Saturday, April 17, 2010

How Pyramid Schemes Work

Throughout my last post, I referred to pyramid schemes and multi-level marketing interchangeably for ease of understanding.  That's not entirely accurate, however.  This post will set that record straight, as well as shed some light on how these schemes operate, and why they actually don't work.

The following is an excerpt from my latest book, Bunk: Strange Beliefs and Dangerous Superstitions.  It's still undergoing the revision process, but I felt I ought to share this particular snippet here.

We’ve all heard the term “pyramid scheme,” and we’ve all come the realization that the term is generally used interchangeably with “ripoff.”  Pyramid schemes are often confused with multi-level marketing schemes, and this is not entirely accurate.  Though they’re not nearly as different as the MLM people would have you believe, they aren’t exactly the same either.

First, let’s look at the pyramid scheme.  The idea is that the originator of the scheme recruits ten people to give him $100 each.  Then each of them recruit ten people to send them $100 each, making a $900 profit.  Those people each recruit ten more, and so on and on.

The more sophisticated schemes usually involve people lower on the pyramid passing a portion of their income from their own recruits up the pyramid to the person who recruited them.  That person passes a portion of the money to whoever recruited him, an so on, so that there’s a relatively constant flow of income for the couple of people at the top.

The problem is, though it’s certainly possible for a few people at the top to make a lot of money, they’re doing it at the expense of the people they’ve deceived into joining.  In order for the scheme to continue, it must have a steady supply of fresh recruits.  This is never the case.

Generally, it’s hard to recruit people at all, because most people smell the bullshit a mile away.  They might know that pyramid schemes are illegal, or they may just realize that it’s a losing proposition for everyone except perhaps the con man at the top and maybe, if it’s particularly successful, the first couple of levels below him (maybe).  So most people just won’t buy into the scheme to begin with.

However, let’s imagine that everyone who is asked to join does.  It’s a perfect scenario, and everything that can go right for the scheme is going right.  What happens then?  It still fails.

The reason being, there are a limited number of people on earth.  Let’s stick with our original example of each recruit going out and recruiting ten more people, and see what happens.












You see how fast the pyramid grows.  After just ten layers (below the originator), the pyramid calls for more people than there are in the entire world!  Most of those people, by simple mathematical necessity, are losers.

Pyramid schemes are illegal because they deceive people out of money with the promise that they’ll receive money in the future, which they are not guaranteed or even particularly likely to receive.

I’ve provided an example of a simple pyramid scheme in which there are no administrative fees or payment to higher levels on the pyramid.  You only pay your recruiter, and are only paid by those you recruit.  That’s a straightforward example, but also pretty rare, because it doesn’t get anybody, even the highest levels, very much money.  We should also look at a couple of other versions.

For instance, many pyramid schemes throughout history have taken the form of a chain letter.  For purposes of illustration, I’ll assume that everyone sends the letter to precisely ten people, and each of those ten people actually do choose to participate (I like using multiples of ten because it makes the math a lot clearer and easier to follow).  Let’s say I receive a letter with a list of six names on it.  The letter instructs me to send $1 (just one dollar) to everyone on the list.  I then remove the top name from the list, move everyone else up one position, and add my own name to the bottom.

So I send my grand total of $6 out, alter the list of names according to the instructions, and mail the new letter to ten people.

When those people receive the letter, they each mail their $6 (that’s $1 to each of the names on the list, remember), remove the top name from the list, add their own name to the bottom, and mail it out to ten more people.  From this first level, I receive $10.

As the pyramid grows, my payments get larger and larger.  From the second level below me, now consisting of 100 people, I get $100.  From the third, I get $1,000.  Then $10,000.  Then $100,000.  Ten, from the sixth level, I receive a total of $1,000,000, and my name drops off the list.

If most people didn’t know about pyramid schemes and that they don’t work, you could see how this might seem like a good deal for me.  A really good deal.  After all, for my original investment of only $6, I got a return of $1,111,110.  That’s enough to pay off even my debts!

But unless I’m right at the top of the pyramid, meaning the letter hasn’t gone through very many hands before my own, there’s no way I’ll ever see that huge return, simply because there aren’t enough people in the world to keep mailing dollars.

So it’s a bad investment.  Why is it fraud, though?  After all, it’s possible for the participants to get more out of it than they put in, right?  The reason it’s fraud is because it promises this return, and even if everyone in the world participates, most people who mail their $6 will never see a penny in return, because most of the population is on the bottom level when the whole thing inevitably collapses.  The reason is that no new wealth is created through participation in the scheme.

Economists will debate the “creation of wealth” issue until we’re all blue in the face.  Does the creation of a new product qualify as a creation of wealth, or simply a transfer of wealth?  If it costs $5 to make and you sell it for $10, it would seem to be a creation of $5 in wealth.  The debate is whether the labor involved in the creation of this new product qualifies as wealth itself.  If it does, then the wealth is not so much created as transferred to a different medium.  In other words, by writing this book, I’m transferring my wealth (time and labor) into the book which is a sellable product.

For our purposes here, let us assume that we’ll be dealing with the model of economics in which new wealth can be created by turning lesser valued ingredients into higher valued products.  I don’t care which model you actually prefer, but this is a much easier model to deal with for the purpose of examining pyramid schemes.

Because no new wealth is created by participating in the scheme--in other words, the amount lost by all the losers is the exact amount gained by all the winners--it definitely constitutes fraud.

Let’s imagine that I invite one hundred people to my house.  I tell each of them that there is a small fee, say one dollar, to enter, but that when they leave, they’ll get ten dollars back.

As each person enters, I collect their dollar and put it in a basket by the door.  Then everyone commences with the festivities (which, since it’s my party, would probably involve listening to Eagles music and arguing about the costs and benefits of various types of political systems or some such nonsense).

When everyone is ready to leave, they line up at the door.  As they leave, I hand each ten dollars.  But after the first ten people leave, the basket is empty!  Because the scheme does not involve the creation of new wealth (or the transfer of wealth into a practical medium, if you prefer), I’ve cheated ninety people out of their money.

Of course, this particular example is not a pyramid scheme, as there’s only one level (myself, in this case), so only one person is guilty of fraud (again, yours truly).  But the argument still applies.

Let’s look at another type of pyramid scheme: the administrative pyramid scheme.  The basic modus operandi of this scheme is the same as the others.  It involves new recruits paying up the pyramid to their recruiter and their recruiter’s recruiter.  The difference in this case, is that the payments are centralized around an administrator.  This person, generally the originator of the pyramid, is responsible for collecting payments from new recruits and distributing the proper amount of money to their superiors.  Usually, he takes a fee for himself in return for providing this service.

This scheme works really well for the administrator because he’s guaranteed a profit no matter how poorly the pyramid does on the whole (though the better it does, the greater his profit will be, of course).  However, because this person is easily identified and reported to law enforcement, these schemes generally don’t last very long.

Pyramid schemes have often tried to get around tax law by calling themselves “gifting clubs.”  The idea being that you call your original buy-in a “gift.”  Because the IRS does not tax gifts under $10,000, they advertise all your promised proceeds from your underlings as tax-free.

As much as I loathe the IRS (and I really can’t stand the bastards), they’re absolutely right when they point out that this is untrue.  Legally speaking, your buy-in is not a gift, because you expect to receive further proceeds as a result of paying this fee.  The IRS considers a gift to be something given with no expectation of anything in return.  They are absolutely correct in their definition.

There is truth to the claim that most participants don’t receive anything in return.  However, this does not make it a gift under the law, because they do expect to receive money in return.

What’s even more dangerous is that it’s not just illegal to start a pyramid scheme.  People who’ve simply been deceived into participating in an existing one have had run-ins with the law in the past.  I don’t know if this is the best solution to the problem, but it’s definitely something to be aware of.  Simply participating in a pyramid scheme could get you in trouble for fraud.

That’s a pyramid scheme.  The multi-level marketing (MLM) companies we’ve all had some experiences with at one time or other, are not pyramid schemes, though they’re often called by that name.

There are legitimate (and I use the term loosely) MLMs out there.  Participating in these schemes is not illegal, and they aren’t fraud.  However, I do find them ethically and fiscally questionable.  If a friend approaches me with a pyramid scheme, I will flat tell him that it’s fraud, and to get out immediately.  If he approaches me with a MLM, I won’t participate, and will encourage him to rethink his own participation, but I won’t stand in his way if that’s what he wants to do.  Since it is legal and isn’t actually defrauding anybody, it’s your own choice whether or not to do it, but I think that, if you have all the facts, you’ll probably choose not to.

What distinguishes an MLM from a pyramid scheme is that the MLM actually has a real product or service to sell, so there’s a legitimate business potential with the company.

I find them unethical because they still follow the pyramid format of trying to recruit new salespersons to build your own “downline.”  The idea being that you receive a portion of all the sales accumulated by everyone you’ve recruited, and everyone they’ve recruited, and so on.  In most, perhaps even all, MLMs, I feel that the product, though it is the distinction that divides MLMs from pyramid schemes, is really just a diversion or cover for the pyramid structure of the scheme.

First, we need to dispose of the pyramid schemes posing as MLMs.  They do sell a product, oh yes.  But it’s a product that has no value at all unless you have an interest in joining the pyramid scheme.  For instance, they’ll sell you marketing reports, or access codes for an online pyramid scheme.  These products have no real value or marketability except to participants in the scheme.

Though they call themselves MLMs, they will still be prosecuted as pyramid schemes, because that’s what they are, after all.

Even within legitimate MLMs, there’s a delicate balance of legality.  If the multi-level part of the equation rises to a point where it considerably outweighs the marketing part, it’s little more than a pyramid scheme (and law enforcement is likely to see it the same way).  In other words, is the money coming from recruitment or from sales?

Here’s why I find MLMs unethical: market saturation.  If everyone were just making money from sales, even though it is structured as a pyramid, I would have little problem with it except to say that it’s perhaps not the most effective way to structure a business (there’s a reason the bookstore where you got this book is not an MLM, after all).

But the problem is, MLMs, by their very design, must assume that the demand for their product will never run out.  The fact of the matter is, I don’t care how good your product is, there is a limited demand for it.

Because they assume there is this unlimited demand for their product, they also assume there is an unlimited demand for new sales staff to recruit.

So let’s start an imaginary MLM and see what the problem is with market saturation.

We’ve developed “Product X,” and it’s going to be a big hit.  Everyone is going to want one.  So we set our company up as an MLM and start recruiting people to go out and sell Product X to all their friends.  But instead of just giving them an hourly wage or a commission, we give them a commission, plus a percentage of the commission from everyone they recruit as a new sales person, and charge in a fee (which will be spread across the recruit’s “upline” to become one of our sales representatives.

Quickly, we see our company growing.  Lots of people are buying Product X, and plenty are buying in to the company so they can sell Product X, too.  People are making money from sales, from the sales of their downline, and from recruitments, and everything seems to be going really well.

But there’s trouble on the horizon.  Just about everyone who wants Product X already has one, but we’re still recruiting new sales people, to sell something that no one will buy anymore.  The only money that’s still changing hands is from recruitment of new sales people.  Our company is turning into a pyramid scheme.

Eventually, it’s going to crumble, either with intervention from law enforcement (as it’s now just multi-level with no marketing), or simply due to the financial strain of poor business.

Sure, we can introduce Product Y and Product Z and start selling those, too.  But the fact of the matter is, eventually the market is going to run out, but the company will still be hiring people, because in the short-term, that’s the best thing for the upline (furthermore, when sales drop off, that's the only way our sales people can ever hope to get their money back--they're desperate to build their own downlines).

The MLM scheme is designed to fail.  It’s a carefully disguised and legal form of the pyramid scheme, but eventually it’s going to crumble, and the people at the bottom of the pyramid (which will be most of the people involved) are going to have lost their time, energy, and money to the people who roped them in.

Normal businesses don’t always know how many of a product to make, but they do their best to approximate, so they don’t lose out on any sales or severely overestimate the demand and end up with millions of unsellable units in a warehouse somewhere.  Normal businesses don’t always know how many salespeople to hire, but they do their best to figure it out, so they aren’t paying too many people, and so they aren’t understaffed to meet the demands of their customers.

MLMs have no such controls.  They’ll just keep recruiting and producing unsellable products until eventually the company crumbles under the weight of its own bloated structure.

People often look at the pyramid structure and see it as strong, because all the weight is at the bottom, and doesn’t have to support too much.  It’s better to look at it as an inverted pyramid, where all the mass is at the top.  I don’t care how strong your pyramid is, eventually the weight from the mass at the top is going to bring the whole thing down.

Perhaps worse than all that is the strain these schemes can put on personal relationships.  I don’t classify MLMs as fraud, as I said, because it’s possible to profit purely by selling products.  But the fact of the matter is, in order to be successful in such a venture, you need to keep recruiting along with your selling.  Who do you recruit and sell to but your friends and family?

And when you do recruit, say, your neighbor, promising all this potential for great wealth and success, what do you think she’s going to think of you when the whole thing inevitably goes under?

Before we move on to different types of schemes, scams, cons, and frauds, we should look at one final type of scheme related to the pyramid: the straight-line matrix or “elevator” scam.

It manages to do away with the pyramid structure, but still has most of the same problems.

Basically, the idea is that you get the opportunity to purchase a desired product for, say, 10% of its market value.  It’s based on a list of names, just like the pyramid scheme.  Here’s how it works.

Let’s say Product X costs $100 and you want to get it for $10.  What you do is pay $10 into the scheme, and then try to recruit ten more people.  When ten people have joined, the first person will get the product, its cost having been paid out of the fees paid by the people below him on the list.  When ten more join, the second person gets the product, and so on.

The first couple of people involved will get the product for the promised low price.  But as the pool of victims begins to run dry, people lower down on the list have to wait longer and longer to get their product.  As with the pyramid scheme, most of the people who pay into the scheme will never get anything out of it.

So that's how pyramid schemes and MLM schemes actually work.  Not pretty, is it?  Heed my advice, and stay away from these things.  Your friends, and your pocketbook will thank you for it.

Now that that's done with, perhaps we can return to our regularly scheduled programming.


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