The price of diamonds is too high

Thabo Tokwe
Introduction and background
Some commodities are consumed or bought not only for their intrinsic utility but also for the
impressions they give other people about their consumers. Nicky Oppenheimer (DeBeers
chairman) confirmed that this is true in the case of the diamond industry when he said A
gemstone is the ultimate luxury product. It has no material use. Men and women desire to
have diamonds not for what they [diamonds] can do but for what they desire (Kretschmer
1998). Such commodities -as is the case for most luxury goods- bear a connotation of
exclusivity and subsequently they have to be scarce and accessible primarily to the affluent.
This is sometimes called the Veblen effect (Lehdonvirta 2005).
Until the accidental discovery of vast diamond deposits in South Africa, 1867; diamonds
were indeed rare (Spar 2006). While their procurement meant profits for prospectors there
was also the inherent danger that public awareness of their abundance would most certainly
cause demand to plummet. This gem which has since antiquity been associated with royalty,
power and luxury would soon become commonplace- its allure would be lost owing to lack
of scarcity.
Aware of this problem, Cecil Rhodes founder of DeBeers designed a system of cooperation
among the mine owners and diamond distributors that would guarantee high selling prices
were maintained. He, along with his associates ensured that the flow of diamonds was strictly
managed such as to create an illusion of scarcity. Epstein referred to this as the diamond
invention- the creation of the idea that diamonds are still rare and valuable, and are essential
signs of esteem through advertising and association with romance (Epstein 1982). In 1873,
Rhodes signed agreements with distributors and formed the Diamond Syndicate and thus the
diamond cartel had emerged.
The cartel started to control supply through an intricate system that was to ensure that the
volume of diamonds released to the market would roughly equal the number of wedding
engagements and any excess diamonds were stockpiled (mainly by DeBeers) in order to keep
supplies low and prices high (Kretschmer 1998). By 1890, all of South Africa's major mines,
along with the distribution channels for their output were controlled by Rhodes- making
DeBeers the dominant firm. Later Oppenheimer, Rhodes successor modified the distribution
system by hand-picking buyers and not giving them an opportunity to negotiate how much
they were to sell- DeBeers decided on who should sell and the quantity they were to sell; thus
deliberately controlling supply (Spar 2006).
The advent of new formidable suppliers from Canada, Russia, Botswana, DRC and some
other countries threatened DeBeers firm clasp on the diamond market but these countries
agreed that cooperation was amicable for all. This evolved international cartel would flood
the market with cheap diamonds from its stockpile in order to dissuade suppliers that rejected
the proposal to cooperate with the cartel (Kretschmer 1998). Notwithstanding the many
changes the cartel has undergone in the recent past; it still resembles dominant firm oligopoly
in many respects.
Economic analysis
In light of the abundance of diamonds as well as the economic analysis that is to follow
hereafter, the author is convinced that the price of diamonds is certainly too high. The
analysis will employ microeconomic theory to compare the pricing in perfectly competitive
systems against typical cartels or oligopolies. The scope will therefore be limited to theory
covered in ECO1010F heretofore.
Assuming that self-interest is pursued- the objective of any firm (as is undoubtedly the case
for the diamond industry) is to make a profit and the consumer likewise buys goods for
personal satisfaction- they can always reject what they dont want (Parkin, et al, 2012). This
means the parties both benefit from their transactions so to demonstrate that the price of
diamonds is too high; social interest will have to be considered.
Perfectly competitive market
As shown in Figure 1, when there are a few firms in a market, those firms are able to make
supernormal (economic) profits at the equilibrium price in the short run i.e. total revenue
exceeds total cost when operating at A for instance.

Figure 1 Perfect competition with a few firms initially the graph on the left is for the entire
industry while the other is for a single firm in the industry Economics Online (n.d.)
Since there is a supernormal profit- the firms in the industry get more profit than the
opportunity cost resulting in an increase in the number of suppliers in the market because
they would be pursuing the self-interest of maximising profits. The absence of barriers to
entry further encourages an increase in supply.
As more suppliers join the market in the long run; the supply curve shifts to the right-
reducing the equilibrium price. Figure 2 illustrates this point. The entrance of new suppliers
will continue to shift the supply curve until the industry operates at a normal profit.

Figure 2 Behaviour of a perfectly competitive market in the long run Economics Online (n.d.)
Moreover, the market operates at equilibrium where maximum economic welfare or social
benefit is achieved (Parkin,et al 2012). This is characterised by having the maximum possible
consumer and producer surplus as exemplified in Figure 3 (area ABE). A perfectly
competitive market also results in allocative efficiency since P = MC. Lastly, in the long run
productive efficiency is achieved where MC = ATC.

Figure 3 Consumer and producer surplus for perfectly competitive markets Economics Online
(n.d.)
According to Kretschmer (1998), a perfectly competitive diamond market would result
diamonds being used in industry and the price would be in the range $2 to $30 a carat. This is
obviously not the case in the diamond industry.
The Cartel
The diamond cartel like most major cartels resembles a monopoly more than it does perfect
competition. Therefore, supernormal profits can be maintained in the long run unlike in
perfect competition. And as with all firms, profits are maximised when MC = MR, therefore
the cartel will aim to operate at this point- as suggested in the historical background,
propinquity to this point of operation is determined by the number of wedding engagements.
Given that price (P) in Figure 4 is above ATC at Q, supernormal profits are possible (area
PABC). Although diamonds have a myriad of close substitutes in principle (e.g artificial
diamonds, cubic zircon, rubies and other gems) they have a better esteem in society and are
hence different. The price would be at MC = AR and thus lower in perfect competition.

Figure 4 Long run operation of cartel Economics Online (n.d.)
In addition, the fact that natural diamonds are only found in certain places introduces a barrier
to entry because not anyone can just enter the market at will. Likewise, the cartel itself
imposes barriers to entry.
Inevitably, these conditions result in:
Restriction of output onto the market.
Charging higher prices- cartel members can all agree to increase prices.
Reduction of consumer surplus and social benefit.

Resultantly there is a net loss of social benefit due to the presence of a dead weight loss
(ABC)- see Figure 5. So although the cartel has supernormal profits; the society actually
suffers. Evidently, this system is less productively efficient and less allocatively efficient- job
opportunities are also reduced as a consequence of limiting supply.

Figure 5 Deadweight loss in cartel Economics Online (n.d.)
The current price of a 1 carat diamond is roughly $ 5500 (Scott and Yelowiz 2010). In light
of the analysis above; this price is too high.
The facade of scarcity alluded to in the pertinent history is of equal importance. Consumers
buy diamonds because they think they are rare- they are misinformed. Suppose consumers
were prepared to pay high prices for product x under the impression that it is healthier than
y; upon discovery that x is not at all a healthier alternative they will not get the utility the
used to get from x and naturally the demand for x drops. The same is true for the diamond
market. If the diamond cartel decides to educate society about the profusion of diamonds-
they would probably lose their value because they would not be seen as rare anymore. The
price is based on misinformation, achieved through ingenious advertising campaigns.
In conclusion; the price of diamonds is too high. The author believes that the social loss
imposed by the cartel is enough to prove that this is the case. The current price of diamonds is
based in misinformation and a carefully manipulated supply of the gems.
These conclusions are based on the assumption that consumers pay the current price for a
diamond because they think they are scarce. It is possible that consumers are deliberately
careless about the abundance of diamonds- they purchase them merely because they are
expensive and thus still bear the aura of prestige. Further investigations would have to be
conducted in order to discriminate whether the utility is derived from scarcity or price. A
further limitation is the authors knowledge on the subject presented.


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