A Primer on Pyramid Schemes, 2/23

A few people win a lot, many lose a little

Christopher Mims writes, citing Catherine Flick,

Blockchain-based organizations inevitably have a pyramid-shaped economic structure, in which those who jump in early earn disproportionate rewards through the appreciation in value of their tokens, she argues. Those who come along later are likely to profit little, or lose money, by joining.

In 1994-1995, when the Internet first headed toward mainstream adoption, one of the most widely-used subject lines in spam emails was “Make Money Fast.” The contents of these emails were invitations to join multilevel marketing programs, or MLMs.

One of the most successful MLMs, which long preceded the Internet, is Amway. Amway built the DeVos fortune (Betsy DeVos became President Trump’s Education Secretary, and I happened to like much of what she stood for).

I attended a presentation by Amway in the late 1970s. Amway sold cleaning products. The presentation was by a distributor, who wanted to recruit people in the audience to become salesmen. As a salesman, you bought products from the distributor, and then you tried to turn around and sell them to your acquaintances. The distributor got a cut of all of your sales revenue. His distributor in turn got a cut of all of his revenue, and so on up the chain, until it reached the DeVos family.

Once you recruited 6 people to sell Amway products for you, then you became a low-level distributor. If each of those 6 people recruited 6 other people, then you moved up a level. As you moved up, you got more and more revenue.

In a typical business, people at the lowest level of the sales force are paid by the company. In an MLM, people at the lowest level of the sales force pay the distributor above them for the privilege of selling. I have this simple rule for staying away from MLM’s: getting paid to sell is legit; making you pay to sell is not.

Arithmetically, MLMs strongly favor the people who start them. They exploit the people who join late.

Here is a hypothetical example. To simplify, assume that no actual goods are sold, and all of the revenue comes from recruiting people to pay to join the MLM. Suppose I start an MLM with 10 people at each layer, and everyone who joins has to pay $1000. Every layer takes 50 percent of the revenue from the layer below. When I recruit 10 people, there is no other layer to share revenue, so I take the entire $10,000. Then suppose each of those ten recruits 10 people, so now there is $100,000 more paid in. I get half of the new revenue, or $50,000. The score at this point is:

• me: +$60,000.

• Each of the first 10 recruits: +$4000 (half of $10,000 in sales, minus the $1000 they each paid to join); all together + $40,000

• Each of the last 100 recruits: minus $1000; all together minus $100,000

The more layers that get added, the more that the top layers get enriched. There is a redistribution of wealth in which a large number of people lose a little and a tiny number gain a lot. In the example, 100 people each lose $1000, 10 people each win $4000, and one person wins $60,000. It is like a lottery, except that the winners of the lottery are determined not by chance but by having started the scheme or joined early.

The scheme always ends with a large set of losers, because it is impossible for everyone to keep recruiting new participants. But a scheme can revive after a while when a new cadre of participants becomes available to be recruited.

At least some of the popular digital currencies and NFTs behave like MLMs or other pyramid schemes. If Bitcoin works like a pyramid scheme, it will tend to rise and fall in waves. It will fall when there is a temporary lack of new recruits, and it will rise when there is new word-of-mouth encouraging new buyers. Bitcoin could be the next Amway.

The people who get involved in pyramid schemes and win tend to let you know about it. The people who play and lose tend to keep quiet. It can be easy to believe that you will be one of the winners, even though the arithmetic shows that you are much more likely to end up a loser.

On another rationale for holding crypto, Zvi Mowshowitz points out,

Think about what would happen if your assets, and those of your family, were frozen right now. Your bank accounts are gone, your credit cards do not work. You can’t get new ones. What would you do? How would you keep a roof over your head and pay for food?

I can understand hoping that crypto is the answer. I think having some assets in a free country is a better answer. But I have not yet moved any money into Switzerland.