What is a Pyramid Scheme?

A pyramid scheme is a fraudulent investment scheme that relies on the recruitment of new members to generate profits for earlier investors. Participants are promised high returns for recruiting other participants into the scheme, with the expectation that the new recruits will recruit even more participants, creating a chain of recruitment. The focus of the scheme is on getting as many new members as possible, rather than on the sale of a product or service.

In a pyramid scheme, the early participants receive a substantial return on their investment, which encourages them to recruit others. As more participants are recruited, the returns to each subsequent participant become smaller, until eventually, new participants will not be able to earn enough money to offset their investment, and the scheme collapses. The only people who benefit from the scheme are the early participants, who are able to collect the majority of the funds invested by new participants.

Pyramid schemes are illegal in many countries, including the United States, as they are considered a form of fraud. They are also often called Ponzi schemes, after Charles Ponzi, who became infamous for running such a scheme in the 1920s.

In conclusion, a pyramid scheme is a fraudulent investment scheme that relies on the recruitment of new members to generate profits for earlier investors. The focus of the scheme is on getting as many new members as possible, rather than on the sale of a product or service. The early participants receive substantial returns, while the returns to subsequent participants become smaller, until the scheme collapses. Pyramid schemes are illegal in many countries and are considered a form of fraud.

Simplified Example

A pyramid scheme is like building a tower of cards. Imagine you and your friends are building a tower of cards and one of your friends says they will give you a prize if you can bring them more friends to help build the tower. So you bring more friends, but they also have to bring more friends, and so on. The only way for everyone to get a prize is if more and more people keep joining and building the tower. But eventually, there won't be enough people to keep the tower going and it will fall apart. This is like a pyramid scheme.

In a pyramid scheme, people are promised a reward for recruiting more people into the scheme. The only way for everyone to get the reward is if more and more people keep joining and investing money, just like building a tower of cards. But eventually, there won't be enough people to keep the scheme going and it will collapse, leaving most participants with nothing.

History of the Term "Pyramid Scheme"

The fraudulent practice of pyramid schemes has historical antecedents predating the term itself, often involving chain letters and recruitment-based scams. The earliest documented use of the term "pyramid scheme" can be traced back to a 1934 Federal Trade Commission (FTC) report, which investigated a deceptive business model associated with the sale of beauty products. The term gained prominence in the 1970s as multi-level marketing (MLM) companies proliferated, with some being exposed as pyramid schemes masquerading as legitimate enterprises. The dissemination and standardization of the term occurred through media coverage, where news outlets and investigative reports brought attention to the workings of pyramid schemes, thereby raising public awareness. Additionally, government agencies, notably the FTC, and consumer protection organizations played a crucial role in adopting and popularizing the term through regulatory pronouncements, investigations, and warnings about the harmful nature of pyramid schemes, contributing to its widespread use.

Examples

Multi-Level Marketing (MLM) Pyramid Scheme: A multi-level marketing (MLM) pyramid scheme is a type of pyramid scheme that operates by recruiting a large number of individuals to sell a product or service. Participants are incentivized to recruit more participants, who in turn recruit even more participants, and so on. The recruitment process creates a pyramid-shaped structure, with the top levels of the pyramid earning money from the sales of those below them. In a pyramid scheme, the focus is on recruitment, not on selling the product or service, and most participants will earn little or no money from their efforts.

Ponzi Scheme: A Ponzi scheme is a type of pyramid scheme that operates by using the investments of new participants to pay returns to earlier participants. The scheme attracts new investors with the promise of high returns and minimal risk, but in reality, it is simply using the investments of new participants to pay returns to earlier participants, creating the illusion of a profitable investment. Ponzi schemes eventually collapse when the operator can no longer attract enough new investors to pay the returns owed to earlier participants, or when a large number of investors attempt to cash out their investments at the same time.

Gift Scheme: A gift scheme is a type of pyramid scheme that operates by encouraging participants to give gifts to other participants in exchange for the promise of receiving gifts from a larger number of participants in the future. Participants are often required to recruit new participants to join the scheme and to make a gift to someone else in the scheme. The scheme collapses when the number of participants is insufficient to support the number of gifts promised, and most participants end up losing money. Gift schemes are often marketed as "gifting clubs" or "women's prosperity clubs," and they are illegal in many jurisdictions.

Related Terms

• Ponzi Scheme: A fraudulent investment scheme that promises high returns with little to no risk to investors.

• Pump and Dump: A fraudulent scheme that is commonly used in the stock market and has also been seen in the cryptocurrency market.