Multiple-Level-Marketing or Pyramid Scheme? — an economist’s perspective
I was approached by a guy on Linkedin today. He tried to talk me into what he called a ‘relational-marketing’ business. The company name is called ACN (Australia Communication Network?). The idea is that everyone can become a ‘partner’ with this firm by signing up (with a fee) and start ‘selling’ or more like ‘referring’ utility or mobile phone plans to random people, starting with your own friends of course. Then, you get a share of their bills every month, plus a bonus for the recruitment. If one of your ‘customer’ become a partner of ACN and managed to get their own ‘customers’, you get a share of their bill as well, so on so forth.
Of course, I said no. I was shocked that it is actually legal to do something like this. Because it sounds very much like a Pyramid Scheme. I mean, look at the Wikipedia definition of a Pyramid Scheme:
A pyramid scheme is a business model that recruits members via a promise of payments or services for enrolling others into the scheme, rather than supplying investments or sale of products. As recruiting multiplies, recruiting becomes quickly impossible, and most members are unable to profit; as such, pyramid schemes are unsustainable and often illegal.
That sounds very much like ACN’s business model he is talking about, right? How is that legal? Well, they called themselves a multi-level-marketing (MLM) company. Again, from Wikipedia:
ACN, LLC (formerly ACN, Inc.) is a North-American based multi-level marketing (MLM) company[5] which provides telecommunications, identity theft protection, energy, merchant services and other services, depending on the country, through a network of independent sales agents known as “Independent Business Owners” (IBOs), who themselves can recruit new IBOs. IBOs can earn residual income and bonuses through the acquisition of personal customers, as well as customers by other IBOs who they recruit.
I don’t know. It still sounds like a Pyramid Scheme to me. This piqued my interest. I googled online and found the background story. It turns out that this company ACN has been around since 1993, and they are definitely legal. Back in 2006, the ACCC (Australian Competition and Consumer Commission) tried to sue them for ‘Pyramid Selling’ and won the first trial, but than ACN appealed and the Full Federal Court upheld their appeal, which means they are a legal business now.
So, what’s the difference between a pyramid scheme and a legit MLM business? The key distinction is whether the profit for the members comes from a “real product”, rather than the recruitment fee. What ACN is selling is ultimately some utility or mobile phone plans – legit products. As long as the recruitment bonus does not become a major share of the total income, the business is a legit multi-level marketing (MLM) operation.
I am not interested in the legal debate of whether ACN is a legit business or whether you can actually profit by ‘starting your own business’ with them. I just want to explore the economics behind it.
Exponential growth
Most people are attracted by a pyramid selling scheme through the illusion of exponential growth — “You will have to build your network, that’s hard at the start. But once your network is established, it will grow without needing any attention from you anymore. Because your customers will go and find their own customers, who in turn pay you, so on so forth ”.
Make sense, right? We found something that can grow proportionally to itself, the bigger it is, the faster it grows, and the bigger it gets. Isn’t that, amazing? Except — isn’t that the way everything grows? If I think a restaurant is good, I will tell my friends about it. My friends will tell their friends who will tell their friends, etc. So the restaurant should be flooded with new customers, right? Well, last time I went there for dinner, it still has plenty of empty seats. What’s wrong? It turns out that my words do not make the food more delicious*. I can only communicate my opinion to others. The information can spread at whatever speed. But the food is the food, those who like it will like it, those who dislike will ditch it. My words do not generate extra value to the product or services. It serves no more than an advertisement.
(*I understand that good reviews resolve the information asymmetry and do make the product better in a ‘risk-adjusted’ sense. Since ACN is mostly selling utility plans where the price and the quality of services are relatively transparent, I would rather skip this and focus on other more relevant concepts. )
The nature of supply
Why does the advertising industry exist, then? Because it is costly to send the right information to the target audience. If only one percent of the people in the whole city would recommend a restaurant after they tried, the purpose of the advertisement is to reach to these one percent of people at the lowest possible cost within the shortest possible time. The advantage of having a giant poster on the highway is that it does not incur an extra cost when an extra person sees it. The more people see it, the less the average cost of the advertisement. Additionally, a good advertiser can tell the sellers where their potential customers are. When you search for ‘mobile phone plan’ on Google, it knows that you are the target audience for the ads from Vodafone. So Vodafone is willing to pay Google a lot to put their ads on top of the search results.
The punch line is — a marketing channel cannot blow up the size of the customer base out of thin air. The value of marketing or advertisement is to reach the target customers at lower costs. Over the past few decades, modern technologies, such as television, mobile phone, the Internet, etc., has significantly lowered the cost of communication. This has led to the boom of the advertising industry — including peer-to-peer advertising. Nowadays it is quite easy to reach out to strangers on social media platforms such as Facebook, Instagram, Linkedin, etc. As a result, many people can start their own business to participate in peer-to-peer advertising. MLM arises as the cost of such type of marketing product become cheaper to produce. The same reasoning can be applied to the emergence of ride-sharing. The GPS technology in our phone, the free navigation services from Google and the internet platform from Uber all contribute to much lower transaction cost to the supply and demand of a ride.
Lower cost of production leads to an outward shift in the supply curve. Many people would laugh at the simplicity of the graph below. But economists would appreciate such simplicity.
The outward shift is simultaneously a shift to the right (more quantity) and down (lower price). The supply curve is more than a depiction of how much a producer would produce at different price levels. It corresponds to the marginal cost of the last unit produced. Why? Because if an extra unit of production cost more than the market price, it won’t be produced; if an extra unit of production most less than the market price, it will be produced more. The supply curve is a collection of optimized production decisions where marginal revenue of production equal to marginal cost. When something becomes cheaper to produce, its marginal cost of production is lower than the ‘current’ market price, thus more production will follow, shifting the supply curve outward — until a new market outcome is reached at a lower price (P’) and higher quantity consumed (Q’).
This casual relationship between “lower cost” and “more production” is backed by economic theory. When we see more products selling around, people typically think of higher demand as the driver (which can be true), but economists are more interested if it is due to the lower cost of production (because the shift in demand is quite unpredictable anyway).
Residual value
Having understood the nature of supply, we can move on to discuss another argument from many MLM practitioners like to quote— residual value. It is believed that there is a surplus from production where the cost of production is lower than the price sold. It is tempting to think that it the existence of such surplus mean that it can be exploited, by providing services such as MLM. Unfortunately, it is not that simple.
We already know that the nature of the supply curve is the marginal cost of production, the gap between the cost of production and the market price (blue triangle below) represents the ‘producer surplus’ resulted from the production. Just like the supply curve itself, producer surplus is a result of the optimization of the production levels by the producers — it is an outcome after the level of production is decided. The reason that producer surplus exist is to compensate for fixed cost and capital (i.e. profit). There is not much money left on the table for anyone else to exploit. Instead, to acquire a share of such profit, one needs to contribute to the lowering of the supply curve which would enlarge the blue area.
To isolate the effect from fixed cost vs profit, we introduce the ‘average total cost’ (ATC) curve. The ATC curve lies below the supply curve because when the marginal cost (supply) increases, average total cost increases at a lower rate as the extra cost is ‘spreads’ across all previously produced units in the denominator. The gap between the two lines and the volume of production gives the amount of profit. Here Q is the number of customers a utility or telecommunication retailer would like to reach/maintain through a marketing channel, and P is the per-unit price they would pay. A provider of such marketing channel would reap the blue area as profit. I have simplified the chart by making the demand curve flat. It is not unreasonable because the final product producer (e.g. utility provider) tend to offer a fixed price for each extra customer provided from the marketing channel.
However, in the case of MLM marketing, the profit needs to be ‘shared’ across all participants. Because ACN partners typically do not offer ‘discount’ on the utility plans compared to the market price. The only incentive for people to participate in the scheme is to become another ‘Independent Business Owner’ and start looking for their own customers. What does it mean for the marginal cost of acquiring a new customer? It increases along with the number of customers. This is a built-in property of any hierarchical selling structure— the cost of acquiring an extra customer is more than the cost of acquiring the last customer. The rate of increase could be very fast — even exponential. What does that mean to our chart? Somewhat unintuitive — bigger profit.
Note that I have not changed the intersection point of the supply and demand. Basically, I am assuming that MLM marketing could somehow acquire the same volume of customers as traditional marketing, at the same cost — but the rate at which marginal cost increases is steeper. This won’t be realistic if you look at the whole market. But if we can limit ourself to a smaller customer segment of the population where MLM works (or is attractive), we can find something quite interesting about this business model— when you make the marginal cost curve steeper, the gap between marginal cost and average cost would be widened, which means more profit.
Where does this profit come from? That’s the key observation I would like to highlight — the pillar for a successful MLM business model is LOWER COST, just like the nature of the supply of all economic activities. Did you notice that the new (steeper) supply curve lies below the old one to the left of Q in my chart above? As we have discussed, this means it is cheaper for the MLM model to ‘attract’ this number of customer to the end product (utility plans, etc.). If you think about it, it does not cost ACN much to let you set up your ‘own business’ under their brand, where you automatically become part of their customers and even pay them an entry fee. In my opinion, what companies like ACN have done is using the “start your own business” idea to mask the lower marketing cost of acquiring these specific niche segment of customers for the end products. In doing so, the pyramid structure is the perfect way of only rewarding the very top performers while keeping players down the hierarchy engaged. This is why the MLM model could still have a role to play in such a competitive marketing or advertising industry.
Summary
The provision of some new (or more) product in an economy is usually associated with producers’ ability to provide it at a lower cost. Sometimes this is not obvious. The new producer might have a very different corporate structure or business model. But if they cannot provide the goods or services at a lower cost than the existing market participants, they would not thrive in a free market.
The MLM model arised as the cost of peer-to-peer communication is significantly lowered by modern technology. The MLM model also succeeded in its ability to approach a very specific segment of customers — those who are attracted to the idea of “start your own business” and are probably over-optimistic about their sales skills. The MLM company such as ACN can acquire these customers at a much lower marketing cost and supply them to end product providers. But to make this model work, top performers need to be awarded and promoted to keep players at the lower hierarchy engaged — hence the pyramid structure.
