How pyramid schemes work

An individual who joins a multi-level marketing (MLM) company can make money by selling products directly to consumers AND more importantly by getting other people to become distributors at a lower level in the pyramid. In fact, even if nobody ever sells any products to ordinary consumers, people at the top of the pyramid can make a lot of money by recruiting lots of people to become distributors because all the distributors have to pay for inventory, samples, and marketing supplies.

Everyone who sells for a MLM has to sign a business contract which few have time to read:

When they initially sign on work with an MLM, distributors may not recognize the full extent of the terms that the MLM will attempt to hold them to. While a potential distributor might be presented with a brief, one page document to sign, those short forms often cross-reference and purport to integrate huge, outside documents outlining terms that heavily favor the MLM. These additional documents could include disciplinary procedures allowing the MLM to terminate a distributor with little or no due process or compensation. They can also include terms that are so vague that they leave the MLM near-absolute discretion to interpret its side of the deal as it sees fit.

Now the FTC is reviewing whether MLMs should be held to the same standards as other businesses and have to provide information to potential distributors about how much their existing distributors profit before signing a contract. Such transparency rules are becoming more important as the economy shifts towards increasing gig employment, but the MLM industry is lobbying hard against it and say that it could ruin the industry because MLM companies are unprofitable for all but a tiny percent of distributors:

According to the Direct Selling Association, the multilevel marketing (MLM) industry’s lobbying arm, one in six American households is involved in the industry. Most MLM salespeople don’t make a ton of money — a 2017 report by the Federal Trade Commission found that 99 percent of MLM sellers actually lose money. The website Magnifymoney recently polled 1,049 MLM sellers across various companies and found that most sellers make less than the equivalent of 70 cents an hour. Nearly 20 percent of those polled never made a sale, and nearly 60 percent earned less than $500 in sales over the past five years.

Similarly, according to a study released by AARP Foundation:

Among the more than 20 million Americans who participate or have participated in multilevel marketing (MLM) organizations, 90 percent say they got involved to make money. However, nearly half (47 percent) lose money and a quarter (27 percent) make no money.

Those surveys actually paint the industry in a pretty generous light compared with some other researchers. A study by the Consumer Awareness Institute found that 99 percent of MLM sellers lose money. The FTC found that even the top 1% BIGGEST Amway sellers in Wisconsin lost money on average and less than one tenth of one percent (0.001) of NuSkin sellers earned a profit (although the insiders at the top did make millions of dollars!). The FTC analyzed 29 MLM companies including Herbalife, Sunrider, and Tupperware. At all of the MLMs studied, more than 99% of participants lost money. 99.7% of Amway sellers lost money in the UK too.

Every study agrees that MLMs are unprofitable for most sellers among the bottom 90%- 99% because there are inherent problems with the MLM supply chain.  It is comically inefficient at getting products from manufacturers to consumers and that leads to excessively high prices.  

And the growth of MLMs is a movement in the opposite direction of technological advances are moving the rest of retailing. Technological change over the past century has tended to cause disintermediation (also known as vertical integration) in retail which cuts out as many middlemen as possible.   

Before the internet, there were door-to-door traveling salesmen who had a supply chain with many middlemen that looked like this:

Manufacturer: $50 cost + $50 markup (100%)

Distributor: $100 cost + $30 markup (30%)

Door-to-door Retailer: $130 cost + $50 markup (28%)

Consumer: $180 price paid

This supply chain has the so-called “double” markup problem even though there is actually a triple markup. Each level has an incentive to markup the price as much as the next level will bear which creates inefficiently high prices. The optimal, profit-maximizing markup is determined by the elasticity of demand, but each level of markup has an incentive to maximize their share of the markup and when that happens at every part of the supply chain the end result is an inefficienly high price that hurts everyone in the supply chain because a lot of customers stop buying because the price is too high. Disintermediation is what all big retailers have done. They cut out middlemen between the manufacturer and the consumer. They buy directly from manufacturers and then add only about a 30% markup which is a lot smaller than the old markup for labor-intensive sales methods like door-to-door and MLM:

Manufacturer: $50 cost + $50 markup (100%)

Big Retailer: $100 cost + $30 markup (30%)

Consumer: $130 price paid

This supply chain only has a double markup problem because disintermediation eliminated some of the extra markups in the supply chain and achieved greater economies of scale and higher profits because greater efficiency leads to a lower price which boosts the quantity of sales. If it were profit maximizing for big retailers to charge $180, they would do so, but the fact that they charge less means that eliminating the markup of an intermediary and thereby lowering prices is actually better for profits. Big-box and internet retail have dramatically increased retail efficiency and that has almost completely eliminated door-to-door sales and decimated small ‘main street’ retailers. Some manufacturers like Dell have taken disintermediation even further and even eliminated the retailer. No double markup problem:

Manufacturer (Dell): $50 cost + $50 markup (100%)

Consumer: $100 price paid

MLMs have done the opposite of disintermediation. Instead of cutting players out of the supply chain, MLMs add additional layers to the supply chain and each level adds a markup which drives up costs more than in any other kind of supply chain.

Manufacturer: $50 cost + $50 markup (100%)

Top of the pyramid: $100 cost + $10 markup (10%)

Platinum level: $110 cost + $11 markup (10%)

Gold level: $121 cost + $12 markup (10%)

Silver level: $133 cost + $13 markup (10%)

Ruby level: $147 cost + $15 markup (10%)

Emerald level: $162 cost + $16 markup (10%)

Bottom of the pyramid level: $178 cost + $36 markup (20%)

Consumer: $214 price — but it is hard to get anyone to buy such overpriced merchandise

This hypothetical supply chain shows a MLM with only seven levels between the producer and ultimate consumer, but many MLMs have many, many more levels than that. For example, Amway officially lists 22 “levels of achievement” in their award system. I do not know how big the markup is for each level of the pyramid, but any markup is inefficient when the ‘middle-man’ is just a ‘middle-man’. The reality is that only the top <1% of the elites at the pinnacle of a MLM pyramid get any profits. Almost nobody at the lower levels even break even because they buy so much inventory and supplies from their upline handlers and sell so little, but the dream is to make the sort of big markups shown above.

In addition to the extra costs of Many Levels of Markup, MLM distribution also has less efficiency than the logistics systems that competitors like Amazon and Walmart use for distributing goods across the nation. Because the MLM supply chain is so much less efficient than ordinary retailing, MLMs cannot compete directly with the big retailers, so MLMs are forced to invest in product differentiation efforts which further inflates costs.

As a result of their high costs, many MLMs mainly sell to their ‘sellers’ instead of selling to consumers. The only way to make a living in MLM is not to sell products to individual consumers, but to get other people to become sellers for you who will be required to buy a lot of inventory in their “starter package” so that they can dream of getting others to sell below them.

As a result of their high costs, MLMs struggle to sell to consumers, but that isn’t really the goal. The only way to make a living in MLM is not to sell products to individual consumers, but sell other people on becoming sellers who will work under you in the pyramid. Every seller is required to buy a “starter package” with lot of inventory and that is the real MLM business. In the UK, 90% of Amway sellers did not sell a single item to anyone, but they all had to buy a lot of inventory.

Unlike most retail businesses, MLMs don’t bother advertising directly to consumers much because their main customers are not consumers but potential sellers. For example, Amway sells consumer packaged goods and in that industry, the typical company spends 24% of their budget on marketing. Amway hardly advertises any of their specific products at all because their pyramid of sellers does time-consuming word-of-mouth advertising for free.

An army of word-of-mouth marketers is an inefficient use of time, and no company could afford to pay a living wage for such inefficient marketing, but that isn’t a worry for MLMs.

What little advertising Amway does do is to sell the company because their real customer is not the end consumers, but potential sellers. That is why the link they pay for when you do a Google search for “amway” turns up “startabusiness” as you can see below. They don’t market their products because their main goal is to attract potential sellers and that is the focus of their advertising dollars as shown here.

Everyone knows you cannot make a living wage selling products directly to consumers door-to-door anymore so the real dream for MLM sellers is to get other sellers under you in the pyramid who you can skim money off of. The only reason your underlings would join is also hopes of getting more underlings to join under them. The easiest targets are your family and friends, but once you get them to sell the same thing you are selling, market saturation soon means that nobody can make money. This is the opposite of the old single-level direct sales model where professional door-to-door sellers didn’t want anyone else to sell the same products in their territory. MLMs get as many people as possible selling the same thing in the same territory.

For traditional door-to-door sales, each seller jealously guarded their territory because even one more salesperson in a territory would saturate the market and leave more work and less revenues for both sellers. But in the MLM model, each salesperson wants as many sellers as possible regardless of whether it saturates their market because they do not care about efficient scale. If each person wants at least 10 sellers in the level below them, then with three levels there are 100 sellers and with six levels there are a million. Just six levels in the pyramid creates almost three times more workers than Target’s total American workforce, and most MLMs have many more than six levels. Amway lists 22 “levels! Amway is the biggest MLM and they try to keep how many sellers they have a secret, but the Chinese government reported that Amway had 1.5 million sellers in China and they have been estimated to have 700,000 in North America. Just Amway’s sellers in China and North America equal Walmart’s worldwide total of 2.2 million employees and Amway probably has millions more sellers worldwide because China and North American only represent a couple percent of the over 100 countries where Amway operates. Although Amway has many more workers than Walmart, Walmart’s global revenues in 2019 were 61 times bigger than Amway’s, so Walmart’s revenues per employee are undoubtedly much more 100 times bigger than Amway’s. With Walmart generating more than 100 times more revenues per employee than Amway, it would be hard for Amway to pay each seller one percent as much as Walmart pays its sellers. But retail is not a highly paid industry and even highly-efficient Walmart doesn’t have a reputation for high wages.

Inefficient scale and market saturation sets in quickly for MLMs. The math just doesn’t work for this business model to be profitable for the bulk of the people below the pinnacle of the pyramid. Since an MLM is a very inefficient supply chain technology, what explains why it has been a more successful business model than most other retailing systems in recent decades?

Ironically, the same information technology revolution that has enabled the disintermediation of global supply chains by electronically connecting each cash register in each store to manufacturers across the globe has also fueled the growth of MLMs over the past half century. Social networking technology has boosted MLMs by making it easier to leverage one’s social network than the old days when social networks were dependent on face-to-face communication and snail mail. So the same communication technology revolution that boosted Amazon and nearly eliminated door-to-door sales have also dramatically boosted MLMs because it is easier for individuals to network online and use social media to sell to their friends and family. In 1990, 75% of the companies in the Direct Sales Association used single-level (door-to-door) sales and only 25% was MLM. Twenty years later, in 2009, over 94% of firms in the Direct Sales Association were MLM (and only 6% single-level) and MLMs accounted for 99.6% of sellers.

Technology has made it nearly impossible to compete with mail order and Walmart doing door-to-door sales, so the direct sales industry has abandoned that methodology and moved to an even less efficient business model where the real goal is to recruit other sellers instead of selling products directly to consumers. Imagine if MLMs sold everything: all companies including Ford, Ikea, and Proctor and Gamble were MLMs. It would be a mess. Cars and furniture and Tide laundry detergent would be much more expensive. America would be an inefficient nation of shopkeepers all hustling to get others to sell for us.

The inefficiently high transactions cost of MLM sales means that they cannot compete with traditional retailers when selling products whose quality is easily compared.  That is why MLMs focus on selling placebo products.  These are products whose quality is highly subjective and prone to suggestion.  Dubious wellness products are a natural fit for pyramid schemes, but because of medical licensure regulations, only vitamins, supplements and ‘snake-oil’ devices like magnets are legally viable for pyramid schemes.  Beauty products, soaps and cleaning products, clothing, jewelry, travel packages, handicrafts, and status goods are also good products for MLMs as long as the quality is highly subjective and susceptible to suggestion and these are common in pyramid schemes.

Drugs like alcoholcaffeine, and medical marijuana are also highly prone to placebo suggestions.  So naturally there are pyramid schemes selling them despite the complicated difficulties of complying with numerous regulations on selling psychoactive drugs.

In an efficient supply chain, each level of the chain adds value. For example, a distributor manages the logistics of shipping and warehousing for a wide area more efficiently than any other company. A retailer adds value by adding essential service and support and the convenience for customers of having many complementary products located in the same place. In comparison, is there any value added by the many levels of a MLM?

For the elites at the top of the pyramid, the hierarchical organizational structure works great. The the 0.1% of people at the top who make money know that in reality, there are mainly just two levels, them and all their worker bees below who pay for the inventory up front, store the inventory in their homes, deliver the inventory to customers (if any), market the goods, and most importantly, provide the human resources management for recruiting and training new workers. All of this is done without the elites paying any wages. MLM companies don’t have to spend much money on advertising, recruiting employees, warehousing, and the expensive last mile of delivery because the 99% below the peak of the pyramid do it all for free.

Another way that some MLMs add value for the elites at the top (but not for end consumers) is that MLMs are good at getting their foot soldiers to make misleading claims about products. There is no practical way to hold the foot soldiers accountable for making fraudulent claims because each seller is doing very little business and making no money and it isn’t worth anyone’s time to prosecute them for making illegal exaggerations. For example, my father was snookered into selling expensive “healing” magnets and “medicinal” supplements and he really believed that these products were medical miracles. His faith in the products made him an ideal seller and he made illegal health claims about these products to friends and family, but nobody prosecutes individuals talking medical BS with their family and friends. In contrast, if the MLM’s management had been documented making the same kind of claims to the public, the FDA would shut down the entire company for practicing medicine without a license and making fraudulent health claims!

Gaby Del Valle found an example of a MLM company using its multiple levels to distance the wealthy leaders at the peak of the scheme from their debts and unsavory parts of their business in the lower levels to try to insulate themselves from legal liability. Similarly, companies like Uber have also fought expensive battles to prevent their drivers from being classified as employees because that would mean that the corporation would be legally responsible for their workers.

This is one of the functions of the bizarre organizational structure of pyramid schemes.  The leaders who are accumulating most of the wealth do it by form a hierarchy of multiple layers of “independent contractors.” But unlike a normal bureaucracy, very few of the workers in the organizational hierarchy are employees because almost the entire organization is made up of salespeople and none of the salespeople in massive bottom levels of the hierarchy are employees.  Therefore, the masterminds at the top cannot be held legally responsible when their minions earn less than minimum wage or go bankrupt or, perhaps most importantly, when they fabricate claims about their products’ miraculous qualities or use other unethical sales tactics.

Illegal drugs are also sold in a business model that is similar to a MLM except with less branding and even more decentralization.  Like multi-level marketing, illegal drug gangs need to insulate the big-money managers at the top of the pyramid from the street dealers who are taking everyday risks selling the product to numerous buyers. 

As with more legitimate pyramid schemes, the arms-length distance between the gang leaders and each layer of “independent contractors” gets a cut of profits and marks up the drugs that finally make it to the street vendors. The extra layers reduce the cost-efficiency of the supply chain, but they dramatically reduce the risk for the drug kingpins at the top of the pyramid and that is the point of having the inefficient organizational structure.

MLMs have also found a market niche by creating a social community for their sellers. I have had numerous relatives including my father who liked the social aspects and the optimistic dreams of MLM culture. Whereas nearly all Americans shop at the big retailers, most Americans never buy anything from MLMs and only a minority of Americans puts a large fraction of their household resources into in this kind of supply chain. According to the MLM industry lobby, only about 16% of American households are involved, and this may be overstating it because the industry has an incentive to exaggerate their reach.

The real benefit of MLMs for most sellers is not the money, but the social community for the 99% who buy inventory that greatly exceeds their sales. They lose money from the business, but they do get lots of social support and self-esteem-boosting praise and encouragement from their upline handlers. An MLM is like a social club with conferences and parties where like-minded people can discuss their shared hobby and ideology. We don’t expect most people can make money from their clubs and hobbies, so we shouldn’t expect MLMs to be any different. Here a clip from a great podcast called The Dream showing the real benefits of an MLM in the words of women who don’t make any money, and love it nonetheless.

These happy MLM members gush about how their MLM has boosted their self-esteem and helped them develop a community and helped them pursue a dream. That was what my parents loved about MLMs. My mother lost money in her Discovery Toys business, but she loved throwing parties and she loved buying the toys for her grand kids. It also gave her an identity as a businesswoman. When people asked what she did, she could say she was an entrepreneur and that is much more prestigeous than saying that she was an empty-nest housewife with a hobby that combined parties and buying an inventory of expensive toys for her grand kids.

My father also liked the social aspects of the MLMs he joined. He never really even tried to make any money. He sold everything to his friends at his cost or gave inventory away to family as gifts. He still ended up with a lot of inventory that he couldn’t sell even at his cost and after he died I ended up selling it on Ebay for below what he paid, or giving it away. But dad had no regrets about that. He liked the conventions and the dream of it all.

Some MLMs are much worse than others in terms of how much money they suck out of their average member and how healthy the social support is that they provide in return. At the worst end are the cults and true pyramid schemes. All MLMs say that they are absolutely NOT a pyramid scheme because pure pyramid schemes are illegal. This may be true, but only because the legal definition of a pyramid scheme is very narrow due to extensive political lobbying by wealthy MLMs. Legally, a pyramid scheme doesn’t sell any goods or services to end consumers and make all of their money from people who intend to earn money from selling. In practice, many MLMs are very close to this standard. As mentioned before, one study found that only 10% of Amway members in the UK sold at least a single product to anyone else.

The original pyramid schemes were just like Ponzi schemes except that the pyramid schemes were more honest in that it should be obvious to everyone that all profits are dependent upon bringing in more “investors”. A true Ponzi scheme works exactly the same way as a pure pyramid scheme except that a true Ponzi scheme has a manager who

  1. Lies to the “investors” about where the return on investment is coming from. The Ponzi scheme manager usually claims to be a high ROI mutual fund or hedge fund, but they really pay a high ROI to previous investors from some of the money coming in from new investors.
  2. Does not pay previous “investors” specifically for bringing in new “investors”. Investors just get a fixed ROI determined by the manager. In contrast, a pyramid scheme is more honest because each “investor” knows that she won’t get paid unless she brings in enough new “investors” under her.
  3. Skims off some hidden profit and money to pay for administrating the scheme. In some pyramid schemes, there is no administrator to pay because the cash from the bottom level is paid directly to the person at the top of the pyramid.

Examples of pure pyramid schemes are the Airplane Game, Eight Ball, Blessing Loom (popular during the Covid pandemic), and “Make Money Fast” which was a chain-letter pyramid scheme.

MLMs combine elements of both Ponzi and pyramid schemes as well as legitimate direct sales organizations (which is what all MLMs claim to be). For example, when the leaders of the Airplane Game realized that it was illegal to run a pyramid scheme that doesn’t involve selling any product, they decided to keep the pyramid scheme exactly the same, but give roses for the $1,500 required ‘investment’ so they could say that they were direct selling roses! Similarly, since only 10% of Amway sellers in the UK actually sell products to anyone, then 90% of that business is a pure pyramid scheme.

MLMs that use the party system invented by Tupperware seem to be farther away from the pure pyramid model and closer to direct sales because they claim to generate more money per seller. They also tend to have more of the benefits of social clubs since it is all about hosting parties! Other companies that have copied the party plan include Discovery Toys, Mary Kay, and Norwex. But there has been increasing temptation over the past half century to move away from the direct-selling model towards the pyramid-scheme model, so there is no guarantee that a direct-sales company will always be offering a legitimate business selling products.

MLMs try to argue that they are just like any other organization which all have a pyramid-shaped structure, but the incentives are what makes an MLM different from other types of supply chain. Jon Taylor researched over 600 MLMs to determine what makes them unique and Brett and Kate McKay compiled the list:

1. Incentives to recruit new distributors into the company. Jim earns a commission on the product the distributors below him buy from the parent company.

2. Advancement in the sales hierarchy is achieved by recruitment rather than by appointment. Jim can’t get to the next level in the sales hierarchy by someone above him saying “We think you’d be a good executive distributor.” It’s only determined by the number of people he recruits and that his sub-recruits recruit.

3. “Pay to play” requirements are met by ongoing “incentivized purchases” and/or recruitment minimums, with participants the primary buyers. To become a distributor, Jim had to buy a starter kit. To maintain his status as a distributor, he’s required to make minimum monthly purchases.

4. Company payout (in commissions & bonuses) per sale for the total of all upline participants equals or exceeds that for the person selling the product – resulting in inadequate incentive to retail and excessive incentive to recruit. Jim can make more money getting commissions off the product that distributors beneath him are required to buy from the company than he could from selling the shakes at retail to customers outside of the business.

Arguably the most defining feature of an MLM is that the main customers of the company’s products are not unassociated folks outside the company, but the distributors within it.

For a more biting critique of MLMs, see Steven Hassan of the Freedom of Mind Resource Center who says that pyramid schemes have an an incentive to use same tactics to brainwash people that cults use. Some MLMs like NXIVM have actually become cults! Other resources include:

Or this cartoon:

Posted in Managerial Micro
One comment on “How pyramid schemes work
  1. […]  Entrepreneurs are a small, shrinking share of American workers with a few exceptions such as the members of multi-level marketing organizations (popularly called ‘pyramid schemes’) which have been growing, but almost none of them […]

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