1. Free Slides from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Diamonds: How to Price a Finite Resource? Created April 26, 2010 http://dolanecon.blogspot.com/ Terms of Use: You are free to use these slides in your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics, from BVT Publishers. Check it out at http://www.bvtpublishing.com/disciplines.php?Economics

2. Posting P100426 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ De Beers Announces New Diamond Price Strategy  De Beers, the huge South African diamond producer, has announced a new pricing strategy  The new strategy is based on a belief that there will be no big new diamond mine discoveries  If they are right about this, what should their pricing strategy be? www.pdclipart.org

3. Posting P100426 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Using Supply to Control the Price  De Beers produces 40% of the world’s diamonds, which gives it considerable power to control supply  If the company wants to push the price up from its current level P to a higher target price T, it can cut production enough to shift the supply curve from S 1 to S 2  If it wants to push the price down to a lower target, T’, it can increase production, shifting the supply curve to S 3

4. Posting P100426 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Effect of a Price Cut Today on Prices Over Time  If the total quantity of diamonds available is fixed, any action to change the price now will affect the future price, too  For example, if De Beers increases supply today to push the price down, fewer diamonds will remain in the ground to be mined in the future, so the future price will be higher  Conclusion: Lowering the price today will put diamonds on a new price path that rises faster in years to come

5. Posting P100426 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Effect of a Price Increase Today on Prices Over Time  If De Beers cuts production now to raise today’s price, the action will have the opposite effect on prices over time  The price today will be higher, but with more diamonds available to mine in the future, the price will rise less rapidly  Cutting production today rotates the future price path clockwise

6. Posting P100426 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ The Effect of Demand  Meanwhile, De Beers must also take into account the effect demand changes will have on prices  For example, rising demand for diamonds in Asia is expected to push the price higher over time than it otherwise would be  Today 40 percent of brides in Beijing and Shanghai get diamond engagement rings. 15 years ago it was zero, De Beers Chief Gareth Penny told the Financial Times recently. http://www.ft.com/cms/s/0/b0174b7e-5169-11df-bed9-00144feab49a.html

7. Posting P100426 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ To Mine or Not to Mine: The Opportunity Cost  So, taking both supply and demand into account, what is the optimal price path De Beers should aim for?  It should base the decision on opportunity cost  If it leaves diamonds in the ground in order to push up today’s price, the opportunity cost is less current revenue, which it could invest in financial assets like U.S. Treasury Bonds www.pdclipart.org

8. Posting P100426 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Matching the Price Path to the Market Interest Rate  The solution to the pricing problem is to adjust production so that the future price rises at a rate equal to the opportunity cost, that is, the interest rate on alternative investments (bonds)  If the diamond price is rising too fast (Path A), cut production now and leave more diamonds in the ground to harvest in future years  If it is rising too slowly (Path B), mine more diamonds now and invest the revenue in bonds

9. Posting P100426 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ So, What Has De Beers Decided To Do?  For now, De Beers has announced that it will produce 40 million carats annually, well below its production of 51 million carats in 2007, before the global economic crisis  That rate of production is expected to allow the price to rise at 5 percent per year, taking both supply and demand into account  Not by coincidence, 5% is almost exactly the current yield on 30- year U.S. Treasury Bonds! www.pdclipart.org