Consumer preferences may explain the pricing puzzle that is diamond engagement rings

On the Marginal Revolution blog last month, Alex Tabarrok presented a bit of a puzzle:

DeBeers also produces lab-grown diamonds and they have a very strange pricing strategy:

De Beers started selling its own lab-grown diamonds in 2018 at a steep discount to the going price, in an attempt to differentiate between the two categories. The company expects lab-grown prices to continue to tumble, in what it sees as a tsunami of more supply coming on to the market, Rowley said. That should create an even bigger delta in prices between natural diamonds and lab grown, helping differentiate the two products, he said.

What? Ordinarily, the bigger the price between a competitor and its substitute the greater pressure on the competitor to lower prices! Yet DeBeers is gambling that the bigger the difference in price between natural and lab grown diamonds the bigger the demand for natural diamonds! Strange. The only way I see this working is if the fiancée knows the price of the ring, which maybe they do! In that case, the buyer still has to spend 10k and doesn’t care whether it’s 10k on synthetic diamonds or 10k on natural grown diamonds. But 10k on synthetic diamonds will get you more carats so we need an equilibrium in which a smaller diamond signals more expensive. But that runs against hundreds of years of expectations! And remember natural and lab grown diamonds are indistinguishable by the naked eye. It’s one thing for the fiancée to know the price of the diamond but surely her friends judge by what they can see, namely the size of the ring. Which signal is the most important to send?

The quote embedded above is from this Bloomberg article. In producing its own lab-grown diamonds, De Beers is competing with itself (as I noted in this post in 2018). In that post, I noted that De Beers was engaged in rent-seeking behaviour:

Synthetic diamonds are a close substitute for natural diamonds, and natural diamonds represent a highly profitable business for De Beers. If some of De Beers' competitors (like Chatham or Diamond Foundry) start producing high-quality synthetic diamonds and selling them relatively cheaply, then some diamond consumers will be induced to switch from natural diamonds to synthetic diamonds, and De Beers will lose profits. By selling synthetic diamonds itself at a very low price, clearly De Beers' goal is to make it unprofitable for the synthetic diamond producers to operate, by seriously undercutting their prices - a tactic known as predatory pricing. The synthetic diamond competitors won't be able to compete with De Beers for long at the low prices, and will soon go out of business (at least, that is what De Beers is hoping). At that point, De Beers can quietly exit the synthetic diamond industry and resume claiming high profits from natural diamonds (having taken a bit of a hit to its profits from both synthetic and natural diamonds in the meantime).

I noted that the problem with that strategy for De Beers is that there needs to be some barrier to entry to keep competitors out once De Beers had exited the synthetic diamond industry and wanted to resume high profits in the natural diamond industry. Tabarrok presents a different problem, and potential puzzle: if consumers can't tell a lab-grown (synthetic) diamond and a natural diamond apart, why would lab-grown diamonds sell at a discount?

I thought that the solution related to signalling, as Tabarrok suggested. That is, until I started writing this post, and then ended up back at the puzzle. But I think I have a solution. So, let's work it through. As I noted in this 2015 post, spending on engagement rings (and weddings, as I noted here) is a signal. In fact, there are two potential signals. But first, let's take a step back and think about why signalling is necessary.

Signalling is a solution to an adverse selection problem. Adverse selection arises when one of the parties to an agreement has private information that is relevant to the agreement, and they use that information to their own advantage and to the disadvantage of the other party. Adverse selection is a problem of 'pre-contractual opportunism', and can cause markets to fail. Signalling is one way that markets have adapted to deal with adverse selection problems. With signalling, the informed party finds a way to credibly reveal the private information to the uninformed party (a signal). There are two important conditions for a signal to be effective: (1) it needs to be costly; and (2) it needs to be costly in such a way that those with lower quality attributes would not want to attempt the signal (and one way this criteria is fulfilled is if it is more costly for those with lower quality attributes).

In the case of engagement rings, there are two adverse selection problems that the engagement ring signal might solve. First, the person proposing marriage has private information about their quality as a future partner. The person receiving the proposal may not know this information. If the proposer is a low-quality partner, they have an incentive to hide this information until it is too late and they are already married! The engagement ring provides an effective signal, that reveals the quality of the proposer. An engagement ring is an effective signal because it is costly, and because it is costly in a way that a low-quality partner would not want to attempt. That's because the proposer would lose their investment in the ring if they are low quality and the relationship breaks up. Going one step further, the more valuable the ring (relative to the income of the proposer), the higher the quality of the signal.

The second adverse selection problem arises because the couple have private information about their quality as a couple (as I noted in this post about the cost of weddings). The people attending their wedding likely do not know this information. The couple receives gifts at their wedding, and wedding attendees are more likely to want to provide gifts to couples who will be successful. So, low-quality couples have an incentive to hide from wedding attendees that they are low quality. Is an engagement ring a good signal here? I'm not so sure. Yes, the engagement ring is costly. But is it costly in such a way that a low-quality couple wouldn't want to attempt? A low-quality couple could buy a wedding ring, receive the wedding gifts, then divorce and sell the engagement ring to re-coup their initial outlay. It seems to me that this signal is not nearly as effective as the overall cost of a wedding (which is not recoverable).

Ok, so I think we have established that an engagement ring is an effective signal from one partner to another, but not necessarily from a couple to others. A more valuable ring provides a higher quality signal. Does whether the diamond is natural or lab-grown matter? In theory, it shouldn't - they are indistinguishable to the untrained eye. However, in practice they may be very different. Natural diamonds are scarce. Lab-grown diamonds are less scarce. Perhaps, in the minds of consumers, a natural diamond is a more desirable product, even if they are indistinguishable? After all, a motivated consumer can find out (through an expert appraisal) whether a diamond is natural or lab-grown. In that case, the perceived quality of the diamond really matters - a smaller natural diamond would provide the same quality of signal as a larger lab-grown diamond. And for two diamonds of the same size, a natural diamond would be priced higher than a lab-grown diamond. In other words, consumer preferences (for natural rather than lab-grown diamonds) would explain this pricing puzzle.