Pyramid Schemes and Ponzi Schemes Explained in One Minute

As the name suggests, a pyramid scheme is an investment scam which revolves around current investors receiving money by recruiting new members. The new members will receive money by recruiting other people, and so on.

Let's assume Peter starts a pyramid scheme where the cost of being a member is $100 per month. He promises to pay people $90 monthly for each person they get to join and keeps $10. Paul and George pay Peter directly and join; therefore, Peter now makes $200 per month. Paul then invites Rachel and Sarah, whereas George invites Bill and Jim. Peter now makes $240 per month, whereas Paul and George make $180 monthly but are left with $80 after paying their $100 fee.

The four newest members, however, aren't making any money and have to pay $100 monthly. If they don't manage to get new people to join, they'll quit. This means Paul and George won't make money anymore, so they'll quit too if they don't get new members, making the pyramid scheme collapse.

A Ponzi scheme, on the other hand, also relies on new money coming in to pay existing investors, but with one exception: the investors don't know this. They're being lied to and think it's a legitimate investment. This is what Bernie Madoff got away with for decades. He convinced people he generated returns by trading when, in fact, he was simply using money from new members to pay existing ones.

Some people think our entire financial system is a Ponzi scheme because it needs perpetual growth, but that is the topic for another video.