Direct Selling Under Scrutiny: Assessing Analytic Direct Selling Models

Direct selling (DS) is simultaneously a business model, a channel of distribution, and an activity engaged in by its distributors. In this paper, we provide a framework for analyzing and discuss academic research on the DS distribution model. We focus in particular on research that develops economics-based analytic models to examine business and legal issues. This focus is motivated by the fact that analytic models are sometimes used as part of the assessment of whether a DS firm operates a legitimate DS channel or an illegal pyramid scheme. These models potentially have a significant economic impact on, and affect the outcomes of legal cases against, the affected DS firms. They may also be cited in the business press and in academic circles, influencing opinions of the viability or legality of the DS business and distribution model. It is therefore particularly important that such research be carefully grounded in sound logical and analytic bases, and that it appropriately reflect whatever key facts about the firm (or about DS in general) are relevant to the model’s scope of analysis. We first describe direct selling as an economic activity and business model. We contrast illegal pyramid schemes with legitimate DS firms and outline the key definition of an illegal pyramid scheme. This definition is distinguished from the many possible indicia of pyramid schemes that can result from pyramid scheme operation, but do not themselves prove the existence of a pyramid scheme. We next define and discuss various logical and analytic errors that can lead to the mis-diagnosis of a legitimate DS firm as an illegal pyramid scheme operator. While many such error types are possible, we focus on four that we find to be particularly important in evaluating the analytic literature on DS and pyramid schemes: • The “Begging the Question” fallacy, in which the research in effect presumes the existence of a pyramid scheme through its (implicit and/or explicit) assumptions, and as an unsurprising result, concludes the existence of a pyramid scheme; • A variant on the “Begging the Question” fallacy in which the research effectively models a pyramid scheme through its omission and/or misrepresentation of substantive facts on which the determination of legality versus illegality depends; • The “Fallacy of the Converse,” in which the converse of a true if-then logical statement is incorrectly asserted to be true on the grounds that the original if-then statement is true. For example, even if the statement {if a firm operates a pyramid scheme, then one can expect to see some or all of a set of resulting indicia at some point in time} is reasonably true, it is not automatically true that the converse statement {if one observes a set of pyramid scheme indicia at some point in time, then the firm must be operating a pyramid scheme} is also true; and • A special case on the “Fallacy of the Converse,” in which the research ignores standard policies and protections that characterize legitimate DS firms, and therefore starts with an inaccurate premise that these policies and protections do not exist. All of these modeling errors are substantive. This means that correcting any of these errors overturns the model’s results. Such a model is thus not a reliable tool to assess whether a DS firm does, or does not, operate a pyramid scheme. We apply this framework to the analysis of a recent working paper, “The Alchemy of a Pyramid: Transmutating Business Opportunity Into a Negative Sum Wealth Transfer” by Andrew Stivers, Douglas Smith, and Ginger Zhe Jin (“SSJ”). We find that this research begs the question, omits and/or misrepresents substantive DS firm facts, and commits a fallacy of the converse by omitting consideration of standard DS firm policies that mitigate a pyramid scheme analysis. Specifically, SSJ “begs the question” of whether or not a DS firm operates an illegal pyramid scheme by explicitly assuming a pyramid scheme in its list of “stylized assumptions” – which duplicate the conditions for a pyramid scheme defined in the Koscot case. Thus, the authors cannot deliver on their research goal of answering the question “What makes an MLM firm a pyramid?”, because they have already assumed the pyramid scheme outcome from the beginning. Further, SSJ commits another “begging the question” error in explicitly assuming that the firm in its model commits fraud by purposefully misrepresenting the business opportunity to its prospects and distributors. Because a pyramid scheme cannot persist through time without such fraud, the authors again essentially presume a pyramid scheme outcome. These first two critiques fully invalidate the SSJ research, whose authors state that its goal is to answer the question: “What makes an MLM firm a pyramid?” One cannot achieve this research goal by assuming a pyramid scheme as the basis for a model that then produces the inevitable result that a pyramid scheme exists. Nevertheless, other errors further weaken the SSJ analysis. Many substantive facts about DS firms – which are important to the resolution of the model’s claimed purpose – are omitted or misrepresented. Among them are: • Its omission of any income sources to a distributor other than bonus awarded for mere recruitment without regard to sales (such as retail markup income or the economic benefit of personal consumption at wholesale prices); • Its misrepresentation of the basis on which bonus/commission income is awarded by DS firms, by assuming they are only awarded for pure recruitment; • Its omission of products that have market value to consumers; • Its omission of consideration of distributor differences on substantive dimensions that matter for the research question at hand; • Its omission of active choices by distributors concerning what to sell, how hard to work, how to price products for retail sale, how much to invest in training, whether or not to seek to recruit other distributors, or how much to personally consume; • Its misrepresentation of the DS firm’s objective as the maximization of one-period profit, with no consideration of the legal implications of the fraud it implies; and • Its omission of consideration of standard consumer and distributor protections offered by legitimate DS firms. • We discuss other substantive and technical problems with the SSJ model in Appendix B. The SSJ paper concludes with a set of recommendations to control pyramid scheme threats. Because of the shortcomings we find in the model and analysis, we find that any such recommendations similarly rest on shaky foundations and are unreliable as cures for the question at hand. We use our framework to offer an analysis of a subset of other economics-based analytic modeling papers in the DS area in Appendix A. We emphasize that our goal is not to argue that all such analyses are flawed. Indeed, economics-based analytic models are productively used in many applications and should continue to be applied to analyze firms’ operations, participants’ decisions, profitability, and growth. We hope that assessment of these efforts will be aided by applying guidelines for reliable and applicable scientific inquiry into various aspects of the DS distribution model.