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What Is a Pyramid Scheme?

By Todd Mei PhD | Crypto U Education | 17 Jan 2023


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Whenever fraudulent crypto projects make off with a lot of money, people tend to throw around the term "Ponzi scheme" a lot. While I explain exactly what a Ponzi scheme is in a related post, it's worth mentioning here that often such fraudulent scams are closer to pyramid schemes. With Ponzi schemes, there is typically no valuable asset or service in which one is investing. Ponzi schemes also do not rely on the type of layered and hierarchical structure of returns on which pyramid schemes rely.

It's also important to bear in mind that pyramid schemes are not necessarily fraudulent, just a bit vicious for those late adopters. In any case, knowing how a pyramid scheme works will not only save you from the confusion but help you to identify whether a venture you're in which you are about to get involved deserves more caution than not.

Build that Pyramid and They Will Come

Pyramid schemes often have an asset or commodity that drives profit. However, the pyramid structure is one in which only one or a few people have control over the asset. The asset is either valuable in itself or has the potential to be valuable. Other people literally buy into the pyramid in order to gain access to the asset; and they usually only stand to realize a profit if they can sell it on to others at a higher price (i.e. those lower on the pyramid). Hence, what is key to the pyramid scheme is that early buyers pay less in price relative to those who come later.

The pyramid functions so long as:

  1. the asset is valuable or is seen as gaining value in the future; and
  2. there are other people willing to buy the asset.

It seems like point 2 would be necessarily entailed in point 1 — i.e. there is no value or future value without someone willing to buy it. This is true, but as we will see in our examples, this necessary relation is not always clearcut.

Example 1: Weak Pyramid
Orca Corporation produces the gizmo. It sells its product by relying on salespersons going to the public. It recruits its sales force with a few perks–be your own boss, create your own schedule, work as much as you want, etc. All a prospective salesperson has to do is buy the gizmo starter kit. While the salesperson makes money off selling the gizmo, there is also another time-based incentive.

Salespeople who are hired early can sell gizmo kits (and act as recruiters) to later prospective salespeople. Yet the earlier generation of salespeople sell the kits at a higher price; and likewise, the next generation does so to subsequent salespeople.

Why is this a weak example of a pyramid?

It does not solely rely on additional lower layers of the pyramid being added. This recruiting/selling scheme works so long as the gizmo product can be sold. It does not necessarily rely on there being a constant flow of potential salespeople (i.e. lower levels of the pyramid) to buy starter kits.

Example 2: Strong Pyramid
Perhaps the most prominent form of a pyramid scheme is the housing market, which is really the land market. Because land is a finite resource, commodity-wise only a relatively small percentage of the population have ownership of it. While land is essentially for livelihood in terms of having a place to live and a place to work, the land market is typically about leveraging the limited amount of land. In most urban areas, there simply is no more land to go around except at a high price. And living in rural places where there may be land available means being far from job opportunities.

So the land market is often one in which people will invest in it in order to “flip it” at a higher price to someone who wants it. Because everyone knows land is limited in amount, the pressure to buy is enormous. Land values tend to drop significantly only when the wider economy is in recession.

Why is this a strong example of a pyramid?

It requires additional buyers being added to the pyramid. This type of pyramid scheme is viable only so long as land is valuable and there are people willing to pay the price being offered. If prices remain too high, or there is simply the lack of financial wherewithal to buy land (as in a recession), then land values will drop. Not only is there no new additional bottom layer of investors being added to the pyramid, but the lack of buyers will cause those higher up on the pyramid who own land to lose on their investment.

*****

In sum, a pyramid scheme is not necessarily fraudulent. It can be a Ponzi scheme, and a Ponzi scheme can use a pyramid structure; but the two are not identical. Pyramid schemes can be based on real value, but its hierarchical structure means that the majority of people who participate in the scheme are losers in relation to those at the top.


This article originally appeared on Medium and is a part of the Crypto Industry Essentials educational program presented by The Art of the Bubble.

Though this article is credited to me, it contains some written material by Sebastian Purcell, PhD from his The Art of the Bubble education series on cryptocurrencies.

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Todd Mei PhD
Todd Mei PhD

Todd is a former Associate Professor of Philosophy with over 16 years of research experience in the philosophy of work and economics. He is currently the lead researcher and writer for the Web3 consultancy group, 1.2 Labs.


Crypto U Education
Crypto U Education

Cypto U is a series of blogs providing educational content for crypto enthusiasts. Content and lessons have been taken from The Art of the Bubble and 1.2 Labs.

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