPress,2018> Game theory,behavioral economics,and market design all allow us to look at rules, and howpeople interact with them, understand them, circumventthem, and change them.
  7. 7. Game Theory – Mechanism Design –Market Design Game Theory The study ofmathematical models ofstrategic interaction betweenrational decision-makers Mechanism Design How to design the ‘ruleofthe game’? Market Design A kind ofeconomicengineering, utilizinggametheory, algorithms, simulations, and more ’94 : JohnHarsanyi,JohnF. Nash,Reinhard Selten ’05 :ThomasC. Schelling,Robert J.Aumann ’96 : William Vickrey,JamesMirrlees ’07 : LeonidHurwicz,Eric S.Maskin,RogerB. Myerson ’14 : JeanTirole ’12 : LloydS.Shapley,Alvin E. Roth Reverse Applied Behavior Psychology Behavior Economics Complexity Economics Influenced
  8. 8. What is Game Theory?
  9. 9. What is ‘Nash equilibrium’? <Source:http://studycas.com/component/k2/revisiting-nash-equilibrium-in-prisoner-s-dilemma> If each player has chosen a strategy and no player can benefit by changing strategies while the other players keep theirs unchanged, then the current set ofstrategy choices and the corresponding payoffsconstitutes a Nash equilibrium. Prisoner's Dilemma – Payoff Matrix
  10. 10. What is ‘Schelling point’? <Source:https://en.wikipedia.org/wiki/Focal_point_(game_theory)> Thomas Schelling describes "focalpoint[s] foreach person's expectation of what the other expectshim to expect to be expected to do"
  11. 11. What is Mechanism Design?
  12. 12. History of Mechanism Design <Source:https://en.wikipedia.org/wiki/Socialist_calculation_debate> A new theoretical framework with which to tackle the comparison offundamentally different types of economicorganization, such as capitalist and socialist institutions. A discourse on the subject of howa socialist economywould perform economic calculation given the absence of the law ofvalue, money,financial prices forcapital goods, and private ownership ofthe means of production.* Optimizing Social Institutions Socialist calculation debate
  13. 13. Lange-Lerner model(Oscar Lange, Abba Lerner)* <Source:https://brooklynrail.org/2018/07/field-notes/Dreams-of-National-Capital-Market-Socialism-Past-and-Present>
  14. 14. Key Concept of Mechanism Design <Source:L.Hurwicz&S.Reiter,<Designing Economic Mechanisms> CambridgeUniversity Press,2008> The goalfunction is the main "given",while the mechanism is the unknown. Therefore,the design problem is the "inverse" of traditional economic theory, which is typically devotedto the analysis ofthe performanceof a given mechanism.* Mechanism design is a field in economics and game theory that takes an engineering approach to designing economic mechanisms or incentives, toward desired objectives,in strategic settings, where players act rationally.
  15. 15. Mechanism Design for Cake Cutting <Source:Y.Narahari,<Game TheoryandMechanism Design> WorldScientificPublishing Company,2014> • Oneof thekids wouldslicethe cake intotwo pieces. • The otherkid gets the chanceto pick upany ofthe pieces,leavingthe remainingpieceto the kidwho slicedthe cake into two pieces. • Child1, whocuts the cake willsliceit exactly into two equalhalves, as any otherdivisionwillleavehim with the smaller piece. • Child2 is happybecause she gets to chooseand also chooses what inher eyesis the larger of the two slices.
  16. 16. Structure of Mechanism Design <Source:https://en.wikipedia.org/wiki/Mechanism_design> .The upper-leftspace Θ depicts thetype space and the upper-rightspace Xthe space of outcomes. .The socialchoicefunctionf(θ)maps a type profileto an outcome. . In games of mechanism design,agents sendmessages M ina game environmentg. .The equilibriuminthegame ξ (M, g, θ)can be designedto implementsome social choicefunctionf(θ). §Amechanism design is a game ofprivate information in which one ofthe agents, called the principal, chooses the payoff structure.* à f(θ) : Θ → X (Definea social choicefunctionf(θ)mappingthe (true) typeprofiledirectlyto the allocationofgoods receivedorrendered)
  17. 17. Incentive-compatibility and Revelation Principle <Source:Y.Narahari,<Game TheoryandMechanism Design> WorldScientificPublishing Company,2014> §Incentive compatibility essentially refersto offeringthe right incentivesthat make agents reveal their types truthfully.* . DominantStrategy IncentiveCompatibility(DSIC):Truth revelationis a best responsefor each agent irrespectiveof what is reported bythe other agents. . Bayesian Nash Incentive Compatibility(BIC):Truth revelationis a best response foreach agent in expectationof thetypes ofthe rest ofthe agents. §The Revelation principle :Any social choice functionthat can be implemented by any arbitrary mechanism, can also be implemented by a truthful, direct-revelation mechanism with the same equilibrium outcome. .The RevelationPrincipleforDominant Strategy Equilibrium .The RevelationPrincipleforBayesian Nash Equilibrium
  18. 18. What is Market Design?
  19. 19. Market and Equilibrium Price What is Market? Finding an Equilibrium Price üAMarket is an Institution where goods and services are exchanged or traded. üThe role ofa market is to determine who get what. üPrice may affect people’s decisions, but may not be sufficient to determine the ‘equilibrium’. üOther forces (than price) are at work, and they need to be taken into account.
  20. 20. Key Concept of Market Design* <Source:NirVulkan, AlvinE.Roth,ZvikaNeeman, <TheHandbookofMarket Design> OxfordUniversity Press,2015> ‘Market Design’ is the term used to refer to a growing bodyof work that might also be called microeconomicengineering and to the theoreticaland empirical research that supportsthis effortand is motivated by it. Science Art it applies the formal tools ofgame theoryandmechanism design. Practical designoftencalls for decisions that arebeyondthereliable scientific knowledge of the field.
  21. 21. What a Market Needs to Work* <Source:GuillaumeHaeringer, <Market Design :Auction andMatching>TheMITPress,2018> Market Thickness Avoid Congestion Make the market safe • We need ‘enough’actors from both sides. • In a thin market, there are fewbuyers and sellers, which can have negative effects,such as increasing price volatility or reducing competition. • Most people prefer to participate in markets that are safe and simple. • Without propersafety, participants may wish to transact outside of the market. • Congestion in a market is like a traffic jam. • The market must mitigate traffic jams to enable the freeflow of transactions.
  22. 22. Principles of Market Design Applied to Tokens <Source:https://medium.com/tokenfoundry/market-design-with-tokens-348a4d097a85> IncreasingThickness Mining,Partnerships, Referral Bonuses Reducingcongestion ProvidingSafety Transaction Fees, MembershipDeposits Governance, Smart Contracts, Attestations,Staking Through the pillars of market thickness, congestion,and safety, we can orient tokens, smart contracts, and game-theoretic mechanisms towards higher goals.*
  23. 23. Simple Auctions : A Definition* <Source:GuillaumeHaeringer, <Market Design :Auction andMatching>TheMITPress,2018> §Bidding format rules (theform of the bids) .Bids can be priceonly,multi-attribute, priceand quantity, orquantity only. §Bidding process rules .Closing/timingrules, availableinformation,rules for bidimprovements/counter-bids §Price and allocation rules .Final price(s) andquantities, winningbidders §An auction is referred as .A type ofmarket mechanism, whichuses prices to determineallocations(who gets what). .A pricediscoverymechanism.
  24. 24. Auctions are everywhere §eBay,Art sales, house foreclosure,etc. §Treasury bonds §Internet ads(Google, Bing, Facebook, Twitter, etc.) §Public facilities(bridges, tunnels, etc.) §Daily quotation at stock exchanges §Course allocations at business schools §Spectrum licences(wireless communication) §Smart Contract Transaction Fee
  25. 25. Ascending Auctions <Source:GuillaumeHaeringer, <Market Design :Auction andMatching>TheMITPress,2018> Ascending auction : the price starts low and goes up (gradually) until a winner is declared(or the auction is cancelled).* Types •Only bidders announce prices: English outcry auctions •Only the auctioneer announces prices : Japanese button auction Ticking Price •The amount by which the price has to go up or down •Price increment rule Truthful Bidding •pressing the button until the displayed price equals one’sown valuation •In the English auction, truthfulbidding is a dominant strategy.
  26. 26. Second-Price Auction <Source:GuillaumeHaeringer, <Market Design :Auction andMatching>TheMITPress,2018> Vickrey Auctionis an auction that is aimed at capturing what we have just described for an ascending price auction. .Each biddersecretly submits a bidto the auctioneer.It is a sealed-bidauction. .The winneris the bidderwiththe highest bid;theother bidders losethe auction. .The pricepaid bythe winneris equalto the second-highestbid. §English vs Vickreyauctions .The Vickreyauctionis a strategic formgame :bidders can neverlearn the bidsof theiropponents. .The Englishauctionis an extensiveform game : biddersmay observethe bids oftheir opponents.
  27. 27. First-Price Auction <Source:GuillaumeHaeringer, <Market Design :Auction andMatching>TheMITPress,2018> The first-price auction is a static auction that looks similar to the Vickrey auction, with the only differencebeing the price paid by the winner. .Each biddersecretly submits a bidto the auctioneer.It is a sealed-bidauction. .The winneris the bidderwiththe highest bid;theother bidders losethe auction. .The pricepaid bythe winneris equalto the highest bid. §The payoffof bidder i is .0 if bi < bmax .1/(|{𝑗:𝑏𝑗=𝑏 𝑚𝑎𝑥}|)(𝑣𝑖−𝑏𝑖) if 𝑏𝑖 = 𝑏 𝑚𝑎𝑥
  28. 28. Optimal Bids in the First-Price Auction <Source:GuillaumeHaeringer, <Market Design :Auction andMatching>TheMITPress,2018> §AStrategy ofa bidder maps avaluation to a bid. (v à s(v)) .Assumption 1 - Eachbidder uses the same strategy : forany pair of bidders,i and j,si = sj. .Assumption 2 - Thebiddingfunctions is strictly increasing.So ifbidderi’s valuation is higher than bidderj’s valuation, thenbidderi bids higherthan bidderj. .Assumption 3 - For each bidderi = 1, …, n,s(vi) ≤ vi. §Equilibrium : a bidding strategy for each bidder such that no bidder can be better offby bidding according to a different strategy §Result : When there are n bidders and their valuations are uniformly distributed, and bidders’bidding strategies satisfy assumptions 1, 2, and 3, then a bidder with valuation v bid in equilibrium .s(v) = ()* ( 𝑣
  29. 29. Dutch Auction <Source:GuillaumeHaeringer, <Market Design :Auction andMatching>TheMITPress,2018> §The Dutch/descending price auction isa first-price auction. .There is a ‘clockprice’that displays a pricethat is decreasingover time. .The auctionstops as soonas someonesays ‘Mine’. §Dutch vs first-price auction : - Strategically equivalent to a first-price sealed-bid auction - Bidding one’s valuation is not a dominant strategy(in practice, not so equivalent). . Bidders use thesame strategies. . Bidders obtainthe same payoffs. . Theseller get the same revenue.
  30. 30. The Basic Matching Model <Source:GuillaumeHaeringer, <Market Design :Auction andMatching>TheMITPress,2018> §The basic matching problem consists of matching two sets of agents. §One-sides matching problems : We only have one set of individuals and we have to form groups of two or more individuals. §Many-to-Onematching problems : Several individuals from one side can be matched to the same individual from the other side. §Many-to-many matching problems :Any individual fromany side can be matched to several individuals formthe other side.
  31. 31. Matching Market §Economicsstudies howgoodsand services are exchanged or distributed via a market. §Traditionally, markets determine allocation through prices, which are sufficient statistics to determine who gets what. §But in some cases prices may not be enoughto characterize allocations(e.g., College admission, labor market, etc.) §Matching markets are typical examples ofmarkets where there is no monetary transactions(and thus no price). . Schoolassignment, Medical match,Allocationof dorms,Assignment ofcadets to branches, Organ transplants, Allocationofsubsidized/publichousing,etc.
  32. 32. Matching Definition <Source:GuillaumeHaeringer, <Market Design :Auction andMatching>TheMITPress,2018> § A matching is simply a mapping (or a function)fromthe set of all individuals to the set of all individuals. § A matching is afunction µ : M∪S à M∪S such that : -For eachsingler s∈S, µ(s)∈M∪{s}, and foreach musician m∈M, µ(m)∈S∪{m}. -If µ(s) = m, thenµ(m) = s. §Amatching µ is stable if : .it is individuallyrational,meaningthat for eachindividualv∈M∪S,vweakly prefers µ(v) tov; and .there are no blockingpairs, meaningthat thereis no singer-musicianpair (s, m) such that µ(s) ≠ m and mPs µ(s) andsPm µ(m). à Stabilitycan beunderstoodastheequivalentoftheequilibriumin a“classic” supply-demandproblem.
  33. 33. The Deferred Acceptance(Gale-Shapley) Algorithm* <Source:GuillaumeHaeringer, <Market Design :Auction andMatching>TheMITPress,2018> Step 1 Step k, k≥2 End •Each singerproposes to the musician whois ranked first among his preferences. •Each musicianwhoreceivedat least oneoffertemporarily holds the offerfrom the most preferred singeramong the singers who made a proposal to her and whoare acceptable, and rejects the other proposals. •Each singerwhose proposalwas rejectedin theprevious step proposes to his most preferred musician among themusicians to whomhe has no yetproposed. •Each musicianreceivingnew proposals temporarily holds the proposal ofthe singer she prefers the most among - thesingerswho justproposedtoher and are acceptabletoherand -thesingerwhoseproposalsheheld from thepreviousstep. •The algorithm stops whenno singer’s offeris rejected. •Each musicianis matched to the singer who made the offershe was holdingwhenthealgorithm stopped.
  34. 34. Deferred Acceptance and Stable Matchings* <Source:GuillaumeHaeringer, <Market Design :Auction andMatching>TheMITPress,2018> PBob PJohn PDavid PDinah PMelanie PJanis Dinah Melanie Janis Bob Dinah Melanie Janis John Dinah Janis Melanie David Bob John David Dinah Bob David John Melanie Bob John David Janis - Step1 :µ(Bob)=Dinah,µ(John)=John, µ(David)=David,µ(Melanie)=Melanie, µ(Janis)=Janis - Step2 :µ(Bob)=Dinah,µ(John)=Melanie, µ(David)=Janis àNo singer is rejectedin this step, so the algorithm stops. • Finally,since allsingers and musicians prefertheir match to beingsingle,the matching µ described aboveis individuallyrational. • So the µ is a stable matching.
  35. 35. Behavioral Economics for Market Design Cryptoeconomistis a behavioral public policy maker. Extrinsic Motivation Intrinsic Motivation 《ChoiceArchitect》based on ‘LibertarianPaternalism’ Libertarian paternalism is the ideathat it is bothpossible and legitimatefor private and publicinstitutions to affect behaviorwhilealso respectingfreedom ofchoice,as wellas theimplementationof that idea. <Source:https://en.wikipedia.org/wiki/Libertarian_paternalism>
  36. 36. What role do Cryptoeconomics play?
  37. 37. Where is Cryptoeconomics useful? <Source:https://medium.com/l4-media/making-sense-of-ethereums-layer-2-scaling-solutions-state-channels-plasma-and-truebit-22cb40dcc2f4> Consensus Protocol Level Layer 2 Scaling SolutionLevel dApp/ Ecosystem Level • Economicdesigncanhelpensure that users contribute resources as the foundingteamintended. • Cryptoeconomicsisalso appliedto design tokensales or ICOs. • The economicmechanismsused by layer 2 solutionstend to be interactivegames : theywork by creatingincentivesfor differentparties to competeagainst or “check” oneanother. • State Channel,Plasma, Truebit,etc.* • Onthe contributionsofminers who maintain theblockchain • Onhow muchpoweris exerted by thoseminers • Onhow costlythe system is to run, whichbothinfluence whetherusers or apps willwant to adopt it
  38. 38. Cryptoeconomic Design Case : Transaction Fee Market <Source:https://github.com/zcash/zcash/issues/3473> Mismatch between volatility of transaction fee levels and social cost of transactions Inefficienciesof first price auctions Instability ofblockchains with no block reward • The protocolinternallymaintains a fee level f, and a minerthat creates a blockthat includesd bytes must pay a feeoff * d, whichgets put into a pot. • There is a maximum weight limitM. • If the last blockwas 50% full,leavethe fee unchanged,ifthe last blockwas 10% full, drop itby 10%, if thelast blockwas 90% full, increase it by10%. • In every block,a minergets a reward equal to 1/N (eg.1/10000) ofthe money remainingin thepot. Three Major Problem in Transaction Fee Market Alternative Mechanism (Suggested by Vitalk Buterin)
  39. 39. Cryptoeconomic Design Case : Layer 2 Solutions <Source:https://medium.com/l4-media/making-sense-of-ethereums-layer-2-scaling-solutions-state-channels-plasma-and-truebit-22cb40dcc2f4> §Cryptoeconomicconsensusgives us a corehard kernel ofcertainty. §The insight behind layer 2 solutions isthat we can use this core kernelof certainty as an anchor — a fixed point to which we attach additional economicmechanisms. §ABC application can assume that a given claim is likely true, because we’ve created a strong incentive for another party to provide information showing it to be false. State Channel In state channels, this is how we confirm the final state of the channel — by giving parties a chance to “rebut” each other. Plasma In Plasma, it’show we manage fraud-proofsand withdrawals.
  40. 40. Agent based Modelling for Cryptoeconomics <Source:https://en.wikipedia.org/wiki/Agent-based_model> “Agent-Based Model(ABM)”is a class of computational models for simulating the actions and interactions ofautonomousagents with a viewto assessing their effectson the system as a whole. Interactions Rewards Observations EnvironmentAgent(Miner,User) ABM allows us to bypass any theoretical limitations and modelthe agents of our assumptions directly, while taking into account any kind of constraint or assumption we want. [ComplexAdaptive System]
  41. 41. A New Typology of Political Economy In a cryptoeconomyboth the economyand the ledgers are decentralised. Blockchains take the state out of both planning and verification.* <Source:https://medium.com/cryptoeconomics-australia/byzantine-political-economy-de25bf8f047e>
  42. 42. From Authority to Governance üDecentralized platforms, like those that utilize blockchain technology are complex economic system that require rigorous design because they lack authority.* üOn decentralized platforms, authority has to be replaced by incentives and other mechanisms. <Source:https://prysmgroup.attach.io/B1KdY0dEm?viewer=new> (Bureaucratic) Authority Rule of Office Bureaucratic Paper-basedSystem (Algocratic) Governance Rule of Code Technologically drivenCode-basedSystem
  43. 43. Crypto Constitutionalism* <Source:https://medium.com/cryptoeconomics-australia/crypto-constitutionalism-c25d0c503ac>  Rule-Systems in which individuals(or firms, or algorithms) can make economicand political exchanges. ü Blockchains have systems of governance. ü Blockchains look a lot like countries. ü They have currencies(tokens),property(digitalassets), laws(protocols), corporations(DAOs),and security systems(proof-of-work,orproofof stake, or delegated byzantine fault tolerance, etc.). Blockchainsare constitutionalorders! 
  44. 44. “Only recently have we economists started to understand enough about how markets work so that we can help in that process.” ” - Alvin E. Roth 2012 Nobel Prize laureate (withLloydShapley) “for the theoryofstable allocations and the practice of market design.”

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