Pyramid Scheme

Updated About encyclopedia.com content Print Article Share Article
views updated

Pyramid Scheme

What It Means

A pyramid scheme is a fraudulent business practice that involves the building of a network, or “pyramid,” of investors who pay money into the scheme with the hope of earning a high return on their investment. Hierarchical in structure, a pyramid scheme has a single individual or entity at the top of the pyramid, underneath which is an expanding base of investors. An investor pays to participate in the scheme and then recruits other investors to join the pyramid, who subsequently pay money to the investor who recruited them. Pyramid schemes rarely provide an actual product and rely solely on the willingness of recruits to invest money into the scheme. Pyramid schemes are considered a form of business fraud in most countries and are therefore illegal.

In most pyramid schemes, the person who originates the scheme sends a letter or other form of communication to a number of individuals. The letter typically describes a business opportunity that promises a high financial reward in a short time and that requires little effort. In some cases, the letter will purport to offer the recipient an actual product, such as a financial report, or, in the case of many Internet pyramid schemes, a computer code. These products generally contain no intrinsic value, however, and are used to persuade participants to pay money into the scheme. The recipient of the proposal is asked to send a relatively low sum of money, the “investment,” to the person who sent the communication. The recipient is also asked to send the same letter with the same instructions to a number of other people. The letter, which is sent to an increasing number of recipients, is called a chain letter.

The revenue, or income, of a pyramid scheme is generated through the recruiting of more and more participants who are willing to send money to the people who invited them to participate in the scheme. The success of a pyramid scheme depends on the number of people who are willing to become involved in the scheme. As the network of potential participants expands, the pyramid scheme begins to collapse as lower percentages of people are willing to send money to the people above them and the scheme ceases to generate income. The only people who profit from a pyramid scheme are those that join it near the beginning. Without exception, the people who form the bottom levels of the pyramid, those who join the scheme after it is well under way, lose their money.

When Did It Begin?

Although the exact origins of the pyramid scheme are unknown, one of the earliest and most notorious pyramid schemes in modern history dates to the years immediately following World War I. The scheme was created by Italian-American Charles Ponzi (1882–1949). In December 1919 Ponzi founded the Securities Exchange Company, a firm that promised to double investors’ money within 90 days of the initial investment. As Ponzi lured more and more people into his scheme, he began paying the scheme’s earliest investors double the amount of their initial return. Word quickly circulated of the company’s success, and soon Ponzi was taking in more than $1 million a week. By July 1920 newspaper reports began to expose some of the flaws in Ponzi’s business model, and by the end of the summer it was revealed that he was bankrupt. Ponzi disappeared after a brief stint in prison, only to emerge a decade later in Florida, where he ran another lucrative pyramid scheme involving fraudulent land deals.

More Detailed Information

A legitimate business model involves a product or a service that creates wealth for the people who participate in the business. For example, a person invests $20 to buy supplies to build a birdhouse. After building the birdhouse, the person then sells it to a customer for $40. The person earns 100 percent profit ($20) on his initial investment, and the consumer receives a product he or she considers valuable.

Pyramid schemes, on the other hand, do not create wealth. No product or service is actually offered, other than the idea of wealth. The majority of people who pay into the scheme lose money. Pyramid schemes involve a redistribution of existing wealth from the hands of many into the hands of a few, without actually providing an actual product or service in exchange.

The unsustainable nature of a pyramid scheme becomes apparent when one considers how quickly the number of recruits grows. For example, say the originator of the pyramid scheme, a single individual, writes a letter to 10 people inviting them to participate in a “can’t miss” business opportunity. The letter instructs the recipient to send the same letter to 10 additional people. In this way, the number of investors increases exponentially; that is, the number of investors continues to multiply at a constant rate, even as the number of investors grows higher and higher. Say that each of those 10 individuals contacts 10 more individuals, creating a total of 100 individuals. Those 100 individuals contact 1,000 individuals, the 1,000 individuals then contact 10,000 individuals, and so on. Theoretically, the pyramid scheme would encompass 1 billion participants by the 10th round of contacts.

Recent Trends

The Internet brought on a revolution in human communication, creating an electronic network for people to communicate with one another and to buy and sell goods. Along with new communication and business opportunities, the Internet also created a wealth of new opportunities for scam artists. The speed of Internet communications made it possible for pyramid schemes to grow at a rate that would have been impossible using traditional mail. Easy-money opportunities have become prevalent on the World Wide Web, as invitations to participate in various schemes, from marketing electronics to joining money-making online “games,” flood people’s e-mail accounts daily.