Pyramid Schemes, Ponzi

Schemes, and Their

Impossible Legitimacy
1B IB SL Mathematics
Oliver Homa
2/4/2016
Homa 1

Pyramid Schemes

A pyramid scheme is a business model that operates by recruiting members

through a promise of payments or services for enrolling others into the scheme. This

constant addition of members creates a model that resembles a pyramid, thus earning

these scams their name. Recruiting multiplies very quickly, and the delivery of the

promised payments or services becomes impossible. This leaves most of the members

unable to profit. Pyramid schemes are currently illegal; however, they have existed for at

least a century. Charles Ponzi organized the Securities Exchange Company in Boston in

1919 and tricked very many investors, shocking the financial market of the United States

and introducing this type of fraud.

My inspiration to explore this topic comes from my recent attendance of a finance

class during a college visit. The professor was speaking about investing and how pyramid

schemes trick investors. I became very interested in the topic from a mathematical

standpoint, and decided to apply what I have learned in class to the reality of the world of

finance.
Homa 2

The Airplane Game

The “Airplane Game” is a common pyramid scheme that was very active in the

late 1980s in North America and Europe. The system involves a single “Captain” at the

top of the pyramid. The captain recruits two “Co-Pilots,” who proceed to each recruit two

“Crew” members. Afterward, each of the four “Crew” members recruits two

“Passengers.” This pattern can virtually continue without end.

Figure 1

Figure 1 illustrates the progression of the recruitment. In four tiers of the scheme, there

are 15 total people (1+2+4+8). The system is a geometric progression.

A geometric progression, or geometric sequence, is a sequence of numbers where each

term after the first is found by multiplying the previous one by a fixed number called the

common ratio. The following is the general form of a geometric progression.

 a is equal to the initial number

 r is equal to the common ratio

Homa 3

In order to demonstrate the rapid expansion of the “Airplane Game” scheme, I will model

the recruitment using a geometric progression.

 a=1, resembling the initial “Pilot”

 r=2, resembling the number of new members each individual must recruit (the

common ratio)

1, 2, 4, 8, 16, 32, 64, 128 . . .

As we can see, the number of members grows very rapidly, even at a low recruitment

requirement of just two members.

Impossibility

The schemes often require new members to recruit more than two people. I will

investigate and demonstrate the impossibility of establishing a successful pyramid

business model.

For my investigation, I will implement a recruitment requirement of four people for each

new member using the “Airplane Game” system. This means that in order to join into the

scheme, one must bring four additional individuals with them. First, the same geometric

progression equation will be used.

 a=1, the model will once again begin with a single individual initiating the

recruitment

 r=4, each new member will need to recruit four more, establishing the ratio

1 + 1(4) + 1(4)2 + 1(4)3 + 1(4)4 + 1(4)5 + 1(4)6 + 1(4)7

= 1 + 4 + 16 + 64 + 256 + 1024 + 4096 + 16384

= 21845
Homa 4

Essentially, this means that each individual number is the amount of people that each new

level of members must recruit in order for the scheme to remain possible. Above, I

extend the progression to eight levels. Although it becomes very large, with 21,845 total

people participating, it still remains manageable. So at which point does the scheme

become impossible?

LEVEL RECRUITION REQUIREMENT

8 16,384

9 65,536

10 262,144

11 1,048,576

12 4,194,304

13 16,777,216

14 67,108,864

15 268,435,456

16 1,073,741,824

It is obvious that the system grows out of control very quickly. Table 1 only shows the

number of members that need to be added to the system in order for it to function;

therefore, the total number of members is equal to the sum of all of the previous levels

and the current level. Claiming that the model remained manageable with 21,845 total

participants was a stretch; however, as the number reaches into the millions, it is clear

that this is in no way manageable.

Homa 5

Since each level brings in four times as many members, at the nth level down from the

top, there are 4𝑛 members.

 n= the level down from the top

 the top level is equal to n=0

This means that the total number of members for the nth level plus all of the levels above

1−4𝑛
is equal to 4 ∗ . This uses the formula for the nth term of a geometric sequence
1−4

with a common ratio r (𝑎𝑛 = 𝑎𝑟 𝑛−1 ).

This means that:

𝑀𝑒𝑚𝑏𝑒𝑟𝑠 𝐿𝑜𝑠𝑖𝑛𝑔 𝑀𝑜𝑛𝑒𝑦 4𝑛

=
𝑇𝑜𝑡𝑎𝑙 𝑀𝑒𝑚𝑏𝑒𝑟𝑠 1 − 4𝑛
4∗ 1−4

 We assume that each new member brings in four more.

 We assume that only the last row loses money. Theoretically, each row above it

could profit if the system continues. However, that is unlikely and practically

impossible.

I simplify the fraction:

4𝑛 4𝑛 4𝑛 −3 ∗ 4𝑛
= = =
1 − 4𝑛 1 − 4𝑛 −12 1 − 4𝑛 −12 ∗ 4𝑛 − 1
4∗ 1−4 4 ∗ −3 −3 ∗ −3

𝑀𝑒𝑚𝑏𝑒𝑟𝑠 𝐿𝑜𝑠𝑖𝑛𝑔 𝑀𝑜𝑛𝑒𝑦 −3∗4𝑛

∴ =
𝑇𝑜𝑡𝑎𝑙 𝑀𝑒𝑚𝑏𝑒𝑟𝑠 −12∗4 𝑛 −1

−3∗4𝑛 1
If we neglect the -1 in the denominator, we get = , which is less than
−12∗4 𝑛 4

−3∗4𝑛
.
−12∗4𝑛 −1
Homa 6

𝑀𝑒𝑚𝑏𝑒𝑟𝑠 𝐿𝑜𝑠𝑖𝑛𝑔 𝑀𝑜𝑛𝑒𝑦 1

This means that > = 25%
𝑇𝑜𝑡𝑎𝑙 𝑀𝑒𝑚𝑏𝑒𝑟𝑠 4

The formula I used above is the geometric series formula commonly used in calculus. As

we can see, over one-fourth of the members of the scheme will lose their invested money.

Ponzi Schemes

A Ponzi scheme is a very complex form of a pyramid scheme. A Ponzi scheme utilizes a

fraudulent investment operation to scam members instead of a recruitment requirement.

The operator of the scheme, an individual or organization, pays returns to its investors

from new capital paid to the operators by new investors, rather than from profit earned by

the operator. This means that when people invest, they are not in reality being paid a

profit from the fund’s success; however, their profit is coming from the money of other

investors. This tricks individuals into perceiving the fund as profitable. At first, the

system works, but soon it becomes impossible to sustain.

Even when money surprisingly disappears from a fund, it may not actually disappear.

The money simply transforms into either a product or tangible item or is transferred

somewhere else. Observing this rule, money follows the same laws of the conservation of

energy. I will write an equation to describe the dynamics of an investment fund.

Homa 7

 t= time since beginning of operation of the fund (starts at t=0)

 c(t)= amount of cash in the initial deposit at time t

 λ(t)= the cash influx rate at time t (amount of cash that flows in the deposit scam)

 T= the lock-up period. The operator promises to return the money to the investors

after having the money for T units of time.

 R= Ponzi Rate. The rate on investment promised by the operator.

𝑐(𝑡) = λ(t) − (1 + R) ∗ λ(t − T)

In a Ponzi scheme, the rate at which cash moves out of the investment is higher than the

rate at which money moves in. Therefore, when a large cash influx occurs, it will be

insufficient to pay off the debt to the investors.

 The initial amount of cash can be represented by 𝑐(0) = 𝑐0

 At time t = 0, the cash influx λ(t) = λ(0) = c(0) = 𝑐0

 λ(t) is the amount after a certain time that will be credited to the operator’s pocket

The above equation is a first order linear differential equation. It only involves the

function λ and first derivatives of λ. The equation shows the rate of change of the fund

with respect to time. Below is the solving of the differential equation. A differential

equation is solved by finding the integrals of the equation.

Homa 8

𝑡 𝑡
𝑐(𝑡) = 𝑐0 + ∫ λ(t − T)dt − (1 + R) ∫ λ(t − T)dt
0 0

*λ(t-T) is the money going into pocket minus the promised lock-up period*
𝑡
For 𝑡 ∈ [0, 𝑇): ∫0 𝜆(𝑡 − 𝑇)𝑑𝑡 = 0

𝑡 𝑡−𝑇
For t > T : ∫0 𝜆(𝑡 − 𝑇)𝑑𝑡 = ∫0 𝜆(𝑡)𝑑𝑡

𝑡 max(𝑡−𝑇,0)
∴ ∫0 𝜆(𝑡 − 𝑇)𝑑𝑡 = ∫0 𝜆(𝑡)𝑑𝑡,

With the general solution being written as:

𝑡 max(𝑡−𝑇,0)
𝑐(𝑡) = 𝑐0 + ∫ 𝜆(𝑡 − 𝑇)𝑑𝑡 − (1 + 𝑅) ∫ 𝜆(𝑡)𝑑𝑡
0 0

What this equation states is the following: the amount of cash at time t is given by the

initial amount of cash, plus the amount of cash the operator’s creditors lent him, minus

the amount of cash the operator had to pay to his creditors (multiplied by R over time

interval (t-T,t). The operator begins to return money to the investors at time t=T.

The operator will become bankrupt fairly quickly, with no money to pay back investors.

This leaves the operator with only one option: to bail with the money before this happens,

which is why Ponzi schemes are illegal.

Homa 9

Conclusion and Limitations

In this investigation, I have found how pyramid and Ponzi schemes work and proved

their impossible sustainability, which is the reason for their illegality. Some limitations

exist that should be taken into account, however. My investigation explores schemes in

which the amount of members and money inputted are consistent and ordered. In reality,

since these are schemes, different members are likely to be tricked into investing varying

sums of currency, or recruiting varying amount of people. Additionally, since the

operator’s main goal will be to profit as much as possible and bail before being caught,

there is a high chance that they use endless types of tricks to obtain what they want,

throwing off the dynamics of the system.

I learned a lot from completing this investigation, and I am very glad that I chose this

topic. It has increased my interest in the field of finance and business maths. Before I

began exploring the topic, I did not know anything about how pyramid schemes work.

Now, I am very familiar with the subject. In my opinion, it was very beneficial to conduct

my investigation on this particular topic as I will now be more aware of the common

scams operating around the world. I can confidently conclude that my chance of

mistakenly enrolling in one of these schemes is now much lower.

Homa
10

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