Paper 1 real world example: The role of the price mechanism in the diamond market
Diamonds are forever?
Questions
Answers
The diamond market is undergoing a huge structural shift. The world’s leading diamond business, De Beer’s major shareholder Anglo American has put its 85% stake in the company up for sale as its revenues and profits fall. De Beer’s diamond revenues have fallen 18% this year.
De Beers sees falling demand in the US and China as reasons for its difficulties, but there may be a more existential threat to DE Beer’s in the form of laboratory-made stones. Synthetic diamonds have been around for decades but have never had the ‘beautiful look’ of mined diamonds and have an industrial use as cutting tools in manufacturing businesses.
The new laboratory-made diamonds are different. These synthetic diamonds are optically, chemically, thermally, and physically identical to mined diamonds. Laboratory-grown diamonds are made using Chemical Vapor Deposition technology that produces a rough diamond that can be cut into a final polished version identical to a mined diamond. The big difference is the price.
Laboratory-made diamonds are currently 40-50% cheaper than mined diamonds. The example in the picture is for two 1.50-carat diamond Solitaire Rings. The mined ring on the right is priced at $11,100 and the laboratory-made ring on the left is priced at $5,900.
The emergence of significantly cheaper Laboratory-made diamonds is a huge threat to mined diamond producers such as De Beers. Will consumers be prepared to pay a significantly higher price for the same good just because they know it has been mined? Can a company like De Beer’s market its product as genuine diamonds against its synthetic competitor?
Unlike mined diamonds where the scarce nature of the product limits supply in terms of where it can be found and mined, the supply of laboratory-made diamonds is not constrained in the same way and can be increased much more easily. This could mean the price of diamonds could fall further and push mined diamonds to the periphery of the diamond market. This kind of structural change in the diamond market could lead to business failure and unemployment. A decline in the mined diamond market could also have macroeconomic implications for Botswana which is the world's largest producer of mined diamonds
Historically, one of the things that have made diamonds so attractive and valuable is their scarcity. If laboratory-made diamonds significantly reduce this scarcity will the allure of owning a diamond ring or necklace be taken away and the good becomes just another ‘pretty stone’?
Questions
a. Explain the role of the price mechanism in allocating more resources to produce laboratory-made diamonds. [10]
The price mechanism is how the interaction of demand and supply sets market prices to allocate resources.
Resources are the factors of production (land, labour, capital and enterprise) used to produce goods and services.
Improvements in technology in the laboratory-made diamond market cause an increase in the supply of laboratory-made diamonds from S to S1. At the existing price P at the increased supply of S1, excess supply will lead to a decrease in the price of laboratory-made diamonds through the rationing function of price. As the price of laboratory-made diamonds decreases it sends information to producers and consumers about changing market conditions through the signalling function of price.
The falling price of laboratory-made diamonds leads to the incentive function of price where consumers have the incentive to increase their quantity demanded of laboratory-made diamonds because they receive more utility per $ spent at the lower price. The lower price decreases the quantity supplied by producers as they receive less profit from producing laboratory-made diamonds.
The rationing, signalling and incentive functions of price mean more resources are allocated to the laboratory-made diamond market. This movement of resources can be shown by the PPC diagram which shows laboratory-made diagrams increasing in output from 1000 units to 1300 units and the output of mined diamonds decreases from 1400 units to 1200 units. An opportunity cost of 200 units.
b. Using a real-world example, evaluate the impact of a decrease in the price of a good caused by an increase in supply on different stakeholders in the market.[15]
Supply is the willingness and ability of producers to offer a given quantity of a good for sale at a given point in time and price level.
As the supply of laboratory-made increases the world price of diamonds decreases and this has the following effects on different stakeholders:
Consumers of diamonds worldwide will benefit from lower-priced jewellery made using diamonds, and this will increase their consumer surplus. However, part of the utility consumers derive from a diamond-made product is its ‘high price’ and might feel less satisfaction from owning it (evaluation).
Producers of diamonds will receive lower prices which could lead to lower profits and a decrease in their producer surplus. Producers of mined diamonds in Botswana might be particularly hard hit by falling laboratory-made diamond prices because mined diamonds are a substitute for laboratory-made diamonds which leads to a decrease in demand for mined diamonds. This is shown in diagram 3 where demand shifts from D to D1 for mined diamonds and the price and output decrease from P to P1 and quantity from Q to Q1 and this leads to a decrease in their revenue and producer surplus.
Businesses that use diamonds in production such as jewellery producers and retailers will experience a fall in their costs which could lead to an increase in their profits (evaluation).
In the labour market, jobs might be created in the laboratory-made part of the diamond market as this section of the industry grows. However, laboratory-made diamonds is a capital-intensive process so it may not create that much employment . If the mined diamonds part of the diamond market declines as the price of diamonds falls this could lead to rising unemployment in countries with a large diamond mining sector such as Botswana (evaluation).
The governments of countries that produce mined diamonds such as Botswana’s government might lose from the fall in the price of mined diamonds because declining profits from a diamond producer such as Debeers would lead to a decrease in the Botswana government's tax revenues. In countries where consumer expenditure on lower-priced diamonds increases, there could be a rise in indirect tax revenues from higher diamond sales (evaluation).
Welfare in society might increase if the decrease in the price of laboratory-made diamonds leads to a contraction in the mined diagram industry because the environmental costs of mining for diamonds are reduced and this reduces the negative externalities associated with the mined diamond market. There may, however, be external costs associated with laboratory-made diamonds (evaluation).