De Beers may become its own biggest competitor

This week in my ECONS102 class, we covered monopoly and firms with market power (a topic we actually cover much earlier in the semester in my ECONS101 class). One of the examples I talk about is De Beers, which had a stranglehold over the diamond market up until the late 1980s, but still commands a high degree of market power today. It is interesting to see what they are doing to maintain their market power. Bloomberg reported last week:

De Beers hasn’t even opened its first synthetic diamond store, but its looming entry into the market for man-made gems has already shaken the industry.

The unit of Anglo American Plc said three months ago that it plans to sell lab-grown diamonds at a fraction of the going rate, undercutting rivals like Chatham Created Gems Inc. and Diamond Foundry Inc. That’s already cut the price of man-made gems, furthering De Beers’s aim of increasing the premium paid for the diamonds it mines in Botswana, Namibia, South Africa and Canada.

De Beers will target younger consumers with its lab diamonds, sold under the Lightbox name for about $800 a carat. That’s a fifth of the price of existing man-made stones and one-tenth of the cost of buying a similar natural gem.

This is an interesting example of rent seeking, where a firm attempts to build (or maintain) its market power. It is also similar to a tactic we discuss in my ECONS101 class, which is where firms try to crowd the market by competing with themselves. However, I don't think that is De Beers' strategy in this case.

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).

There is a problem with this strategy though, and it's a problem with predatory pricing generally. Unless there is some barrier to entry into the synthetic diamond industry, undercutting those competitors and forcing them out of the market is only a temporary solution for De Beers. As soon as De Beers exits the market, or raises the price of synthetic diamonds, some other new competitor can come into the synthetic diamond market. Unless De Beers can keep new competitors out of the market.

Is there a barrier to entry? I don't know the synthetic diamond market well, but I suppose that the number of ways that you can create high-quality synthetic diamonds is probably limited, and that Chatham and Diamond Foundry, as well as De Beers, use technologies that are covered by patents. Patents can create a (time-limited) barrier to entry into the market, since no competitors can use the technology covered by the patent. So, if De Beers makes it untenable for their synthetic diamond competitors to operate, perhaps this is a cynical ploy by De Beers to capture the synthetic diamond patents, either by a hostile takeover of the firms that are struggling to be profitable in the wake of low prices, or by buying the patents in a fire sale of those firms' assets?

It will be interesting to see how this plays out in the long term.

Dumped steel

International dumping of steel has been in the news again recently, this time with particular regard to Chinese steel imports into New Zealand. John Nowlan (general manager of NZ Steel) wrote in the New Zealand Herald last week:

Many New Zealand domestic industries built up in the past 50 to 100 years are in jeopardy because of inadequate trade remedies that favour importers over local producers.

Steel production is in that boat.

It is easy to talk changing trends and globalisation, but the risk of closure of NZ industries inevitably means the loss of jobs and essential skills, and the possible disappearance of some of our smaller communities...

Now of course, you would expect the general manager of a steel producer to complain about cheap steel imports. After all, if you are an importing country it is typically because overseas firms can produce at lower production costs. If inefficient New Zealand firms have to compete with more efficient foreign firms, then the inefficient New Zealand firms must either become more efficient, or shut down (with consequent costs as I have noted in this post from earlier this year on dumping and tariffs). The flip-side to that is that our more efficient producers benefit from exporting (this is part of the reason that our dairy industry is such a large exporter).

However, the problem is not just imports, but 'excessively cheap' imports being 'dumped' into the New Zealand market. Nowlan explains:

Dumping is the exporting of goods cheaper than the products are sold in their own domestic market and is dealt with under WTO guidelines.

The guidelines also cover the subsidisation of products, where an uncompetitive business is paid to stay in production...

For a small country like New Zealand, dumping and subsidisation can have major adverse effects not just on an industrial sector, but also our entire economic fabric. More so, where an industry is one of a kind. Steel making is a pertinent local example.

Monday's New Zealand Herald editorial also makes valid points:

The answer from policy makers would be it helps to lower our high costs of building and construction, which have been identified by the Productivity Commission as a contributor to high and rising house prices. Many might not be convinced the benefits of lower construction costs would outweigh the possible loss of a local industry and jobs. But on that argument we would have maintained the protection that saddled us with a high-cost economy of a previous era.

It made sense to expose all industries to international prices so we might be left with those that are truly competitive and consumers could buy more of the world's goods.

It makes less sense when international prices are artificially low as a result of subsidies or dumping. The World Trade Organisation permits member states to impose countervailing duties on imports coming in at prices below their cost of production.

Is 'dumping' an issue? Here's what I wrote earlier this year:

So countries create additional tariffs to apply when foreign firms are thought to be using otherwise free trade to 'dump' their products into the domestic market. However, as Gary Becker has noted (for example, in this book), this type of predatory pricing is probably not sustainable. If you drive competitors out of the market and raise your prices, then new competitors will enter, assuming that the fixed costs of production aren't high enough to constitute a barrier to entry (which is arguable for some industries, such as steel production). However, even if there are high fixed costs, if you have relatively free trade then competitors from other countries can also step in when the predatory pricing stops.

That line of argument still applies, but so too do the results of Autor et al. that I note in that post (see here, or ungated here). The short-term pain (in terms of lost jobs) from free trade can persist for a longer time than we previously thought, or is conventionally argued. So, when this pain is created by unfair competition from abroad, this may provide a clearer case for some limited protectionism.

The Herald editorial concludes with:

...provided the quality meets the standards required, dumped steel can be an economic benefit. Larger countries may be able to protect their own steel makers but New Zealand needs to think carefully. Is Glenbrook vital?

Glenbrook may not be vital (in the sense that its closure would make the wider economy vulnerable), but we do need to think carefully about the costs and benefits of importing excessively cheap imported steel. The costs of foregoing cheaper steel (lost consumer surplus, higher construction costs, etc.) should be weighed up against the benefits (retaining jobs in the steel industry, option value, etc.). We certainly don't want to find ourselves in the position of having $750,000 steel workers.

Read more:

• New arguments against free trade

New arguments against free trade

Earlier in the month, The Economist reported on the rise of anti-dumping tariffs:

Dumping is the practice of selling goods in foreign markets at an unfairly low price—typically, one lower than the going rate in the exporter’s home market. Anti-dumping measures are intended to prevent a company from selling goods below cost in order to drive competitors out of business, before using the resulting market power to gouge customers.

So countries create additional tariffs to apply when foreign firms are thought to be using otherwise free trade to 'dump' their products into the domestic market. However, as Gary Becker has noted (for example, in this book), this type of predatory pricing is probably not sustainable. If you drive competitors out of the market and raise your prices, then new competitors will enter, assuming that the fixed costs of production aren't high enough to constitute a barrier to entry (which is arguable for some industries, such as steel production). However, even if there are high fixed costs, if you have relatively free trade then competitors from other countries can also step in when the predatory pricing stops.

There are other arguments put forward in favour of anti-dumping tariffs (from the same Economist article):

In Britain, where rock-bottom global steel prices now threaten Tata Steel, the owner of the country’s biggest surviving mill, proponents of tariffs argue that it is important to preserve domestic steelmaking to ensure supplies for the defence industry, among others.

The 'national security' argument is an old favourite of some anti-free-trade groups, particularly those that stand to benefit directly from trade barriers. The Economist points out the folly of the argument:

...it is hard to see how the use of French steel in British submarines harms Britain’s security (its pride is another matter). For manufacturers of all sorts, most notably carmakers, cheap steel is a boon.

In other words, the gains (to domestic consumers, and to domestic manufacturers using steel in production) from free trade in steel probably outweigh the losses (to domestic steel producers). And national security isn't much of a consideration.

But is it always the case that the gains from freer trade outweigh the losses? In another interesting blog piece from earlier this month, Tim Harford writes:

Fifteen years ago, the conventional economic wisdom was that free trade was almost unambiguously a good idea. Here’s the basic logic. There are two ways for the British to get hold of wine. We can grow and press our own grapes, or we can make something that the French want and trade with them. If we’re good at making, say, computer games and the French are good at making wine, then trading is the better way to get what we want...

I’ve been phrasing all this “conventional wisdom” in the past tense but, for the most part, it stands up. However, it is acquiring an important and depressing footnote. A new research paper, “The China Shock”, from David Autor, David Dorn and Gordon Hanson, is part of a rethink under way in the economics profession...

Autor, Dorn and Hanson conclude that the American workers who have been hurt by competition with China have been hurt more deeply, and for a longer period, than many economists predicted. Employment has fallen in industries exposed to trade competition, as expected. But it has not shown much signs of rising in export-oriented sectors.

The research paper by Autor et al. is here (ungated here). Economists recognise that there are gains from trade. In fact, it is one of the things that economists most agree on. However, although there are gains from trade, and therefore gains from making trade freer, those gains are not obtained without cost. When we open our markets to international trade, our export industries (the industries in which we have a comparative advantage) will produce more, while other industries (in which we have a comparative disadvantage) will shut down. In New Zealand we experienced this - which is why we no longer have much in the way of car assembly plants, whereas there were previously several large plants around the country. The conventional wisdom is that there is some short-term pain (workers losing jobs in the industries with comparative disadvantage) for long-term gain (additional jobs in the industries with comparative advantage).

The Autor et al. paper demonstrates that the short-term pain can last much longer than previously thought (the paper is mostly very readable - I encourage you to do so). Although the 'national security' argument is weak, perhaps the so-called 'jobs argument' against free trade has some truth to it after all? Which might give us reason to pause on free trade agreements, particularly when the gains are marginal at best, or occur far in the future (while the costs are incurred in the short-term).