Alchemy of A Pyraimd Scheme: Transmutating Business Opportunity Into A Negative Sum Wealth Transfer

The Alchemy of a Pyramid:
Transmutating business opportunity into a

negative sum wealth transfer∗
December 3, 2019
Andrew Stivers1 , Douglas Smith2 and Ginger Jin3,†

1
astivers@ftc.gov, 2 dsmith2@ftc.gov
Bureau of Economics, Federal Trade Commission
3 jin@econ.umd.edu
Department of Economics, University of Maryland, College Park and NBER

† Much of the work on this paper was done while Dr Jin was Director of the
Bureau of Economics at the Federal Trade Commission.

Abstract
Multi-level marketing (MLM) presents a challenging informational
environment for participants. MLMs offer participants the right to
sell a product with the recursive right to recruit new participants.
In addition to typical business opportunity challenges of assessing re-
tail demand, individuals face challenges in trying to understand the
recruitment opportunity. To illuminate the difference between a po-
tentially beneficial MLM and a harmful one — typically referred to
as a pyramid — we model the pricing decisions of an MLM firm. We
take beliefs about the value of an associated product and about the
probability of recruitment as given, but potentially wrong. We find
that participant optimism about the offer creates expected loss from
demand — as is usual for deceptively marketed business opportunities
— but also creates an opportunity for the firm to induce a transfer
scheme, and associated losses related to that scheme, independent of
consumer demand for any product.
∗ The analyses and conclusions set forth are those of the authors and do not
necessarily reflect the views of the Commission, or any individual Commissioner.
Electronic copy available at: https://ssrn.com/abstract=3497682

1 Introduction
Multi-level marketing (MLM) is a distribution and incentive mechanism that
has seen extensive scrutiny by law enforcement over the last 50 years, but
by comparison relatively little in the economics and marketing literature.1
MLMs are recursive, recruiting-based mechanisms that bundle the right to
sell a product with the right to sell the right to sell the product — i.e., partic-
ipants can sell the product and recruit participants who can sell the product
and recruit participants, recursively. Because the use of these distribution
contracts, by construction, results in multi-tiered networks of participants,
who each attempt to exercise and pass along the right to sell the product
and recruitment rights, this method of distribution is known more broadly
as multi-level marketing.
According to the World Federation of Direct Selling Associations (WFDSA),
globally, over 107 million individual were involved with MLMs in 2016, gen-
erating a sales volume as large as $182 billion.2 In the US alone, the Direct
Selling Association (DSA) identified 5.3 million people as being involved in
direct selling as a “business opportunity,” with a further 15 million identified
as being “discount customers.” Direct Selling Association (2016) estimated
that this U.S. based activity accounts for $36 billion in retail sales.
MLMs have attracted significant attention from consumer protection agen-
cies, as MLM-style contracts have also been used in what are called “pyramid
schemes.” Pyramid schemes share the structure of MLMs, but at least some
participation incentives are largely independent of any retail demand. Pyra-
mids are negative sum transfer mechanisms. These schemes are among the
top 20 frauds in the US (by prevalence) as surveyed by the U.S. Federal Trade
Commission and analyzed in Anderson (2013). The FTC has alleged that
some companies holding themselves out as lawful MLMs are instead illegal
1
For related Federal Trade Commission cases see: Koscot Interplanetary, Amway,
Omnitrition, Fortune HiTech Marketing, Burnlounge, Herbalife, AdvoCare International,
Vemma and Bitcoin Funding
2
See World Federation of Direct Selling Associations (2017). These estimates includes
all member countries of WFDSA except for China (as China did not report its 2016 number
to WFDSA). Distribution systems that are characterized by these bundled selling rights
are referred to by the Direct Selling Association (DSA) — an industry association — as
“direct selling,” where participants “are eligible to purchase products at a discount, and
resell them at a profit. They are also eligible to sponsor others to do the same.”See Direct
Selling Association (2016).

pyramid schemes.3
The central question that this paper addresses is: What makes an MLM
a pyramid?
Economically speaking, we typically presume that any economic actor
will only voluntarily enter into transactions that they expect to be welfare
improving. That is, parties will voluntarily agree to participate in a venture if
they have some expectation at the time of the transaction that they are better
off for having done so. Conversely, we would not expect economic actors to
voluntarily agree to a transaction where they expected to be worse off for
having done so. In many cases we could characterize transactions where at
least one party is induced to participate in a welfare reducing transaction as
fraud. A transaction that is not wealth generating and involves dissipative
transaction costs — i.e. is a negative sum wealth transfer — by definition
will make at least one party worse off.
As is well understood, an expectation of gain does not mean that partic-
ipants in a transaction will be better off ex post (or believe that they will
be better off), but rather that the ex ante expected value of entering into
the transaction is positive. Voluntary participants expect that the risk asso-
ciated with possible bad outcomes is offset by sufficient gains in the better
outcomes. Of course, in any business opportunity potential participants may
have inaccurate beliefs about the existence, probability, and/or magnitude
of gains.
In retail business opportunities, a common locus of inaccurate beliefs that
lead to unanticipated losses is consumer demand. Poor quality priors, incor-
rect information or deceptive practices can lead a participant to overestimate
demand and thus induce participation in a welfare reducing venture. An ad-
ditional potential locus of inaccurate beliefs in an MLM is the probability of
finding and recruiting additional participants. As discussed in this paper, in-
accurate beliefs about the recruiting opportunity contributes to the possible
losses from overestimating demand, but also has distinct effects. In particu-
lar, it appears to be a primary driver for when an MLM could be operated
3
See, for example, AdvoCare International, https://www.ftc.gov/news-
events/press-releases/2019/10/multi-level-marketer-advocare-will-pay-150-million-
settle-ftc; Fortune Hi-Tech Marketing, https://www.ftc.gov/enforcement/cases-
proceedings/112-3069/fortune-hi-tech-marketing-inc-et-al and Vemma Nutrition Com-
pany https://www.ftc.gov/enforcement/cases-proceedings/142-3230-x150057/vemma-
nutrition-company. See also Herbalife, https://www.ftc.gov/enforcement/cases-
proceedings/142-3037/herbalife-international-america-inc-et-al

as a pyramid.
The wealth generating potential of an MLM rests on the idea that, when
there is a product of sufficient value to consumers, the firm may be able to
reduce distribution costs relative to more typical distribution systems by us-
ing an existing or created network of links between its distributors, potential
distributors and customers. Theoretically, in the right context, and with the
right incentives, an MLM could be an efficient way to cover a market for a
product that would be more costly, or prohibitively costly, to reach through
a single-layer (or more complex, but still explicitly defined finite-layer) distri-
bution system. For example, the marketing of experience goods or credence
goods might be done more easily through testimonials or demonstrations by
friends or acquaintances that a potential consumer trusts.4 Regardless of
what the product is, the wealth-generating potential of an MLM rests on
there being sufficient consumer demand for the product to cover all pro-
duction and distribution costs, including all investments of time, effort and
money by participants.
By contrast, the mechanisms typically known as pyramids are primar-
ily transfer schemes. When there is no product involved, the pyramid is
a chain referral scheme or pure pyramid which, at best, ends up zero-sum
over all participants (and negative-sum, if a third party such as the scheme
organizer, takes a cut of revenues). When a viable product is involved, a
pyramid scheme may deliver some surplus gains to end-use consumers but
will remain zero-sum or negative sum over its participants, as laid out in
Vander Nat and Keep (2002). Often, pyramids are able to attract partici-
pants by exploiting inaccurate participant beliefs, and the recursive nature
of the recruiting opportunity; the basic objective is to create in the minds of
potential participants an inflated value of holding a right to recruit that ex-
ceeds any value that could be justified by consumer demand for the product
being distributed. By doing so, the operators of these schemes are inducing
money transfers into a scheme with a negative expected value payments we
refer to as transfer loss.
Injury to participants is relatively obvious in a simple chain referral
scheme or “pure” pyramid. These schemes are essentially decentralized Ponzi
4
According to ACNielson’s 2013 report titled ”Global Trust in Advertising and
Brand Messages”, word-of-mouth recommendations from friends and family continued
to be the most influential source among 84% of respondents to the Nielsen online sur-
vey. Source: www.nielsen.com/us/en/insights/news/2013/under-the-influence-consumer-
trust-in-advertising.html, accessed on June 30, 2017.

schemes, where current participants do the work of finding new participants.
Payments out of the scheme are necessarily funded by payments into the
scheme by other participants in a recursive pattern. Thus, any individual
participant’s positive return is necessarily offset by losses imposed on other
participants seeking to replicate those returns. Given that current partic-
ipants are dissipating resources to attract new participants, and there is
nothing in the scheme that generates new surplus, the average payout for all
current participants must be negative.
The informational challenge for potential participants is relatively simple
in this kind of pyramid. Without a product, there is no need to evaluate the
existence and magnitude of demand for a product, there is only uncertainty
over the odds of finding new participants. As we show below, a firm cannot
induce voluntary participation in a pyramid and earn a profit from doing so
unless participant beliefs over recruiting potential are optimistic about those
odds.5 These schemes have no demand risk and no demand loss (demand
is always known to be zero, as there is no product), but will have transfer
loss because at least some participants do not know a priori if they will suc-
cessfully recruit and thus receive a transfer, and will have inaccurate beliefs
about the probability of a payoff. As we show below, the presence of inaccu-
rate beliefs is necessary for a firm to profitably offer a pyramid scheme and
for any participants to voluntarily accept.
Consumer protection agencies tend to recognize that these schemes are
typically marketed deceptively as some kind of wealth generation scheme
— rather than as the negative sum wealth transfer schemes that they are
— and shut them down. While, theoretically, these schemes could try to
operate openly as lotteries to avoid deception, that would likely create other
law enforcement problems for the operator.
Because of this, we focus on the typical presentation of these schemes as
business or investment opportunities.6 We also presume, as is generally the
case when analyzing business incentives, that participants are risk neutral.
5
In principle, potential participants need not have any information aside from the bare
fact of the contract itself to know that participation has a negative expected value. In
practice, many potential participants may not be sophisticated enough to reach this con-
clusion, or may be actively dissuaded from doing so. Furthermore, with heterogeneous
beliefs, some participants may believe that they have greater than average chance of suc-
cess.
6
We presume here that participants are interested in making money because that is
how most of these schemes are marketed.(For two recent examples see footnote 3)

While in some negative transfer schemes, like gambling, some participants
derive significant utility from the riskiness, or social aspects, of the prac-
tice, we examine these opportunities as business opportunities and evaluate
them by their profitability, which is generally consistent with how they are
marketed.
Because chain referrals so obviously are negative sum wealth transfer
schemes, some fraudsters use the MLM mechanism of bundling the right to
sell a product of some value with the recursive right to recruit new partici-
pants. This allows the operator of the scheme to exploit one of the funda-
mental justifications for legitimate use of the MLM mechanism. Specifically,
that knowledge of demand for the product being distributed is allegedly local
to a participant and is not cost effective to be directly observed or met by
the operator of the MLM. The difficulty of observing that product demand
— without significant analysis — makes it difficult for outsiders to deter-
mine the nature of the risk that participants in a particular mechanism may
be facing. Observed losses may be due to unsuccessful participants: taking
on normal demand risk; being deceptively induced to take on unanticipated
demand risk, or; taking on necessarily loss-inducing transfers. The operator
exploits this perceived uncertainty to make representations and set incentives
that perpetuate the scheme.
Demand uncertainty has been studied extensively and is well understood
to be part of the normal entrepreneurial and organizational dynamic (while
the exact effects of risk on behavior are perhaps more controversial).7 There
are, for example, a variety of well-established principal-agent mechanisms
in use in the market that involve transferring risk of loss from one party
to another. Franchising is probably the most obvious analog to the MLM
mechanism in terms of transferring risk in a distribution context.8 In gen-
eral, when demand uncertainty is present, we expect ex post winners and
losers in market transactions. Participation may, however, be induced by
the presence or inducement of inaccurate beliefs about demand (or about
the costs of meeting demand). While operators have been found to mislead
participants about demand (and, more generally, income from participation)
in law enforcement cases against pyramids and MLMs, this kind of deception
is present across many kinds of business opportunities.
7
See, for example, Leland (1972), Kihlstrom and Laffont (1979), Vereshchagina and
Hopenhayn (2009), Mookherjee (2006).
8
For a discussion of this risk transfer mechanism, see Lafontaine and Slade (2002).

Unlike demand uncertainty, uncertainty over the recruiting aspect of
MLM participation has not been widely studied. This paper considers what
happens when participants have optimistic beliefs about the probability of
finding new recruits. A key result is that optimistic beliefs about recruit-
ing can lead firms to create an MLM that operates as a negative wealth
transfer scheme in which individuals voluntarily participate despite correctly
perceiving that they will lose money on the retailing of product.
The presence of inaccurate beliefs about the recruiting opportunity has
two implications. First, in the context of a potentially profitable retail op-
portunity (where demand is perceived to be sufficiently high to motivate
participation by itself), participants may have inaccurate beliefs about the
existence of additional consumers. This is still a question about demand for
the product. Second, and key to this paper, is that inaccurate beliefs about
recruiting — specifically optimistic beliefs about the probability of successful
recruiting — allows a firm to induce participation in a negative sum transfer
scheme. This gives rise to what we call transfer loss. This transfer loss is not
broadly present in business opportunities, and is thus presents a risk specific
to the MLM context. Aside from its presence in the use of chained recruit-
ing mechanisms, this risk is most closely analogous to that in speculative
bubbles.9
As we show, similar to speculative bubbles, pyramids relies on participant
uncertainty and inaccurate beliefs about the existence of future participants
that would be willing to pay into the scheme, unmoored from any valuation
independent of the opportunity to participate. Also like speculative bubbles,
pyramids typically sell product with some plausibly positive value to con-
sumers to introduce further uncertainty about the value of participation and
the nature of the risk. Doing so potentially invokes expectations of a normal
business or investment venture that could be expected to be a true wealth
generation mechanism. In this paper, we show how the existence of a product
is used as part of the mechanism to induce payments into the scheme.
As we also show in this paper, the MLM mechanism can theoretically
be associated with either the beneficial or harmful scheme. We show that
the outcome depends on whether an operator chooses to exploit participants
beliefs about the value of the product and their recruiting prospects to induce
a transfer mechanism. This suggests that the information provided by the
9
See, for example, Feiger (1976), Hirshleifer (1975), Harrison and Kreps (1978), Tirole
(1982).

firm, and by other participants, will likely be one key factor in creating the
conditions in which participants have expected losses from participating. To
be clear, this may not be a necessary condition. For a variety of reasons
— including existing participant beliefs or incentives of other participants to
mislead — firms may be able to induce participation in transfer mechanisms
without providing misleading information to potential participants.
When participants have accurate or pessimistic beliefs about recruiting,
the firm is constrained to offering at least the perception of a profitable
retail opportunity. In that case, as in any business, inaccurate beliefs about
the existence and magnitude of demand can induce participation when true
expected profits are negative. That is, there may be demand loss relative
to the true expected value. Because a recruiter is typically rewarded for
recruiting based on the purchases of her recruit, demand losses can also be
transfer losses.
When participants have optimistic beliefs about the probability that they
will be able to recruit, an MLM firm has the ability and incentives to oper-
ate a transfer scheme independent of beliefs about underlying demand. In
that case, it profits by inducing payments from participants to itself that
are unrelated to any consumption-generated surplus, and by exploiting the
difference between anticipated and actual reimbursement to participants as
profit. When there is a product of value to consumers, participants that are
optimistic about both demand and recruiting face both demand information
loss and transfer loss.
Thus, transfer loss will only arise when participants are optimistic relative
to the true probability of successful recruiting, and this is loss is distinct
from typical demand losses associated with inaccurate beliefs. As we show
below, when the firm can induce participation with unprofitable retail in
expectation, there is no endogenous limit on the magnitude of the transfer
that can be induced in this model. This is in contrast to transfers associated
with demand loss, which are in principle limited by belief about consumer
demand, an ultimately exogenous value. While we leave an exploration of
the firm’s influence over beliefs to later work, this result suggests a relatively
high incentive to deceive participants about the probability of success and
nature of demand in the MLM mechanism.
The rest of the paper is organized as follows. Section 2 reviews related
literature; Section 3 sets up the basic model; Section 4 analyzes the model.
Section 5 discusses the results in the context of consumer protection policy
and concludes with future research directions.

2 Literature
We are not the first to write about the economics of MLMs, but the literature
examining the theoretical underpinnings of MLM mechanisms is surprisingly
thin, given their long existence and the controversy that often surrounds
them. The basic structure and background of pyramids is laid out in Van-
der Nat and Keep (2002) and Keep and Vander Nat (2014).
Antler (2018) has a parallel analysis studying MLMs and pyramids. The
author uses boundedly rational agents to motivate the existence of a pyramid.
Using a more formal treatment of beliefs and network creation relative to this
paper, but consistent with our results, the author shows that a pyramid is not
sustainable with rational agents with accurate beliefs, and defects in belief
calculation that lead participants to be over-optimistic about success allows
a “scheme operator” to sustain a negative sum wealth transfer scheme.
While Antler (2018) explores important aspects of the theoretical MLM
environment, the current paper uses a much simpler framework, and what
we believe to be one that more accurately represents the reality of how these
scheme operate and the fundamental elements of that operation. Specifically,
one aspect of observed pyramid structures is that the operators typically mis-
lead prospective participants about the odds of success, and those prospects
have little other information to use. In addition, modern pyramids have
largely eliminated both overt recruitment rewards and upfront payments. In-
stead, they rely on recruitment-conditional commissions on purchases from
downstream recruits and encourage large and/or automatic purchases from
those recruits, regardless of consumer demand. For example, an operator
might tie participant eligibility for commissions to meeting purchase volume
requirements, allowing and encouraging participants to satisfy those volume
requirements through their own purchases. In a modeling sense, these play
nearly an identical role, but we believe that our approach better highlights
current issues facing law enforcement.
A small literature examines incentives within an MLM in how participants
divide time between sales and recruiting —notably Coughlan and Grayson
(1998) and Reingewertz (2016) — but these do not address the question of
how these incentive structures could interact with participant knowledge or
result in excessive or inefficient losses to participants. Bosley et al. (2018)
find, using an field experiment, that individuals have difficulty correctly eval-
uating the odds of “winning” in a pyramid-like scheme.
MLMs have some similarities to referrals in that distribution relies on

localized knowledge of demand. Typically, referral systems are modeled as a
channel of word of mouth between consumers, where the referring consumer
gives referral after her own consumption. There is no bundling of the referral
reward with a retail operation. Within these boundaries, referral reward can
be an effective way to spread user feedback, speed up reputation update,
and help to discover retail demand. By contrast, many MLMs market the
contract as a lucrative business opportunity, emphasize chain recruiting as an
important source of income, and highlight participants at the top of the tree
as the success story. The structure of the recruiting mechanism ensures that
almost all of these successful participants’ fortunes comes from recruiting-
conditional rewards instead of retail sales.
Given the significant impact that peer influence has on product sales,
retailers are motivated to use referral rewards to target certain groups of
consumers. Accordingly, researchers have explored ways to optimally design
the referral reward program, using strategic pricing as in Biyalogorsky et al.
(2001), social preference between peers as in Kornish and Li (2010), and
announcement of a reference program as a signal to early product adopters
as in Godes (2012). None of this literature concerns chain referral as an
incentive to entice someone into a business opportunity.
In terms of referral trees, the trees in Emek et al. (2011), as directed
graphs emanating from a single firm, are essentially the same as the social
graphs in this paper. However, that paper and related work — Lv and
Moscibroda (2016), Drucker and Fleischer (2012) — focus on the resilience
of reward mechanisms to multi-identity manipulation, not the potential harm
of the mechanism to the participants or the society as a whole.
Our paper is related to the literature of retail distribution (see review in
Basker (2016)). However, that literature draws a clear distinction between
the sales force and final customers, where sales force is an organization issue
inside a firm and consumers are economic players outside the firm. MLM
firms blur the boundary between salesmen and consumers: a participant
may purchase products from the MLM as a consumer; purchase products as
a salesman; or purchase as a salesman but end up as a consumer because of
low retail demand for her inventory.
The franchising literature considers a more decentralized distribution
mechanism where the sales force is external to the company. In both the
MLM and franchise settings, local demand variation creates risk, which can
influence revenue sharing and risk sharing between the firm (MLM firm or

franchisor) and the agents (MLM distributors or franchisees).10 The MLM
contract used in this paper is analogous to a simple linear franchise contract
with a fixed, certain investment (which may be negative) and a risky payoff
tied to sales from uncertain retail demand. In our MLM model, the certain
payout comes from the retail margin from own sales (which again may be
negative), and the risky payoff is tied to anticipated revenue from potential
recruits.
3 Model
Consider a risk neutral firm and N risk neutral agents organized in a fixed
and exogenous social graph. Consistent with the stylized structure of an
MLM, we consider an inverted tree emanating from the firm, where each
agent is a node with direct links to M unique downstream agents (except
K
M k = N . For a tree
P
end nodes). There are K levels in the tree, such that
k=1
with M k nodes at each level and K levels, there are M K end-nodes. Each
agent in level k faces the same incentives, so we generically refer to all agents
in level k as agent k.
Contact to any node in the graph can only be activated through the
previous direct link in the tree, so that the firm can only link to the first
level agents, a first level agent can only link to her M second level nodes,
and so on. If a first level agent bridges a link to the second level, then the firm
can observe and extend the contract to the second level, and so on through
all K levels and all N agents. Attempted recruitment, i.e. bridging the direct
link, is costly at a constant amount per contact, γ > 0. Bridging indirect
links — including for the firm — is assumed to have an infinite cost.11
The firm offers contacted agents a fixed, uniform contract. We incorporate
a number of stylized observations about typical MLM contracts into this
10
See Lafontaine and Slade (2002) for an discussion of the franchising problem.
Economists often describe the principal-agent problem in a moral hazard framework,
where the principal does not observe the agent’s effort but the observable outcome de-
pends on the agent effort and some noise such as local demand fluctuation (see reviews
in Prendergast (March 1999) and Mookherjee (2006)). Franchising is often thought as a
two-sided moral hazard problem, adding the principal’s effort (in brand-wide marketing)
as the unobservable on the agent’s side.
11
This structure also assumes that the cost of recruiting more than M participants is
prohibitive.
10

contract.
Observation 1. Contracts include both the right to purchase a product from
the company and the right to recruit others into the network in exchange for
a reward.
Observation 2. Contracts incentivize recruitment by agents.
Observation 3. Contracts bundle eligibility for recruitment rewards with
product purchase (or other up-front expenditure) by a participant.
Observation 4. Rewards are tied to product payments to the firm, which do
not necessarily reflect the consumption value of the product.
Observations 1 and 2 capture the defining features of an MLM, that
consumption, retail and distribution roles can overlap.
Observation 3 captures a common feature of these contracts that while a
participant can purchase product without recruiting, rewards for recruiting
are conditional on product purchases or other payments to the firm. These
purchases typically can be either made directly by a participant or by a par-
ticipant’s customers or recruits. Observation 4 highlights a feature that is
common to a variety of business dealings: rewards, commissions, residual
payments etc, are tied to payments to the company, rather than directly to
retail demand. The reason it is noteworthy here is that unlike most distribu-
tion methods, where Observation 3 does not hold, in an MLM a participant
may have incentives to purchase product either to meet market demand or
to meet the requirements of the contract.
As we show below, Observations 3 and 4 are necessary in the context of
this model to allow the firm to create transfers and take advantage of transfer
losses.
Consistent with these observations, the firm makes a take it or leave it
offer to all contacted agents consisting of: a unit good purchase requirement;
the price of that purchase, p, and; a per-recruit reward for successful re-
cruiting (and thus unit good purchase of that recruit), λp. The direct price
should be interpreted as an “all-in” cost that includes any fees or charges by
the firm for participation, including charges for training, or other business
development services. The reward λp is given to a recruiter in level k as a
fraction λ of the direct price p paid to the firm by their recruits in level k + 1.
Given the offer, each contacted agent makes two coincident choices. First,
the agent decides whether to accept the contract. Second, conditional on
11

acceptance, the agent decides whether to contact other agents for the purpose
of recruiting them into the network. More formally, an agent chooses from
the menu of actions ak ∈ {d, s, r} after being linked to and observing the
firm’s offer. These actions correspond to: do not participate (d); participate
by “retail”12 only — which implies some part or combination of consuming
or selling the product — without recruiting (s), and; participate by both
retailing and recruiting (r).
3.1 Beliefs
In the context of a real world MLM, agents would have limited, and poten-
tially biased, information about how participation in the firm’s offer would
affect them. For simplicity, we limit the model to two sources of uncertainty:
demand uncertainty and recruiting uncertainty. The first of these is common
to most business opportunities where entrepreneurs do not necessarily know
ex ante the demand for the products they wish to sell. The second, as its
name suggests, is unique to recruiting-based business opportunities where
the existence of available recruits may not be known ex ante.
In terms of the recruitment uncertainty, at best, agents might know ex
ante the number of their potential contacts M , but they would not typi-
cally know their place in the network, k relative to K, or overall network
parameters N or K (either of which would be sufficient to determine the
other). Because of this, participants typically would not have enough infor-
mation to calculate the probability of being an end-node or not, which is
a crucial value for them to be able to evaluate their expected profit from
participation. Even given this information, typical participants may not be
able to correctly calculate the probability of success either due to innumer-
acy or incorrect information or deceptive practices. Recent empirical work
by Bosley et al. (2018), and the consistent presence of deception in schemes
that have been found to be pyramids, suggests a likelihood of inaccurate
beliefs by participants. We examine the effect of incorrect beliefs about the
availability of recruits on the firm’s offer, and agent outcomes. Given the
uncertainty, beliefs about success are plausibly k-independent and therefore
may be homogeneous across all participants, as we assume here to simplify.
Participants have exogenous ex ante beliefs µ̂ about the probability that
12
We use retail loosely here to encompass both discount purchases for self consumption
and selling to an outside consumer
12

they will have potential recruits. Prior beliefs are not necessarily informed
by accurate information about the structure and size of the network, but
beliefs are rationally updated if possible and are based on all of an agent’s
available information. We denote accurate beliefs about the probability of
potential recruits as µ. Accurate beliefs are those that are equal to the true
ex ante probability that any one of the N individual agents will have available
recruits (i.e., be an interior, rather than end, node):
N − MK
µ= .
N
As we lay out below, we will be simplifying the model by examining the
case where the population size goes to infinity. We do this by fixing M , and
letting K go to infinity. In that case, for a fixed M we define µ as the limit:
N − MK 1
µ = lim = . (1)
K→∞ N M
N
To see this, note that N − M K can be written as M
− 1.13 Substituting this
in to µ yields µ ≡ NN−M
M
, and simplifying yields:
1 1
µ= − . (2)
M N
As K → ∞, N goes to infinity and the final term goes to zero.
Agents also face demand uncertainty. Consumption value for the firm’s
product, w, (through own consumption or through retail sale) is unknown
by agents prior to purchase, and is drawn from {0, v} where v > 0 and the
probability of v is δ ∈ [0, 1].14 We assume that agents have homogenous,
exogenous prior beliefs about δ equal to δ̂. Given these beliefs, we assume
agents are risk neutral and have expected value for the product Ew = δ̂v.
We further characterize uninformed beliefs in two categories relative to
accurate beliefs. We call an agent’s belief about the recruiting opportunity
“optimistic” if they believe the probability that they are not an end node
13
PK−1 N
Add and subtract 1 from N − M K . The terms N − M − K + 1 = k=0 M k = M .
N
Returning the subtracted 1 yields M − 1.
14
Enforcement concerns have highlighted differences between consumption that is inter-
nal to the distribution network, and external to that network. The basic function of the
chained recruiting mechanism is not dependent on that distinction, therefore we abstract
away from that here.
13

is greater than the true probability: µ̂ > µ. We call an agent’s belief “pes-
simistic” if they believe the probability that they are not an end node is less
than the true probability: µ̂ < µ. Similarly, we call an agent’s belief about
the expected value of the good optimistic if δ̂ > δ and pessimistic if δ̂ ≤ δ.
The agents’ beliefs µ̂ and δ̂ are common knowledge to agents and the firm.
In addition, the number of potential recruits available to each participant,
M , the support for the value of the product {0, v} and the costs of recruiting
γ are known to all. Given that the firm is likely to be more experienced in
the market, we assume that the firm also knows the true probabilities µ and
δ.15
3.2 Objective functions

Profit for a firm that incentivizes recruiting by participants is given by rev-
enue — the number of agents that participate multiplied by the price the firm
charges — minus distribution costs. For the firm’s M direct contacts, that
cost is just γ per agent. For the remaining fraction of the (N − M ) agents
that participate, the firm pays a reward equal to fraction λ of the price as
noted above. Note that this is not a reward paid to the N − M recruits, it is
a reward paid to the recruiters of the N − M recruited participants that pur-
chase a product from the firm. Supposing that the firm’s offer is attractive
to all agents, this profit is:
πF (p, λ) = (N p − M γ − (N − M )λp) . (3)
It will be convenient to reorganize terms slightly and divide by (the ex-

ogenous number of participants) N to yield average (per agent) profit:
1 M
πF (p, λ) = p(1 − λ) + (λp − γ). (4)
N N
This formulation highlights the fact that the firm’s profit per participant is
the product price, net of the reward needed to incentivize agents to recruit
an agent to pay that price, plus an adjustment term to account for the fact
that the firm does not need to compensate itself with λp for recruiting its M
15
The homogenous beliefs presented here allow us to examine the overall mechanism
and expected outcomes in a relatively simple model. The presence of heterogeneous beliefs
seems likely to allow some more informed participants to join the firm in profiting from
inaccurate beliefs. In order to maintain the simple model, we leave this to future work.
14

direct contacts. Instead, it directly incurs the cost M γ. As N becomes large
(relative to M ), this adjustment term becomes less important to the firm,
and in the limit disappears. We formalize this observation in the following
proposition.
Proposition 1. Holding all other environmental parameters constant we de-
fine π̄F as the limit of Equation 4 as K goes to infinity:
1
π̄F = lim πF = p(1 − λ), (5)
K→∞ N
and the convergence is uniform.
Recall that K is exogenous. For reasonably large K, equation (5) provides
a more straightforward description of firm maximization, and unlike equation
(4) it does not depend on the firm knowing M N
, information the firm is unlikely
to have in practice. Therefore, we focus on the equation (5) version of the
firm maximization problem in our analysis.
Before moving on to participant incentive constraints, first note that the
incentive condition for the firm preferring recruiting over not participating
at all is λ ≤ 1.16 Second, note that the maximum expected surplus that can
be generated by the distribution of the product with value, v, and cost of
distribution γ, across N agents is: T S = N (v − γ).
Expected profit for a potential recruit is a function of her action, condi-
tional on the offer, her beliefs, and her expected demand: π(a|p, λ, µ̂, δ̂, w).
We consider three possible actions. First, if the potential recruit opts out
(d), she gets her reservation utility of zero. Second, if the recruit only sells or
uses the product (s), she gets the difference between the product value and
the price. Third, if the recruit attempts to recruit as well (r), she incurs the
costs of M recruiting efforts, and believes that she will get her recruitment
reward λp for the expected participating fraction of her M contacts with
probability µ̂. Ex ante expected payoffs for an agent are then:
πv (d|p, λ, µ̂, δ̂, w) = 0 (6)
πv (s|p, λ, µ̂, δ̂, w) = δ̂v − p (7)
πv (r|p, λ, µ̂, δ̂, w) = δ̂v − p − M γ + µ̂M λp. (8)
Note that expected recruiting profit is in terms of agent beliefs rather than
actual recruiting probability or expected demand. Consequently, the agents’
16
We also require that the firm commit to paying rewards.
15

beliefs will influence the incentive compatibility constraints and thus the
reward and direct price offered by the firm.
3.3 Incentive Constraints

As we are particularly interested in the recruiting mechanism, we focus on
the case where the firm prefers, and incentivizes, recruiting as noted by Ob-
servation 2 above. In that case, the firm wants to ensure that agents partic-
ipate and that they (weakly) prefer recruiting over retailing only. That is,
from Equation 8, the firm wants π(r|·) ≥ max{π(d|·), π(s|·)}. This condition
yields constraints on the reward as a function of agent beliefs:
(1
µ̂
γ if retailing dominates sitting out, p ≤ δ̂v
λ(µ̂, δ̂v)p ≥ 1 p−δ̂v
(9)
µ̂
γ + M
if sitting out dominates retailing, p > δ̂v.
From µ = M1 we can write this as an expression that highlights how the

relationship between the true probability of success µ and the belief µ̂:
(µ
µ̂
Mγ if retailing dominates sitting out, p ≤ δ̂v
λ(µ)p ≥ µ
µ̂
M γ + p − δ̂v if sitting out dominates retailing, p > δ̂v.
(10)
Equation 10 identifies a crucial distinction in our model: whether —
and if so, when — a firm could induce participation in an MLM with an
expectation of unprofitable retail. We equate an expectation of profitable
retail with the case where the price charged by the firm is weakly less than
the expected value of the good. The first case above presents retailing alone
as a (weakly, in expectation) profitable option for agents, depending on agent
demand uncertainty. This incentive constraint involves the typical demand
uncertainty that any retail business opportunity might hold, where potential
participants may over or under estimate consumer demand. Because the
firm does not force recruitment, it must be incentivized over and above any
expected retailing profit. This implies that the firm must reimburse the
participant for recruiting costs, weighted by the inverse of participants’ belief
about the probability of successful recruiting. As the belief in successful
recruiting falls, the compensation for that perceived risk rises.
The second case shows the incentive constraint when the price charged
by the firm is greater than the expected value of the good, i.e., retail is ex-
pected to be unprofitable by itself. In that case, the next best alternative to
16

recruiting for the participant is not participating at all. When presented as
a bundled contract for retailing and recruiting, the firm has two instruments
to play off each other: expected retail profit, and reward for successful re-
cruiting. In particular, with the bundled offer, and given a belief µ̂, the firm
can potentially profit by shifting participant profit between the retail margin
and the return to recruiting.
From Equation 3, the profit to the firm is decreasing in the reward λ
for positive prices. This means that the incentive constraint will be binding
for the firm’s profit maximizing offer of λ∗ (which corresponds to choosing
λ so that the incentive constraint binds). Substituting these rewards from
Equation 10 into the average profit function for the firm, Equation 5, yields
per participant profit as a function of the agent beliefs and the choice of
direct price:
(
p − µµ̂ M γ if p ≤ δ̂v
π̄F (p, λ∗ (µ)) = µ (11)
p − µ̂ (M γ + p − δ̂v) if p > δ̂v.
Per participant firm profit is the firm’s direct revenue from its distributors,
net of recruiting rewards for all successful recruiting. When the firm’s price
is greater than the expected value of the product, recruiting rewards must
include an upward adjustment to compensate for expected retail losses in
order to keep all recruiters indifferent between participating and not.
From Equations 11, when the expected retail margin is constrained to
be weakly positive — p ≤ δ̂v — the firm’s per participant profit is strictly
increasing with respect to direct price and the firm will charge the highest
price it can under that constraint, that is, p = δ̂v.
In the absence of such a constraint, the firm’s willingness to charge more
than δ̂v is a function of how much it will need to reward participants to
overcome their belief that they may be unsuccessful in recruiting, and to
therefore balance against their expected loss from unprofitable retail. For a
given belief µ̂, the marginal profit associated with increasing p when p > δ̂v
is:
∂ π̄F (p, λ∗ (µ̂)) µ

|p≥δ̂v = 1 − . (12)
∂p µ̂
That is, the firm will be considering the relationship between its marginal
increase in revenue (equal to one) with its marginal increase in payouts (equal
to the ratio of the true probability of payout to the perceived probability).
17

For µ̂ approaching 1 — agents approaching perceived surety of success —
marginal profit is positive and the firm would prefer to increase the price as
high as it can, independent of the expected demand parameters δ̂ and v or the
supply parameter γ. For µ̂ approaching 0 — agents approaching perceived
surety of failure — the marginal effect of increasing price is negative, so the
firm will not be able to profitably increase price above p = δ̂v.
At the point where agent beliefs are accurate, µ̂ = µ, the marginal increase
in revenue is just equal to the marginal increase in reward payout and the
firm is indifferent between raising the price above δ̂v and keeping the price
at δ̂v.
This analysis leads to the following proposition:
Proposition 2. When agents have homogenous beliefs about their probability
of successful recruiting that are greater than µ, i.e. agents are optimistic,
the profit-maximizing firm can increase profits by inducing recruiting with
expected unprofitable retail (p > δ̂v). When agents have homogenous beliefs
that are less than µ, i.e. are pessimistic, the profit-maximizing firm will not
induce participation in a mechanism with expected unprofitable retail, so sets
p = δ̂v.
4 Analysis
In this section, we draw a distinction between demand loss that is typically a
risk in business opportunities, and transfer loss, which is a risk specific to the
MLM mechanism. We examine more closely the firm’s offer to agents with
optimistic beliefs. We contextualize this by also showing the results when
agents are pessimistic.
4.1 Demand vs Transfer Losses

We find it useful to distinguish between two types of expected rents stemming
from incorrect beliefs. These are distinguishable in part because the first,
demand loss, is at least plausibly limited by an exogenously determined value
— the presence of positive demand for the product — that is typical for
business opportunities. Transfer loss, on the other hand, is determined by the
firm’s choice of p > δ̂v and exists because the recruiting rewards offer the firm
a mechanism for delinking payments in (the price) from payments out (the
reward), as translated through the inaccurate beliefs about the probability
18

of success. Note that Proposition 2 means that transfer effects as defined
here are always negative, if they exist, and they only exists when retail is
unprofitable. Note that the distinction is useful to show that MLMs pose
additional risk, relative to other business opportunities, but in practice what
we label as demand losses could be seen as transfer loss.
When there is a profitable retail opportunity and recruiting is incen-
tivized, true ex ante expected profit for participants is given by substituting
p∗ = δ̂ and p∗ λ∗ = µ̂1 γ into Equation 8:

µ
π(r|δ̂, µ̂, p = δ̂v) = δ − δ̂ v + − 1 M γ. (13)
µ̂
Equation 13 illustrates the typical demand loss that entrepreneurs might face
in any business opportunity. In this context, the first term is participant
profit stemming from deviation of their information about the probability of
positive demand from true. Because participants may over- or under-estimate
the value of the product, they may be induced to over-pay, or induce the firm
to accept a lower wholesale price, relative to the true expected value.
The second term is participant profit associated with an incorrect belief
about the probability of recruiting (still with the perception of weakly prof-
itable retail sales). Participants may over or underestimate the probability
of finding a recruit, which in this case is synonymous with whether demand
can be increased by M . Both terms are related to inaccurate beliefs about
an ultimately exogenous issue: whether or not demand exists (from µ̂), and
whether or not the value is positive (from δ̂) if it does exist. Optimism
about either δ or µ leads to expected losses by the participant, as they then
would be, respectively, overcharged for the product and under-compensated
for recruiting new sellers. The effect is ambiguous when beliefs over the ex-
pected value of the good and the recruiting opportunity are mixed between
pessimistic and optimistic.
Based on 13, we use the following definition.
Definition 1. We define demand loss as the expected profit stemming from

optimism about the existence (from µ̂) and magnitude (from δ̂) of consumer
demand shown in Equation 13.
Actual ex ante recruiting profit for participants when the firm sets the
price above retail value — i.e., when the firm offers an unprofitable retail
19

opportunity — includes an additional term related to the excess (above ex-
pected retail value) payment by the participant, and the relevant recruitment-

∗ −δ̂v
conditional reimbursement. Substituting p∗ > δ̂v and p∗ λ∗ = µ̂1 γ + p M
into Equation 8:

µ 1 1
π(r|δ̂, µ̂, p > δ̂v) = δ − δ̂ v + − 1 Mγ + − (p − δ̂v). (14)
µ̂ µ̂ µ
or
µ
π(r|δ̂, µ̂, p > δ̂v) = π(r|δ̂, µ̂, p = δ̂v) + − 1 (p − δ̂v). (15)
µ̂
Equations 14 and 15 show that the same demand loss (or gain) still exists
when retail is expected to be unprofitable. This is because the underlying
value of the product, and then uncertainty about that value and its existence
is still the same. However, there is now a transfer loss stemming from the
difference between the actual transfer into the mechanism — the certain
payment over the expected value of the product, p − δ̂v — and the actual
expected reward to cover that transfer, µµ̂ (p − δ̂v). This is necessarily a loss,
as the firm cannot profitably induce participation in an unprofitable retail
opportunity when consumers are pessimistic.
This is a transfer loss because, unlike the recruiting related loss associ-
ated with demand (γ), which is dissipated outside the model in pursuit of
additional participants, and must be compensated by payments out of the
firm’s share of surplus, the transfer loss from the participant is both collected
by the firm and compensated by the firm.
When agents are optimistic, the marginal cost to the firm of compensa-
tion through the reward is less than one, while the marginal benefit from
inducing the loss is 1 as shown in Equation 12. This means that the re-
cruiting mechanism can potentially be used as a money pump by the firm,
funded by payments from participants that are unrelated to consumer value
of a product. This induced expected loss by participants is the transfer loss
that can arise in the MLM mechanism, and its potential presence constitutes
a risk that is not present in typical business opportunities.
Definition 2. We define transfer loss as net loss enabled by inaccurate
beliefs about the probability of reimbursement for a transfer unrelated to con-
sumer demand.
To further highlight the difference between demand and transfer loss, we
compare the offer from the MLM firm to a linear franchising contract with
20

demand uncertainty in the case of certain value v (δ = δ̂ = 1). In each
case, for each participant, the relevant quantity demanded is either 1 unit
of direct sales (if recruits are unavailable), or M + 1 units (if M recruits are
available).17 The contract takes the form of a certain payout from the retail
margin of required direct sales — v − p — and a risky share of revenue from
the M units. The participant decides whether to invest in capacity to reach
the risky demand at cost M γ.
A franchisor could take advantage of a franchisee’s optimism in reach-
ing the additional demand by under-compensating for investment costs, and
therefore inducing ex ante demand loss. However, unlike the MLM case,
where a retail loss can be compensated through payments from participants
(driven by a a willingness to take on the transfer loss in anticipation of re-
cruiting yet another level of agents), the franchisor’s ability to induce retail
loss is limited by the anticipated retail value of the risky product demand, v,
because any potential profits the franchisee makes on greater capacity must
be funded by consumers’ purchases. This means that while the franchisor
can take advantage of the optimism of the franchisee by under-compensating
for the investment M γ, the loss that can be induced is anchored to retail
value. The maximum that can be extracted from the risky demand is vM
when v is known.
If incentive compatibility assumes a zero outside option, and the fran-
chisee receives vM with probability µ, then the most that a franchisee with
µ
accurate beliefs would be willing to lose is µ−1 vM .18 If the franchisee is
maximally optimistic, so µ̂ = 1, she would be at most willing to lose vM .
In effect, this limits the franchisee to experiencing demand loss exemplified
by the first case in Equation 13 where the retail markup must be weakly
positive. This is not necessarily the case for the MLM firm, as shown by 15.
In what follows, we lay out the conditions that give rise to the transfer
loss and the under-compensation for both demand and transfer losses.
4.2 Optimistic participants

Suppose that agents have optimistic beliefs δ̂ O > δ and µ̂O > µ. If agents
mistakenly believe that they will be able to recruit with a higher probability
17
Unlike the full MLM model, we restrict the structure to at most two levels in order
to allow a comparison.
18
Expected benefit for these participants is: µvM + (1 − µ)X = 0. Solving for X gives
the acceptable loss.
21

of success than µ, then as laid out in Proposition 2, the marginal profit to
the firm of raising p above v is positive. That is, with optimistic agents, the
benefit to the firm of increasing the price is greater than the cost to it of
increasing rewards to compensate for that increase. Because the resulting
profit margin to the firm from inducing that loss on the agents is strictly
positive, the firm’s preferred price is only limited by an exogenous limit on
participant liquid assets. We presume that individual agents have a practical
limit on how much they are able to invest, which we denote by I.
The firm will optimally set price equal to this limit, p∗ = I. In order to
induce participation, the expected reward will need to be perceived as com-
pensating for the known, dissipated recruiting loss γ, as well as the captured
expected retail loss, I − δ̂ O v. From the incentive compatibility constraint in
Equations 10:
∗ O µ O

λ (µ̂ )I = O M γ + I − δ̂ v . (16)
µ̂
Given this reward, participant (perceived) expected profits are weakly
positive (zero). Actual average participant profits, from Equation 14 and
δ < δ̂ O , µ < µ̂ are negative:
! !
1 1
π(r|δ̂ O , µ̂O , p > δ̂ O v) = δ − δ̂ O v+ O 1 γ+ O 1 (I −δ̂ O v) < 0.
µ̂ − µ µ̂ − µ
(17)
This leads to the central result of the paper:
Proposition 3. When agents are optimistic and the firm is profit maximiz-
ing, average and thus total agent profit from participation in the mechanism
is negative. The firm will profitably induce losses on participants as a group
in two ways:
1. Demand loss: Optimistic beliefs allows the firm to under-compensate

agents for risk stemming from demand uncertainty, yielding a negative
total expected profit for participants activity to meet demand.
2. Transfer loss: Optimistic beliefs about the recruiting opportunity al-

lows the firm to profitably induce transfer payments unrelated to any
underlying product demand from unsuccessful participants to itself and
successful participants. The firm profits by under-compensating partic-
ipants for taking on the transfer risk.
22

First, because agents are optimistic, the firm can under-compensate both
for direct demand, and for the uncertainty about whether recruiting costs
will be wasted. When beliefs are accurate, the firm pays a premium of µ1 − 1
over the full informed reward, which exactly compensates for the probability
that an agent was an end node. In the optimistic case, because agents believe
that probability is lower than it is, the firm can offer a smaller premium —
µ̂0 > µ implies that µ̂10 − 1 < µ1 − 1. As noted, this lower payment could
arise in any business opportunity where participants had biased beliefs about
the probability of profit related to distribution cost or demand parameters.
Obviously, and in any case, the firm may have an incentive to influence
beliefs to be more optimistic in order to lower the risk premium that they
pay toward offsetting this demand risk.
Second, in addition to, and distinct from, the ability of the firm to under-
compensate for optimistic demand beliefs and optimistic recruiters for distri-
bution costs relative to the retail demand for a product, using the recruiting
mechanism allows the firm to exploit the optimism of agents about recruiting
to induce transfers unrelated to demand from the unsuccessful participants
to successful participants and to the firm.
To clearly distinguish between demand loss and transfer loss, note that
in the extreme case that both v and γ are set to zero, demand loss is equal
to zero independent of participant beliefs δ̂ O . From Equation 13:

O O

O
1 1
π(r|δ̂ , µ̂, p = δ̂ v) = δ − δ̂ 0 + − 0 = 0. (18)
µ̂ µ
However, the transfer loss still exists. From Equation 15:

O O 1 1
π(r|δ̂ , µ̂, p > δ̂ v) = 0 + O
− (I − δ̂ O v) < 0. (19)
µ̂ µ
Further, this illustrates that we so far have conservatively credited both

the demand belief bias (δ̂ O − δ)and the recruiting costs (M γ) as relating
to demand loss. For the latter, this is obviously the case when no transfer
exists, and demand is positive. However, this is just as obviously not the
case when v = 0. When value is zero and recruiting costs are positive the
recruiting costs are dissipated in pursuit of a reimbursement for the transfer
I, and these costs should be counted as part of the transfer loss. Arguably, in
the intermediate case where demand is not zero (v > 0), but p > δ̂ O v, so that
participation would not occur but for the expectation of a reimbursement of
23

a transfer, the recruiting costs could still be considered part of the transfer
loss. Because successful participants benefit generally from an increase in
the price, the increase stemming from demand belief bias is also a transfer.
4.3 Firm share of the transfer

The average net transfer that can be induced by the firm across the MLM
when participants are optimistic about the probability of recruits can be
broken down into the shares that go to each of three groups: the end node
participants, the non-end node participants and the firm. We write this
average net transfer as: TK +Tk<K (µ̂)+TF (µ̂) ≡ 0. That is, the transfer from
unsuccessful participants, plus the transfer from successful participants, plus
transfers from the firm must be equal to zero. To highlight the distribution
of the transfer we normalize the payment I to be net of any value of the
product.19
The population average negative transfer into the scheme that is actually
paid by unsuccessful participants is the share of unsuccessful participants,
multiplied by their payments, I:
TK = −(1 − µ)I < 0. (20)
This isolates the transfer loss that is captured by other participants and the
firm. It does not include demand loss from optimistic beliefs about demand,
or dissipated recruitment costs.
Each of the successful participants pay in I, and after recruiting their M
contacts, get µ̂1O I in return. Their average net positive transfer is:

O 1
Tk<K (µ̂ ) = − 1 µI > 0. (21)
µ̂O
If transfers the firm induced with accurate beliefs, the total payments to
the successful participants would match the total payments from the unsuc-
cessful ones — TK = Tk<K = (1 − µ)I. There would be no transfer loss,
as shown above, because the risk would exactly be compensated by the re-
ward. However, the optimism of participants allows the firm to profit from
inducing transfers by under-compensating, under the presumption of homo-
geneous ex ante beliefs, to the successful participants. The firm can then
We are changing notation slightly, to define I as I = I˜ − δ̂v, where I˜ is the arbitrary
19
amount participants will invest.
24

skim off part of the transfer for itself. This means that, even setting aside
the under-compensated and dissipated recruiting costs, the total participant
share from the transfer is negative, and the firm’s share of the transfer is
positive:

O O µ
TK − Tk<K (µ̂ ) = TF (µ̂ ) = π̄F = 1 − O I ≥ 0. (22)
µ̂
As noted above, in any business opportunity with optimistic participants
we would expect net losses to participants as a group, as shown in Equation
13, as participants are under-compensated for their risk. However, without
the recruiting/reward mechanism, participants could not be induced to ac-
cept retail losses when they know that there is no retail opportunity (i.e.
v = 0), and therefore no retail risk, as is the case here. In addition, un-
like compensation for dissipated recruiting costs, which will always result
in some cost to the firm, the recruiting structure allows net retail losses by
participants to translate into net gains for the firm.
5 Discussion
Our model highlights the importance of participant beliefs in an MLMs profit-
maximization problem. A key result of the analysis is that even when a
product could be marketed through a network of distributors efficiently (i.e.
delivering consumption value in excess of all production and distribution
costs), optimism on the part of participants may allow the MLM to set
prices and rewards such that the average return across participants is neg-
ative. In part, this result is the typical story of one party in a transaction
exploiting the systematic biases of the other for profit. However, because
the recruiting mechanism sets up a situation where the payment extracted
from a participant, p, is proportional to the rewards she could earn if she
successfully recruits, M λp, participants will always accept an increase in p
and corresponding increase in rewards if they agree to participate in the first
place. The operator of the MLM will find it profitable to increase p when
participants are optimistic about the odds of successfully recruiting because
the expected payments out for the operator are less than the payments in.
In other words, optimism on the part of participants allows the operator of
the MLM to induce a negative sum transfer mechanism where a portion of
the total transfer payments in are paid to recruiters in the form of rewards,
25

but the remainder is kept by the firm as profit. The greater the optimism by
participants, the larger the share of the transfer the operator can keep.
We model beliefs over retailing and recruiting separately in order to un-
derstand what can lead to loss-inducing payments from participants. We see
that under certain conditions, participants may willingly participate even
when they expect a retail loss, so long as they expect a net gain from the
combination of retailing and recruiting. If participants have accurate beliefs
about recruitment, the MLM’s profit is capped by exogenous factors that
it cannot manipulate, but if participants have optimistic recruiting beliefs,
then the firms profits are limited only by participant liquidity constraints.
While any business opportunity entails risk, and therefore may result in
realized losses from failure to find expected demand, and while beliefs about
expected demand may be incorrect or misled, leading to uncompensated
risk-taking, the potential transfer losses associated with exploiting optimistic
beliefs about the recruiting opportunity are different. They are unrelated to
demand uncertainty and instead arise strictly from an under-compensated
gamble that they will be reimbursed for their payment into the scheme if
they successfully recruit.
The nature of the MLM mechanism also has implications for how the
firm might want to characterize the opportunity. In general, a firm may
have an incentive to overstate the demand for a product or the probability of
successful recruiting to participants because that will increase willingness to
pay for the product and reduce the required upside reward for success. How-
ever, in most retail or distribution environments, the firm’s ability to extract
additional payments is limited by participant beliefs about the consumption
value generated by the retail opportunity itself. For a fixed value for the
product when demand exists, once the firm has convinced the participant
that there is zero risk of demand not existing, the firm can only extract the
surplus that the participant believes can be generated as determined by that
exogenous fixed value.
In the recruiting environment, the firm has an additional incentive to
overstate the probability of success at the margin between pessimistic and
optimistic because the addition of a second payoff margin allows the firm to
de-link its price from retail value. The participant’s willingness to pay for the
right to participate ultimately hinges on her expectations over the combined
return to the bundled activities, and not on the return of either activity
individually. A wholesale “product price” in this context acts as a payment
that participants make in return for the joint right to retail and to recruit.
26

With optimistic participants, it allows the firm to induce a negative sum
transfer from unsuccessful participants in the form of under-compensated
retail losses.
Distribution can be nominally efficient (the consumption value of the good
is greater than recruiting cost) even if it creates net losses for participants
and needlessly shifts the distribution of payoffs to higher losses for unsuc-
cessful participants. However, this raises a question as to whether a business
opportunity is typically understood as a negative transfer mechanism for
participants as well as a surplus generation mechanism.
Finally, we have shown that even when distribution of the product is
inefficient (because the value is less than the costs) sufficiently optimistic be-
liefs can sustain participation, and unbounded payments (except from some
exogenous liquidity constraint) in the negative sum transfer scheme. When
beliefs are uninformed and optimistic, the more optimistic beliefs in success-
ful recruiting are, the greater a portion of the transfer from the end node
participants the firm can capture. If participants are completely optimistic
(believe there is no risk), the firm can capture all of the induced payment-in
of the end node participants as profit.
The presence of at least weak pessimism by all participants about whether
any given participant will be able to successfully recruit theoretically prevents
the firm from profiting from the negative sum transfer scheme. In this case,
the upside reward required by participants to cover both the natural risk
of uncompensated recruiting costs and the retail losses that go uncovered is
higher than the additional revenue generated by those retail losses.
From a policy perspective, our analysis of this simple model suggests fur-
ther exploration of two general ways to address risk may be useful. First,
as with any business opportunity, policymakers want to make sure that par-
ticipants are not given misleading information about underlying demand or
supply parameters. This has additional importance in the context of this
model, where optimism about the existence of another level of recruits can
induce a willingness to accept a transfer scheme unrelated to any indepen-
dent demand for product. Second, given that such biases may be preexisting,
or misleading statements may be hard to stamp out, or the structure of the
mechanism itself leads to misperceptions, policymakers may need to better
understand the nature of the contract itself. Especially in the case of a
firm that has shown itself willing to induce a transfer scheme, there may be
benefits to blocking some aspects of the contract.
The natural question is then: which aspects of the stylized contract could
27

be changed to prevent or mitigate the possibility of transfer loss?
While we cannot provide definitive answers, given the limited nature of
the model, we examine each of the stylized observations about MLMs, and
ask what the effect of banning the practice would be on the firm and agents.
In some cases we also address some obvious possible modifications to the
practice. Again, this discussion is in the context of this model, with attendant
consumer harm, and should be taken as suggestive of areas needing more
research.
For convenience, we list them again here:
Observation 1. Contracts include both the right to purchase a product from

the company and the right to recruit others into the network in exchange for
a reward.
Observation 2. Contracts incentivize recruitment by agents.
Observation 3. Contracts bundle eligibility for recruitment rewards with

product purchase (or other up-front expenditure).
Observation 4. Rewards are tied to product payments to the firm, which do

not necessarily reflect the consumption value of the product.
In the context of this model, these observations suggest a few ways to

mitigate or prevent the risk of a pyramid scheme. We examine each of these
observations in turn for possibilities.
First, and most obviously, dispensing with recruiting would prevent the
risk of a transfer scheme. The FTC has imposed an ex post MLM ban on
companies that it has determined to be pyramids as a way to prevent transfer
loss.20
Second, appropriate changes to the incentives to recruit could reduce an
operator’s ability to induce or allow participation in a transfer scheme. In
the context of our simplified model this could occur either through some
mechanism that dampened participant optimism about recruiting, or by ap-
propriately shifting the relative incentives of retailing and recruiting . In a
more complicated setting with more realistic demand, a more economically
intuitive approach could be to ensure that the usual feedback loop between
consumer demand and participant entry decisions is in operation. For ex-
ample, limiting rewards to sales that are directly fulfilled to non-participant
20
AdvoCare International is the most recent case, see footnote 3.
28

consumers could re-establish the disciplining force of downward sloping de-
mand. However, imposing appropriate controls would likely be difficult and
costly to design, implement and audit. This covers both the second, and the
fourth point.
Third, removing purchase requirements as a condition for eligibility for
recruitment rewards would prevent the firm from inducing participants to
accept “retail” losses in exchange for a potential transfer payoff. Partici-
pant’s could make purchase decisions solely on the basis of whether they
expected to be able to profitably re-sell the inventory, or wanted to consume
the product.21 That is, this would allow participants to refuse to participate
in unprofitable retail, and therefore refuse to pay into the transfer scheme.
This would still allow the firm to under-compensate for demand risk, but this
issue is not unique to recruiting mechanisms, and the potential participant
losses would be lower than if retail can be unprofitable.
We emphasize that this discussion is in the context of a simple model,
and further research is needed to understand the conditions under which
these contract changes are implementable, justifiable and effective. Actual
MLMs are more complex than our stylized model, and therefore potentially
offer the firm a variety of other avenues for encouraging participation in a
loss-inducing scheme. For example, because participants benefit from their
recruits’ purchases, they have incentives to encourage excessive payments
(unmoored from consumption demand or explicit incentives in the consump-
tion plan) by those recruits. In addition, the complex structure of the MLM
itself may induce confusion, and excessive payments.
Two obvious areas to explore are more complex belief structures and
downward sloping demand. More complex belief structures could include
examining less uniform beliefs. It might be particularly interesting to under-
stand how beliefs that declined in k or some function of k affect the firm’s
offer to participants. The firm could potentially tailor its offer to match the
level of pessimism by participants, and therefore how much surplus the firm
could extract from each of those participants. However, whether the firm
could, ultimately, sustain any zero sum transfer is likely to be solely a func-
tion of the beliefs of an end node participant (the level of which could be
endogenous). In addition, offering k-dependent contracts may change agents
21
This does not ensure that they will. Recruiters would still benefit from those pur-
chases, and may thus still find ways to encourage purchases by their recruits independent
of consumer demand.
29

information in ways that would not be stable, or would allow agent arbi-
trage between levels or beliefs. Downward sloping demand creates additional
trade-offs for participants in the form of potential competition by their own
recruits and more complex trade-offs in incentives to purchase product from
the firm. As with more complex beliefs, more complex demand may lead to
more complex incentive mechanisms.
Another promising direction for study is the formation and transmission
of participant beliefs. As noted in the introduction, law enforcement concerns
about MLMs typically include both questions about the incentive structure of
the recruiting mechanism and about the characterization of the opportunity.
This latter suggests that the transmission of information from the firm, and
through the network of participants may play a crucial role in determining
whether the MLM is susceptible to abuse.
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Alchemy of A Pyraimd Scheme: Transmutating Business Opportunity Into A Negative Sum Wealth Transfer

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The Alchemy of a Pyramid:

Transmutating business opportunity into a

Andrew Stivers1 , Douglas Smith2 and Ginger Jin3,†

Department of Economics, University of Maryland, College Park and NBER

Bureau of Economics at the Federal Trade Commission.

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3.2 Objective functions

πF (p, λ) = (N p − M γ − (N − M )λp) . (3)

It will be convenient to reorganize terms slightly and divide by (the ex-

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3.3 Incentive Constraints

From µ = M1 we can write this as an expression that highlights how the

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∂ π̄F (p, λ∗ (µ̂)) µ

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4.1 Demand vs Transfer Losses

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Definition 1. We define demand loss as the expected profit stemming from

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4.2 Optimistic participants

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1. Demand loss: Optimistic beliefs allows the firm to under-compensate

2. Transfer loss: Optimistic beliefs about the recruiting opportunity al-

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However, the transfer loss still exists. From Equation 15:

Further, this illustrates that we so far have conservatively credited both

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4.3 Firm share of the transfer

TK = −(1 − µ)I < 0. (20)

amount participants will invest.

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Observation 1. Contracts include both the right to purchase a product from

Observation 2. Contracts incentivize recruitment by agents.

Observation 3. Contracts bundle eligibility for recruitment rewards with

Observation 4. Rewards are tied to product payments to the firm, which do

In the context of this model, these observations suggest a few ways to

Electronic copy available at: https://ssrn.com/abstract=3497682

Electronic copy available at: https://ssrn.com/abstract=3497682

Antler, Y.: 2018, Multilevel marketing: Pyramid-shaped schemes or exploita-

Basker, E.: 2016, Handbook on the Economics of Retailing and Distribution,

Coughlan, A. T. and Grayson, K.: 1998, Network marketing organizations:

Electronic copy available at: https://ssrn.com/abstract=3497682

Direct Selling Association: 2016, Direct Selling in 2015: An Overview, DSA.

Drucker, F. A. and Fleischer, L. K.: 2012, Simpler sybil-proof mechanisms

Feiger, G.: 1976, What is speculation?, The Quarterly Journal of Economics