Transcript Ed Dolan, Diamonds: How to Price a Finite Resource, April 26, 2010

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Diamonds: How to Price a
Finite Resource?
Created April 26, 2010
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De Beers Announces New Diamond Price Strategy
 De Beers, the huge South African
diamond producer, has announced a
new pricing strategy
 The new strategy is based on a belief
that there will be no big new diamond
mine discoveries
 If they are right about this, what
should their pricing strategy be?
www.pdclipart.org
Posting P100426 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
Using Supply to Control the Price
 De Beers produces 40% of the
world’s diamonds, which gives it
considerable power to control supply
 If the company wants to push the
price up from its current level P to a
higher target price T, it can cut
production enough to shift the supply
curve from S1 to S2
 If it wants to push the price down to
a lower target, T’, it can increase
production, shifting the supply curve
to S3
Posting P100426 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
Effect of a Price Cut Today on Prices Over Time
 If the total quantity of diamonds
available is fixed, any action to
change the price now will affect
the future price, too
 For example, if De Beers
increases supply today to push the
price down, fewer diamonds will
remain in the ground to be mined
in the future, so the future price will
be higher
 Conclusion: Lowering the price
today will put diamonds on a new
price path that rises faster in years
to come
Posting P100426 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
Effect of a Price Increase Today on Prices Over Time
 If De Beers cuts production now to
raise today’s price, the action will
have the opposite effect on prices
over time
 The price today will be higher, but
with more diamonds available to
mine in the future, the price will
rise less rapidly
 Cutting production today rotates
the future price path clockwise
Posting P100426 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
The Effect of Demand
 Meanwhile, De Beers must also take
into account the effect demand
changes will have on prices
 For example, rising demand for
diamonds in Asia is expected to
push the price higher over time than
it otherwise would be
 Today 40 percent of brides in Beijing
and Shanghai get diamond
engagement rings. 15 years ago it
was zero, De Beers Chief Gareth
Penny told the Financial Times
recently.
http://www.ft.com/cms/s/0/b0174b7e-5169-11df-bed9-00144feab49a.html
Posting P100426 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
To Mine or Not to Mine: The Opportunity Cost
 So, taking both supply and
demand into account, what is the
optimal price path De Beers
should aim for?
 It should base the decision on
opportunity cost
 If it leaves diamonds in the
ground in order to push up today’s
price, the opportunity cost is less
current revenue, which it could
invest in financial assets like U.S.
Treasury Bonds
www.pdclipart.org
Posting P100426 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
Matching the Price Path to the Market Interest Rate
 The solution to the pricing
problem is to adjust production so
that the future price rises at a rate
equal to the opportunity cost, that
is, the interest rate on alternative
investments (bonds)
 If the diamond price is rising too
fast (Path A), cut production now
and leave more diamonds in the
ground to harvest in future years
 If it is rising too slowly (Path B),
mine more diamonds now and
invest the revenue in bonds
Posting P100426 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
So, What Has De Beers Decided To Do?
 For now, De Beers has
announced that it will produce 40
million carats annually, well below
its production of 51 million carats
in 2007, before the global
economic crisis
 That rate of production is
expected to allow the price to rise
at 5 percent per year, taking both
supply and demand into account
 Not by coincidence, 5% is almost
exactly the current yield on 30year U.S. Treasury Bonds!
www.pdclipart.org
Posting P100426 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/