Sellers of natural diamonds are in big trouble

As I noted in yesterday's post, sellers of natural diamonds are in trouble. Lab-grown diamonds are undercutting their market. The problem here is that consumers can't easily tell lab-grown diamonds and natural diamonds apart. The two types of diamonds are perfect substitutes. And when faced with the option of buying one of two products that are perfect substitutes, consumers will generally choose the product that is lower-priced. In this case, that's the lab-grown diamonds.

To see why, consider the diagram of the consumer choice model below. The two goods are X (natural diamonds) and Y (lab-grown diamonds). The consumer's budget constraint is shown by the black line. The budget constraint is relatively steep, which means that the price of lab-grown diamonds is relatively lower than the price of natural diamonds. The consumer's indifference curves are shown by the two red lines, I0 and I1 (with I1 representing a higher level of utility, or satisfaction, for the consumer). The indifference curves are straight lines when the two goods are perfect substitutes (which is the case here). The consumer's best affordable choice (the consumer's optimum) is the bundle of goods E0, (it's on the highest indifference curve that they can reach, I1), where the consumer spends all of their income on lab-grown diamonds, and spends nothing on natural diamonds. [*] This makes sense, given that lab-grown diamonds and natural diamonds are exactly the same good in the mind of the consumer (they are perfect substitutes), and lab-grown diamonds are relatively less expensive than natural diamonds.

So, how can natural diamond sellers respond to this problem? One way is to lower their prices to match the lab-grown diamond price. That would cause the consumer's budget constraint to pivot outwards and become flatter (just like in this example), and then the highest indifference curve would exactly match the budget constraint. However, lowering prices could easily escalate into a price war, and is unlikely to end well for anyone.

A better option for the sellers of natural diamonds arises when they recognise that the real problem here is not the price, it is that the two goods are identical in the mind of the consumer. If the sellers of natural diamonds can somehow convince the consumer that the two goods are different rather than identical, then they may be able to keep some sales, even if the price of natural diamonds is higher than the price of lab-grown diamonds.

This situation is shown in the diagram below. When the goods are differentiated, the consumer's indifference curves are curves (not straight lines - straight line indifference curves only happen when the goods are perfect substitutes). The highest indifference curve that the consumer can get to is I1'. They will buy the bundle of goods E1, which contains Y1 lab-grown diamonds, and X1 natural diamonds. Even though natural diamonds are relatively more expensive, the consumer chooses to buy some of them.

So, how can the sellers of natural diamonds differentiate their diamonds from the lab-grown diamonds? That is the tricky thing, because there is an asymmetric information problem here. The sellers know whether diamonds are lab-grown or natural, but buyers don't know. The origin of a diamond is private information. Because buyers can't tell the two diamonds apart, they assume that all diamonds are lab-grown [**]. This creates a pooling equilibrium (because all diamonds are pooled together and treated the same). Buyers would only be willing to pay low prices for diamonds, because they assume that the diamonds are lab-grown. Natural diamond sellers don't want to sell their diamonds for the lower lab-grown diamond price, so they drop out of the market. Only lab-grown diamonds would be left in the market. The market for natural diamonds would fail. Economists call this an adverse selection problem. And that is what seems to be happening, since the Financial Times article I referred to yesterday notes that:

By the end of 2024, De Beers had amassed an inventory of unsold diamonds worth $2bn, the largest stockpile since the 2008 financial crisis.

The diamonds are unsold in part because they cannot be distinguished from the lower-priced lab-grown diamonds. How can the natural diamond sellers solve this adverse selection problem? When the informed party (the party that knows the private information) credibly reveals that information to the uninformed party, we call that signalling. To be effective, a signal needs to meet two conditions. First, it must be costly. And second, it must be costly in such a way that the sellers of lab-grown diamonds wouldn't want to attempt the signal.

Unfortunately, it is difficult to identify a signal that meets those two conditions for the sellers of natural diamonds. If they try some recording the chemical signature of their diamonds, those structures can probably be easily copied by makers of lab-grown diamonds. Similarly, microscopically etching a serial number onto each natural diamond is something that makers of lab-grown diamonds can do as well. That rules out branding diamonds. Advertising is not likely to be very effective either, because while advertising natural diamonds and making consumers want them more seems like a good strategy, it won't turn into extra sales if consumers can't tell the lab-grown diamonds and natural diamonds apart. Sellers can often use warranties to signal quality. However, when a good has a warranty, it's quality is eventually revealed to the consumer (because, if the good is low quality, they end up having to claim on the warranty). That isn't the case for diamonds.

So, the natural diamond sellers are not just in trouble. They are in big trouble, unless they can find some way of signalling that their diamonds are natural diamonds (and at the same time hoping that buyers continue to be willing to pay a premium for natural diamonds).

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[*] Yes, this model is assuming that the consumer spends all of their budget on only two goods, natural diamonds and lab-grown diamonds. If it makes you feel better, think of it as the consumer spending all of their diamond budget on those two goods.

[**] I'm treating the lab-grown diamonds as if they are lower quality than natural diamonds. That is what the sellers of natural diamonds would argue, anyway, and given that there is a slight price premium for natural diamonds, the buyers seem to think that way too.

Read more:

• Sellers of natural diamonds are in trouble
• Market power and disruption in the diamond industry

It's good to be different, or why firms differentiate their products

This week in my ECONS101 class, we are covering the decision-making of firms with market power. When firms have market power that means that they have some control over the price of their product. Some firms gain market power through barriers to entry into their market - there is something that keeps competitors out of the market. However, most firms don't benefit from barriers to entry. Instead, most firms derive market power from differentiating their product from the products sold by their competitors. In this post, I'll demonstrate why it is that firms differentiate their product, using the consumer choice model, and assuming that there are only two firms (one firm selling Good X, and one firm selling Good Y).

Before we get that far though, let's consider what would happen if we had two firms selling identical products (what we refer to as perfect substitutes). In that case, the consumer is indifferent between the two firms' products. Since they are identical, the consumer doesn't care which firm they buy from. In that case, the consumer will obviously buy from whichever firm is selling their product for a lower price, and will buy nothing from the firm that has the higher price.

This situation is shown in the diagram below. The consumer's indifference curves are shown by the two red lines, I0 and I1 (with I1 representing a higher level of utility, or satisfaction, for the consumer). The indifference curves are straight lines when the two goods are perfect substitutes (so the consumer doesn't care about how many of each good they have, only how much they have of both goods in total). The consumer's budget constraint is shown by the black line. The budget constraint is relatively steep, which means that the price of Good Y is relatively lower than the price of Good X. The consumer's best affordable choice (the consumer's optimum) is the bundle of goods E0, (it's on the highest indifference curve that they can reach, I1), where the consumer spends all of their income on Good Y, and spends nothing on Good X. This makes sense, given that Good Y and Good X are exactly the same good, and Good Y is relatively less expensive than Good X.

Obviously, the situation in the diagram above is not good for the seller of Good X. How could they respond? One thing that they could do is lower their price to match the price of Good Y. That would cause the consumer's budget constraint to pivot outwards and become flatter (just like in this example). They could even make their price lower than the price of Good Y, capturing all of the market. Of course, there is little to stop the seller of Good Y from then lowering their price as well. This sort of a price war is not good for either seller, and could continue until neither seller is able to make any profit at all (which is the case in a perfectly competitive market).

A better option for the seller of Good X arises when they recognise that the real problem here is that the two goods are identical in the mind of the consumer. The two goods are perfect substitutes. If the seller of Good X can somehow convince the consumer that the two goods are different rather than identical, then they may be able to keep some sales, even if the price of Good X is higher than the price of Good Y.

This situation is shown in the diagram below. When the goods are differentiated, the consumer's indifference curves are curves (not straight lines - straight line indifference curves only happen when the goods are perfect substitutes). The highest indifference curve that the consumer can get to is I1'. They will buy the bundle of goods E1, which contains Y1 of Good Y, and X1 of Good X. Even though Good X is relatively more expensive, the consumer chooses to buy some of it.

So, how do firms differentiate their products? There are many ways, but one of the most common is through branding. By branding their product, firms demonstrate that their product is different in at least a superficial way to the products of their competitors, setting it apart in the minds of consumers. For example, petrol sold by petrol stations from different chains is the same good, regardless of which chain it is purchased from. The petrol stations are differentiated from each other by their branding (as well as by their locations, and by the additional services that they offer in addition to petrol). Supermarket brand cornflakes are often the same cornflakes that are in the boxes of leading brands, just in a different coloured box. And so on.

There are lots of examples. Some firms are good at differentiating themselves, while others are not so good. Ceteris paribus (holding all else constant), the more differentiated a firm's product is from its competitors, the more market power it will have. And that makes the example in the photo below difficult to understand. This photo was taken at the Chapel Downs shopping centre in Flat Bush in January (although the situation there has been the same for many years [*]). You may need to zoom in to see the detail in the photo. However, let me explain what is going on. I've circled the names of three stores. The one on the left is called No 1 Supavalue Supermarket. The one in the middle is called Supavalue Supermarket. The one on the right is called Super Value Supermarket. To be clear, all three stores are in the same shopping centre. This is NOT how you differentiate yourself from your competitors.

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[*] I took this photo during fieldwork, that I have been repeating in January each year for the last fifteen-plus years. The situation I describe here has been present for most of that time. I only captured it in a photo this year.