Lack of variability, faulty assumptions cited as ‘fundamental logical errors’
By: Teresa Craighead
“What they are doing in this paper is trying to put forward a logical argument to set up a premise, to analyze it and to draw conclusions. The problem is that they commit some really basic logical errors, and you don’t have to be a logician to understand them.”
—Dr. Anne Coughlan, professor of marketing, Kellogg School of Management, Northwestern University
On October 13-15, 2020, the Direct Selling Association (DSA) held a virtual Legal and Regulatory Seminar that included a session discussing the Andrew Stivers, Douglas Smith, and Ginger Jin paper, “The Alchemy of a Pyramid” with three experts: Dr. Anne Coughlan, the Polk Bros. Chair in Retailing and professor of marketing at Kellogg School of Management, Northwestern University; Dr. Patrick Brockett, the Gus Wortham Memorial Chair in Risk Management and Insurance at McCombs School of Business, University of Texas at Austin; and Dr. Linda Ferrell, Marketing Department Chair and professor of marketing at Harbert College of Business, Auburn University. Comments in this article are taken from that discussion.
In the July 2020 issue of Social Selling News, we published an article, titled “FTC Reveals True Goals in Research Paper” (page 24), in which we discussed some of the conclusions reached in a paper published by SSRN, an international social sciences research journal.
The article, titled “The Alchemy of a Pyramid,” was written by Andrew Stivers and Douglas Smith, both currently with the Federal Trade Commission’s (FTC) Bureau of Economics, and Ginger Jin, formerly director of the FTC’s Bureau of Economics and currently in the Department of Economics at the University of Maryland.
Stivers, Smith and Jin claimed in their article to address the question, “What makes an MLM a pyramid?” They constructed a mathematical model with multiple assumptions and variables in order to evaluate the potential outcomes for a theoretical MLM contract. The paper purported to present their premise, their economic model and their conclusions.
Conclusions Prompt Scrutiny
Since Stivers and Smith are current FTC employees and Jin formerly served two years as the head of the Bureau of Economics at the FTC, DSA panel expert Dr. Anne Coughlan, of Northwestern University, says these associations call for “special scrutiny on this paper, particularly given its conclusions, to make sure that what they bring to the world actually is backed up by good analysis. That’s what I think is the source of the big concern here.” Coughlan has reason to be concerned. The authors’ conclusions in “The Alchemy of a Pyramid,” based on their mathematical model, produced a very negative outlook on the entire multi-level direct selling business model. In short, the model equates to a pyramid scheme.
Stivers, Smith and Jin conclude that only by encouraging “unrealistic seller optimism” about the products and opportunity can multi-level business executives maintain profits. Meanwhile, the sellers experience loss, thus creating a pyramid situation.
‘Seller Optimism’ and Financial Success
The authors state that “seller optimism” can have two components: product demand and recruitment potential. Product demand optimism and the seller’s financial success, they say, is ultimately determined by the demand for the product, just as with a traditional retail business.
However, when the authors introduced the variable of “recruitment optimism” into the model, they conclude a seller may believe that recruitment rewards and commissions will make up for any sales losses. As a result, sellers will continue to participate in the system, even if they are losing money.
The authors argue that relying on distributor optimism gives the company incentive to overstate both product demand and recruitment potential in order to attract distributors and keep them participating. The authors also strongly suggest that direct selling firms know the negative outcome for participants and entice them to continue to participate to their own detriment.
Matt Dorny, general counsel at Nu Skin Enterprises and moderator for the DSA panel discussion, says it seems that one of the authors’ basic assumptions is that any optimism for a direct selling venture could only be based on false or misleading expectations, and that “the only reason they’re participating is because they’ve been somehow misled by the company.” He adds, “I think people understand some of these things are difficult. But they have a belief that maybe it will work for them; they want to try it out in a fairly low-risk venture.”
University of Texas’ Dr. Patrick Brockett, a business economist and elected fellow of the American Statistical Association with a Ph.D. in mathematics, takes issue with the paper’s reasoning. The panel expert says that some of the conclusions “don’t follow logically from the model they created. It’s drawing a conclusion before you ever start the analysis and then coming back and saying, ‘Oh, my analysis says this’ when it doesn’t necessarily.”
Dr. Linda Ferrell, whose credits include president of the Academy of Marketing Science, explains that her biggest concern in reading this paper is that the authors don’t understand how direct selling actually works. The Auburn University expert says, “that comes through very clear when you look at the assumptions that they posed” in the paper.
False Assumptions, False Conclusions
All economic models begin with a set of assumptions that drive the model; assumptions allow for simplification of a complex process and allow the economist to develop a theory (or hypothesis) that focuses on the most relevant variables to be analyzed. However, all assumptions are not created equal and can be influenced by the subjective opinions and judgments of the person formulating the assumptions.
Inaccurate assumptions lead to inaccurate conclusions, regardless of whether they are presented in a formal paper claiming statistical economic modeling and whether or not it is published in a scientific journal.
According to the panel, the Stivers, Smith and Jin paper is loaded with faulty assumptions. Coughlan says, “I’m not going to tell you all of the things I think are incorrect about the assumptions in this paper because I want to focus on what I thought were the ones that are the most serious. In fact, I believe they are fatal to the analysis in the paper.”
She adds, “What they are doing in this paper is trying to put forward a logical argument to set up a premise, to analyze it and to draw conclusions. The problem is that they commit some really basic logical errors, and you don’t have to be a logician to understand them.”
Coughlan says two of the most problematic logical errors in the assumptions fall under the category of begging the question. This is a logical error in presenting an argument and manifests itself when the conclusion is already assumed in the premise of the argument.
“It would be like saying the sun rises in the east because it rises in the east,” she says. Coughlan goes on to say that the authors of the paper fell into this logical error first with the thesis statement: What makes an MLM a pyramid?
“The paper can’t analyze that question because they don’t have a model whose premise allows the determination of whether or not a firm is a pyramid scheme,” she says. “They assume the conclusion in their premise. This is a fundamental logical problem that defeats the entire purpose of the paper.”
Misrepresenting Company Intent
The second crucial error, according to Coughlan, is the authors’ assumption that direct selling firms commit fraud by taking advantage of distributors who don’t know any better than to trust the company.
She says, “The firm is assumed to know about a distributor’s imprecise or incorrect belief and chooses not to fix it or educate them.” Coughlan believes the authors of the paper misrepresent the objectives of direct selling companies as solely built to take advantage of distributors while also omitting any of the protections established by the DSA Code of Ethics such as buy-back policies.
Additionally, Ferrell points out that Stivers, Smith and Jin also use the example of a Ponzi scheme in the paper to illustrate fraud, and simply by pairing a Ponzi scheme with a discussion of direct selling firms creates a false equivalency. She says, “There are very specific elements that define these types of fraud. They are not inherent in direct selling firms, not today.”
Coughlan additionally says the authors omit variables such as retail selling or personal consumption and create an assumption “that the only inflow of money into this firm is from a required mandatory initial inventory purchase of every registered person, and that in order to join every person must purchase inventory. And that inventory has a sufficiently high value to fund the recruitment bonuses of the person who recruited you. It’s the only inflow into this theoretical company.”
Creating a Pyramid Scheme and Calling It ‘Direct Selling’
The end result, Coughlan points out, is that the paper’s authors have created a pyramid scheme and called it “direct selling.” She says that the model Stivers, Smith and Jin created to illustrate direct selling is “literally, mathematically, a Ponzi scheme, because the money that flows in from mandatory enrollment fees goes to pay the recruitment bonus to the upline when there is no retailable product. They don’t recruit but they also don’t sell, and they never buy more inventory.”
Brockett agrees, stating, “They start with an assumption tantamount to creating a pyramid. The assumption is that everybody in the entire pyramid that they’ve created sells exactly one unit of product. Everybody is so identical that it makes the entire retail side of it illogical.”
He adds, “There is no variation in sales ability, no variation in how much time they will devote to the business. I think they are ignoring reality at the onset, and any conclusions they draw mathematically from this are incorrect because they started with a false assumption.”
Brockett, Ferrell and Coughlan are part of a task force that will work on a formal paper surrounding these topics as well as develop and publish additional papers analyzing many of the mistaken perceptions around direct selling practices.
Brockett says, “I think we will see lots of publishing coming out of this work and lots of commentary that can be useful to various constituencies.”
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