Diamonds are Forever - Transaction Costs
I'm posting a 14-part series of mini-essays on diamonds (but really about the economic point of view). Here's part 8.
Transaction Costs
When De Beers meets with a prospective, commercial buyer, the interaction looks, well, bizarre.
The customer tells De Beers what they’re looking for. De Beers responds by offering the would-be buyer a “sight”—a packet of diamonds De Beers representatives have selected.
De Beers makes this offer on a “take-it-or-leave-us” basis. If the buyer is unsatisfied with the packet and decides not to buy, De Beers will never interact with that buyer again. Ever. Not exactly how exchange works at the local supermarket.
Most analyses suggest this odd arrangement reflects exploitation or nefarious market power. Given the wide-ranging secondary market for diamonds, such an explanation is uncompelling. Furthermore, this practice continues to the present-day, years after it has been meaningful to talk of a De Beers cartel.
Yoram Barzel has argued that the curious De Beers selling arrangement maximizes the value which the exchange creates—for both parties.
It does so by reducing transaction costs. Buyers can economize on the costs associated with sorting, measuring diamond quality, negotiating on price, and the like. Saving on such transaction costs increases the price sellers receive and reduces the measuring costs buyers incur, yielding gains for both.
This curious exchange structure raises the specter of De Beers cheating potential customers by offering a diamond “sight” of low quality relative to the price being asked. But De Beers’ valuable brand name constrains them. If they developed a reputation for short-changing their customers, it wouldn’t be long before buyers would resort entirely to secondary markets or other producers, refusing interactions with De Beers. Remember, De Beers is not the only option to acquire diamonds.
What incentive would De Beers have to repeatedly offer bad batches of diamonds? They’re in the business of making exchanges, after all.
And due to the value of their brand name, we have reason to believe that De Beers’ commitment to quality is credible.