Tuesday, April 27, 2010

Diamonds: How To Price a Finite Resource

What do you do if you are a company like De Beers, the South African diamond producer, and you own a resource that you believe to be finite? This is the actual situation faced by the mining giant, which believes that no big new diamond mines will be found in the foreseeable future. If the decision were up to you, how fast would you dig out the remaining diamonds that you own?

According to standard economic theory, the solution depends on opportunity cost. The opportunity cost of mining a diamond today is one less diamond to mine in the future, when the price may be higher. But the opportunity cost of leaving the diamond in the ground is less current revenue, which could be invested in some alternative asset like U.S. Treasury bonds. This reasoning suggests, then, that the interest rate on bonds is a good approximation for the opportunity cost of present vs. future production.

De Beers seems to think this way, too. Because it accounts for 40 percent of world diamond output, its supply decisions have a substantial impact on diamond prices, both now and in the future. It has recently announced that it will limit production to 40 million carats per year, well below the rate of production before the global economic crisis. Its aim in restraining production is to allow future diamond prices to rise at a target rate of about 5 percent per year. Could it be only coincidence that this is almost exactly the current yield on U.S. Treasury bonds?

Follow this link to download a free set of PowerPoint slides that discusses De Beers' pricing strategy in terms of supply and demand. You are welcome to use these slides in your economic course, either as part of your lectures, or as an independent reading for your students.


  1. the same logic applies to oil.

  2. Isn't this the hotelling principle?

  3. Yes, it is the Hotelling principle (or one of Hotelling's principle--there is also one about location of retail shops that goes by the same time). There seems to be a big literature on the Hotelling principle applied to oil(a Google search uncovers lots of interesting articles). Much of it suggests that Hotelling principle should work for oil (as rjs suggests) but in fact does not. Part of the explanation seems to be that oil deposits are not a simple, known resource--more reserves are constantly being discovered, technology changes, and there are common pool problems. On the face of it, it would seem that diamonds are closer to a "pure" case where the Hotelling principle would work.