Economic Design in Cryptoeconomics_Overview

‘Economic Design’
in Cryptoeconomics
I. Brief Overview of ‘Mechanism Design’ and ‘Market Design’
Jongseung Kim(deframing@gmail.com)
Director, SK telecom Blockchain Business Development Unit
2018. 8. 13

Outline
• What is Cryptoeconomics?
• What is Mechanism Design?
• What is Market Design?
• What role do Cryptoeconomics play?
2

Making Sense of ‘Cryptoeconomics’1 (Joshua Stark)
3
• Crytoeconomics is 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.
• Cryptoeconomics is the use of incentives and cryptography to design new kinds of systems,
applications, and networks.
• Cryptoeconomics is specifically about building things, and has most in common with mechanism
design — an area of mathematics and economic theory.
• In cryptoeconomics, the mechanisms used to create economic incentives are built using cryptography
and software and the systems we are designing are almost always distributed or decentralized.
1https://medium.com/l4-media/making-sense-of-cryptoeconomics-5edea77e4e8d

The properties of ‘Cryptoeconomics’1 (Jon Choi)
4
• Distributed Systems : Open network of computers that communicate with each other
• Cryptography : Mathematical proofs that hide information in open communication channels
• Microeconomics : Maximizing profit against the competition
• Macroeconomics : Aligning the interest of the individual with the interest of the entire ecosystem
• Cryptoeconomics is the study of secure transmission of digital scarcity in open networks.
• Cryptoeconomics is inherently multidisciplinary and it is necessarily a subfield of distributed
systems, cryptography, microeconomics and macroeconomics.
1https://ethresear.ch/t/cryptoeconomics-in-casper-presentation/1002

Vitalik Buterin on ‘Cryptoeconomics’1
5
• Cryptoeconomics is economics.
• Cryptoeconomics is economics specialized to a particular set of circumstances.
• whatever mechanisms you have in cryptoeconomics land have to be fully specified exactly — not exactly
to the standards of a court judge, but exactly to the standards of a computer programmer.
• Cryptoeconomics is basically taking economics with particular constraints and then adding together
insights from fields that are fairly close by to the cryptocurrency space — cryptography, information
theory, math, and distributed systems, including all of the research around consensus algorithms, hash
functions, signatures, zero-knowledge proofs, and what we know about all of those primitives.
• What kind of systems and what kind of mechanisms can we design to achieve the properties that we
want?
1https://medium.com/conversations-with-tyler/vitalik-buterin-tyler-cowen-cryptocurrency-blockchain-tech-3a2b20c12c97

What is Economic Design?
• Game theory provides a structured language that helps in analyzing interactive situations; that is, when
several individuals have to make decisions, and the outcome depends on each person’s choice.1
• The general purpose of mechanism design is to design games in order to achieve specific outcomes.2
- Auctions and matching or assignment problems are in fact special cases of mechanism design.
• Market design is rooted squarely in the tradition of game theory.3
• Market design also deals with behavioral economics.
• Game theory, experimental and behavioral economics, and market design all allow us to look at rules,
and how people interact with them, understand them, circumvent them, and change them.
6
1Guillaume Haeringer, <Market Design : Auction and Matching> The MIT Press, 2018
3Alvin E. Roth, <Marketplaces,Markets,and Market Design>, 2018

Game Theory – Mechanism Design – Market Design
7
Game Theory
The study of mathematical models of strategic
interaction between rational decision-makers
Mechanism Design
How to design the ‘rule of the game’?
Market Design
A kind of economic engineering, utilizing game
theory, algorithms, simulations, and more
’94 : John Harsanyi, John F. Nash, Reinhard Selten
’05 : Thomas C. Schelling, Robert J. Aumann
’96 : William Vickrey, James Mirrlees
’07 : Leonid Hurwicz, Eric S. Maskin, Roger B. Myerson
’14 : Jean Tirole
’12 : Lloyd S. Shapley, Alvin E. Roth
Applied
Reverse

History of Mechanism Design
• Optimizing Social Institutions : A new theoretical framework with which to tackle the comparison of
fundamentally different types of economic organization, such as capitalist and socialist institutions1
- Discussions between the likes of Oskar Lange and Friedrich von Hayek led to the development of the
idea that economic institutions could be viewed as communication mechanisms, and set the stage for
Leonid Hurwicz to formulate a general mathematical framework for analyzing institutions
implementing collective decision making.
• Socialist calculation debate : A discourse on the subject of how a socialist economy would perform
economic calculation given the absence of the law of value, money, financial prices for capital goods,
and private ownership of the means of production2
- Debate among socialists has existed since the emergence of the broader socialist movement between
those advocating market socialism, centrally planned economies and decentralized economic planning.
8
1https://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/2007/speedread.html
2https://en.wikipedia.org/wiki/Socialist_calculation_debate

Lange model1
9
1https://en.wikipedia.org/wiki/Lange_model

Concept of Mechanism Design
• 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.1
- Because it starts at the end of the game, then goes backwards, it is also called reverse game theory.
- Key words : Economic agent, economic activity, economic environment, mechanism, goal
function(social choice function), informationally efficient mechanism
• Mechanism design studies solution concepts(equilibrium concepts) for a class of private-information
games.
- In a design problem, the goal function is the main "given", while the mechanism is the unknown.
Therefore, the design problem is the "inverse" of traditional economic theory, which is typically
devoted to the analysis of the performance of a given mechanism.2
10
1https://en.wikipedia.org/wiki/Mechanism_design
2L. Hurwicz & S. Reiter, <Designing Economic Mechanisms>Cambridge University Press, 2008

Mechanism Design for Cake Cutting1
11
1Y. Narahari, <Game Theory and Mechanism Design> World Scientific PublishingCompany, 2014
• One of the kids would slice the cake into two
pieces and
• The other kid gets the chance to pick up any of
the pieces, leaving the remaining piece to the
kid who sliced the cake into two pieces.
• Child 1, who cuts the cake will slice it exactly
into two equal halves, as any other division will
leave him with the smaller piece.
• Child 2 is happy because she gets to choose and
also chooses what in her eyes is the larger of
the two slices.
Define a social choice function f(θ) mapping the (true) type profile directly to the allocation of goods received or rendered,
f(θ):Θ→X
f(θ):Θ→X

Structure of Mechanism Design1
12
• A game of mechanism design is a game of private information in
which one of the agents, called the principal, chooses the payoff
structure.
- The upper-left space Θ depicts the type space and the upper-right
space X the space of outcomes.
- The social choice function f(θ) maps a type profile to an outcome.
- In games of mechanism design, agents send messages M in a game
environment g.
- The equilibrium in the game ξ (M, g, θ) can be designed to implement
some social choice function f(θ).
à f(θ) : Θ → X (Define a social choice function f(θ) mapping the (true)
type profile directly to the allocation of goods received or rendered)
f(θ):Θ→X
f(θ):Θ→X

General Workflow of Mechanism Design1
• Choose a target function f * to implement
• Model the situation as a game
- Agents, Outcomes, Preferences, Message Space
• Choose a solution concept SC
• Design f such that the game and SC implements f *
13
1Lirong Xia, <Introductionto mechanism design>, 2016

Revelation Principle1
• The revelation principle is a fundamental principle in mechanism design.
• It states that if a social choice function can be implemented by an arbitrary mechanism(i.e. if that
mechanism has an equilibrium outcome that corresponds to the outcome of the social choice function),
then the same function can be implemented by an incentive-compatible-direct-mechanism(i.e. in which
players truthfully report type) with the same equilibrium outcome(payoffs).
• The principle comes in two variants corresponding to the two flavors of incentive-compatibility:
- The dominant-strategy revelation-principle : Every social-choice function that can be implemented
in dominant-strategies can be implemented by a dominant-strategy-incentive-compatible mechanism
- The Bayesian-Nash revelation-principle : Every social-choice function that can be implemented in
Bayesian-Nash equilibrium can be implemented by a Bayesian-Nash incentive-compatibility
mechanism
14
1https://en.wikipedia.org/wiki/Revelation_principle

Vickrey–Clarke–Groves(VCG) mechanism
• In mechanism design, a Vickrey–Clarke–Groves (VCG) mechanism is a generic truthful
mechanism for achieving a socially-optimal solution.1
• The Vickrey–Clarke–Groves mechanism can motivate agents to choose the socially efficient allocation
of the public good even if agents have privately known valuations.2
- It can solve the ‘tragedy of the commons’—under certain conditions, in particular quasilinear utility or
if budget balance is not required.
15
1https://en.wikipedia.org/wiki/Vickrey–Clarke–Groves_mechanism

Concept of Market Design
• ‘Market Design’ is the term used to refer to a growing body of work that might also be called
microeconomic engineering and to the theoretical and empirical research that supports this effort and is
motivated by it.1
• Market design is both a science and an art.2
- It is a science in that it applies the formal tools of game theory and mechanism design.
- It is an art because practical design often calls for decisions that are beyond the reliable scientific
knowledge of the field.
• Market Design is the area of economics that is particularly interested in how who gets what is decided.3
16
1Nir Vulkan, Alvin E. Roth, Zvika Neeman, <The Handbook of Market Design> Oxford UniversityPress, 2015
2Nir Vulkan, Alvin E. Roth, Zvika Neeman, <The Handbook of Market Design> Oxford UniversityPress, 2015

Why is ‘Market Design’ important?
• Market : An Institution where goods and services are exchanged or traded
- The role of a market is to determine who get what.
• The traditional approach consists of finding an equilibrium price.
- How do we get the equilibrium price?
- Is the “price recipe” the same for all markets?
- What if the price is not the only parameter driving individuals’ decisions?
• Price may affect people’s decisions, but may not be sufficient to determine the ‘equilibrium’.
• Other forces (than price) are at work, and they need to be taken into account.
17

Principles of Market Design1
• Market Thickness : A healthy market must have enough participants willing to transact and create
benefit through trade, and to further attract more participants.
- We need ‘enough’ actors from both sides. Sellers need to meet buyers, and buyers need to meet sellers.
• Avoid congestion : The market must mitigate traffic jams to enable the free flow of transactions.
- Too much thickness can create problems, like too much traffic can create traffic jams.
• Make the market safe : Participants must feel safe to transact on the marketplace and to reveal their true
preferences.
- Without proper safety, participants may wish to transact outside of the market.
• Additionally, certain markets must operate under the constraint of repugnance.
18
1https://medium.com/tokenfoundry/market-design-with-tokens-348a4d097a85

Principles of Market Design Applied to Tokens1
• Increasing Thickness
- Mining, Partnerships, Referral Bonuses
• Reducing congestion
- Transaction Fees, Membership Deposits
• Providing Safety
- 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.
19
1https://medium.com/tokenfoundry/market-design-with-tokens-348a4d097a85

Simple Auctions : A Definition1
• Bidding format rules (the form of the bids)
- Bids can be price only, multi-attribute, price and quantity, or quantity only.
• Bidding process rules
- Closing/timing rules, available information, rules for bid improvements/counter-bids
• Price and allocation rules
- Final price(s) and quantities, winning bidders
• An auction is referred as
- a type of market mechanism, which uses prices to determine allocations(who gets what).
- a price discovery mechanism.
20

Auction 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)
21

Ascending Auctions1
• Ascending auction : the price starts low and goes up (gradually) until a winner is declared(or the auction
is cancelled).
• There are various versions of the ascending auctions, depending on who can announce prices.
- 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 : It consists of pressing the button until the displayed price equals one’s own
valuation.
- In the English auction, truthful bidding is a dominant strategy.
22

Second-Price Auction1
• Vickrey Auction is an auction that is aimed at capturing what we have just described for an ascending
price auction.
- Each bidder secretly submits a bid to the auctioneer. It is a sealed-bid auction.
- The winner is the bidder with the highest bid; the other bidders lose the auction.
- The price paid by the winner is equal to the second-highest bid.
• English vs Vickrey auctions
- The Vickrey auction is a strategic form game : bidders can never learn the bids of their opponents.
- The English auction is an extensive form game : bidders may observe the bids of their opponents.
• A strategy is a more complex object in an English auction : it specifies an action (press/stop pressing) for
any possible history.
23

First-Price Auction1
• The first-price auction is a static auction that looks similar to the Vickrey auction, with the only
difference being the price paid by the winner.
- Each bidder secretly submits a bid(a price) to the auctioneer. It is a sealed-bid auction.
- The winner is the bidder with the highest bid; the other bidders lose the auction.
- The price paid by the winner is equal to the highest bid.
• The payoff of bidder i is
- 0 if bi < bmax
-
!
{#∶%#&%'() |
𝑣𝑖 − 𝑏𝑖 if 𝑏𝑖 = 𝑏𝑚𝑎𝑥
24

Optimal Bids in the First-Price Auction1
• A Strategy of a bidder maps a valuation to a bid. (v à s(v))
- Assumption 1 - Each bidder uses the same strategy : for any pair of bidders, i and j, si = sj.
- Assumption 2 - The bidding function s is strictly increasing. So if bidder i’s valuation is higher than
bidder j’s valuation, then bidder i bids higher than bidder j.
- Assumption 3 - For each bidder i = 1, …, n, s(vi) ≤ vi.
• Equilibrium : a bidding strategy for each bidder such that no bidder can be better off by 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) =
67!
6
𝑣
25

Dutch Auction1
• The Dutch/descending price auction is a first-price auction.
- There is a ‘clock price’ that displays a price that is decreasing over time.
- The auction stops as soon as someone says ‘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 the same strategies.
- Bidders obtain the same payoffs.
- The seller get the same revenue.
26

The Basic Matching Model1
• 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-One matching problems : Several individuals from one side can be matched to the same
individual from the other side.
• Many-to-many matching problems : Any individual from any side can be matched to several
individuals form the other side.
27

Matching Market
• Economics studies how goods and 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 enough to characterize allocations(e.g., College admission, labor
market, etc.)
• Matching markets are typical examples of markets where there is no monetary transactions (and thus no
price)
- School assignment, Medical match, Allocation of dorms, Assignment of cadets to branches, Organ
transplants, Allocation of subsidized/public housing, etc.
28

Matching Definition1
• A matching is simply a mapping (or a function) from the set of all individuals to the set of all
individuals.
• A matching is a function µ : M∪S à M∪S such that :
- For each singler s∈S, µ(s)∈M∪{s}, and for each musician m∈M, µ(m)∈S∪{m}.
- If µ(s) = m, then µ(m) = s.
• A matching µ is stable if :
- it is individually rational, meaning that for each individual v∈M∪S, v weakly prefers µ(v) to v; and
- there are no blocking pairs, meaning that there is no singer-musician pair (s, m) such that µ(s) ≠ m and
mPs µ(s) and sPm µ(m).
- Stability can be understood as the equivalent of the equilibrium in a classic supply-demand problem.
29

The Deferred Acceptance Algorithm1
• Step 1 : Each singer proposes to the musician who is ranked first among his preferences. Each musician
who received at least one offer temporarily holds the offer from the most preferred singer among the
singers who made a proposal to her and who are acceptable, and rejects the other proposals.
• Step k, k≥2 : Each singer whose proposal was rejected in the previous tep proposes to his most preferred
musician among the musicians to whom he has no yet proposed. If there no such musicians, the singer
remains single. Each musician receiving new proposals temporarily holds the proposal of the singer she
prefers the most among
- the singers who just proposed to her and are acceptable to her and
- the singer whose proposal she held from the previous step.
• End : The algorithm stops when no singer’s offer is rejected. Each musician is matched to the singer
who made the offer she was holding when the algorithm stopped.
30

Where is Cryptoeconomics useful?
• Consensus Protocol Level1
- Economic design has an impact not only on the contributions of miners who maintain the blockchain,
- but also on how much power is exerted by those miners and
- how costly the system is to run, which both influence whether users or apps will want to adopt it.
• Layer 2 Scaling Solution Level2 : State Channel, Plasma, Truebit, etc.
- The economic mechanisms used by layer 2 solutions tend to be interactive games : they work by
creating incentives for different parties to compete against or “check” one another.
• dApp / Ecosystem Level3
- Economic design can help ensure that users contribute resources as the founding team intended.
- Cryptoeconomics is also applied to design token sales or ICOs.
31
1https://prysmgroup.attach.io/B1KdY0dEm?viewer=new
2https://medium.com/l4-media/making-sense-of-ethereums-layer-2-scaling-solutions-state-channels-plasma-and-truebit-22cb40dcc2f4

From Authority to Governance
• Decentralized platforms, like those that utilize blockchain technology are complex economic system
that require rigorous design because they lack authority.1
- On decentralized platforms, authority has to be replaced by incentives and other mechanisms in the
day-to-day running of the platform.
• Economic design builds on the field’s methodological tools and over a century of economic research to
produce mechanisms that will guide decentralized communities toward positive outcomes.
• Authority also has to be replaced by governance in the long-run maintenance of the platform.
32

– Alvin E. Roth
“Only recently have we economists started to understand enough about
how markets work so that we can help in that process.”
33
2012 Nobel Prize laureate (with Lloyd Shapley)
“for the theory of stable allocations and the practice of market design.”

References
• https://medium.com/l4-media/making-sense-of-cryptoeconomics-5edea77e4e8d
• https://ethresear.ch/t/cryptoeconomics-in-casper-presentation/1002
• https://medium.com/conversations-with-tyler/vitalik-buterin-tyler-cowen-cryptocurrency-blockchain-tech-3a2b20c12c97
• Guillaume Haeringer, <Market Design : Auction and Matching> The MIT Press, 2018
• Alvin E. Roth, <Marketplaces, Markets, and Market Design>, 2018
• https://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/2007/speedread.html
• https://en.wikipedia.org/wiki/Socialist_calculation_debate
• https://en.wikipedia.org/wiki/Lange_model
• https://en.wikipedia.org/wiki/Mechanism_design
• L. Hurwicz & S. Reiter, <Designing Economic Mechanisms> Cambridge University Press, 2008
• Y. Narahari, <Game Theory and Mechanism Design> World Scientific Publishing Company, 2014
• Lirong Xia, <Introduction to mechanism design>, 2016
• https://en.wikipedia.org/wiki/Revelation_principle
34

References(cont’d)
• https://en.wikipedia.org/wiki/Vickrey–Clarke–Groves_mechanism
• Nir Vulkan, Alvin E. Roth, Zvika Neeman, <The Handbook of Market Design> Oxford University Press, 2015
• Guillaume Haeringer, <Market Design : Auction and Matching> The MIT Press, 2018
• https://medium.com/tokenfoundry/market-design-with-tokens-348a4d097a85
• https://prysmgroup.attach.io/B1KdY0dEm?viewer=new
• https://medium.com/l4-media/making-sense-of-ethereums-layer-2-scaling-solutions-state-channels-plasma-and-truebit-22cb40dcc2f4
35

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