Translated by Kyle Mayl
When we explain the concept and function of a monopoly for the first time in our Economics classes, it makes sense to use many examples that our students know well. Some excellent examples include RENFE, which is still the only railroad operator for many routes in Spain, and public utilities companies like EMASA, which supplies water in Málaga. Other well-known monopolies, like those of Telefónica or Iberia, are already long gone, having passed away years ago.
As we know, monopolies exist because there are barriers to entry that protect them from potential newcomers in the market. The examples that we have mentioned, and others that occur to us, respond to distinct types of barriers to entry: economies of scale, technological superiority, network externalities, barriers created by the government (i.e., the protection that patents and copyrights provide), and the control of resources or scarce productive factors.
A clear example of this last barrier to entry—the control of natural resources or inputs—is the diamond market monopoly. Although it is normal that our students are not familiar with this example, we often find this example in textbooks. For example, Krugman’s manual mentions the monopolist De Beers throughout the entire chapter dedicated to monopolies.
The history of the diamond market is truly fascinating and perfectly illustrates how monopolies function, how a monopolist makes its decisions, and why it is difficult to sustain a monopoly long-term. Many articles and books have covered the topic, and readers will surely remember a certain film surrounding the issue. In seven chapters, the podcast series Diamond Wars explains 150 years of the history of the diamond market.
The Birth of An Industry
The history of this market includes stories of espionage, smuggling, war and blood, diplomatic confrontations, and scientific advancements. It all traces back to the second half of the 19th century when, similarly to what was happening in California with the discovery of gold deposits, an authentic “diamond fever” emerged in Cape Colony, a former British colony in what is today South Africa.
What stands out from that era is the rivalry for control of the diamond mining business between the Englishmen Barney Barnato and Cecil Rhodes. The latter, a magnate and politician who later became lead minister of Cape Colony, founded the De Beers mining company in 1888. Rhodes sought to consolidate the diamond supply so that his control of the mines would guarantee maximum profit. In a short amount of time, Rhodes managed to gain control of 90% of diamond production.
The Creation of the Cartel
With a barrier to entry like the control of resources, De Beers could behave like any monopolist. In other words, it could limit the supply of diamonds to keep prices high, thus generating maximum profit (which, in Rhodes’ case, financed his colonial ambitions). The challenge, then, was maintaining control of the industry.
The Diamond Syndicate was a price-fixing cartel founded by Rhodes. From its headquarters in London, the syndicate controlled the flow of diamonds from the mines to the market. The syndicate told the mining companies, including De Beers, how many gems they could produce and bought all of their diamonds at a price that was previously agreed upon. In exchange for a guaranteed sale at a reasonable price, the mines only sold to the syndicate, which then sold the diamonds in bulk to a select group of wholesalers at a fixed price. The wholesalers knew that the diamonds would never be undervalued and the diamond retailers had no option but to buy the gems.
However, the syndicate needed to control the supply for the cartel to function and to maintain the price agreement. Therefore, throughout the 20th century, De Beers had to negotiate to incorporate new producers into the cartel. This was the case with the mines of Namibia, Congo, and Angola, colonies under German, Belgian, and Portuguese rule, respectively, as well as the USSR mines discovered in Siberia in the 1960s. Negotiating with the Russians, as we can imagine, was not particularly easy, given the conflict of political interests.
The Instability of the Cartel
As economic theory shows, cartels are unstable. Members of a cartel have incentives to break agreements, increasing their production to maximize their own profits. This is so because the quantity effect that the business violating the agreement experiences is greater than the price effect that they face. In other words, the revenue increase generated by the additional units sold (quantity effect) is greater than the revenue loss caused by selling their products at a lower price (negative price effect, which is a consequence of increasing supply).
In the example we are focusing on, at the beginning of the 1980s, the former Congolese state Zaire decides to abandon the cartel. The monopolist gets its turn flooding the market with diamonds similar to the ones in this country, which makes its prices and profits collapse. We know that if everyone breaks the agreements, everyone loses. In this case, this fact allowed a return to the initial agreement.
Something similar occurred with the Argyle Mines in the north of Western Australia. The company extracted lower quality diamonds and had them cut in India to produce cheaper jewels for a segment of the American market with less purchasing power. Their negotiations with the monopolist did not turn out well, so the monopolist made an effort to eliminate this variety of diamonds and its rival. Nevertheless, the monopolist had to abandon the battle when the open fronts in the industry multiplied.
Seeking New Markets
On multiple occasions, the cartel had difficulties maintaining its profits. One simple way it maintained its profits consisted in withdrawing diamonds from the market. The supposed scarcity kept prices high.
However, in an economic context like that of the Great Depression of the 1930s, the demand for luxury goods had fallen sharply, meaning that amassing growing reserves of diamonds had a high financial cost. De Beers needed to stimulate demand, so he launched an extensive propaganda campaign. Product placement in Hollywood’s romantic comedies was key; by the beginning of the 1940s, giving diamond engagement rings had already become a tradition. It was at the end of the decade when the famous slogan “A diamond is forever” was coined.
In the following decades, the search for a higher demand to meet increasing production moved to the Japanese market. However, at the end of the 1990s, with a monopolist who had more and more problems controlling supply, the need was not simply to increase the demand for diamonds, but to increase the demand for De Beers brand diamonds. The cartel needed to stay alive and to achieve that, the monopolist had to offer its members training, intelligence, and marketing.
More recently, the Great Recession entails a new fall in demand. In addition to the economic crisis, consumer preferences today are far from those of the years immediately following the Second World War. Moreover, the reputation of diamonds was severely damaged by the warlike conflicts that surrounded the industry.
Economic difficulties were not the only reasons why keeping the cartel standing was complicated. Numerous armed, geopolitical conflicts were related to the diamond market.
Given that they have industrial uses, diamonds were highly coveted by the Nazi troops, who needed the gems to produce weapons. Although De Beers had stopped selling diamonds to the Nazi government, the Nazis continued stockpiling them from some source, leading the U.S. government to launch an investigation in the Congo to clarify the issue.
Something similar occurred, years later, with the USSR. An open investigation, this time with former MI5 agents, uncovered a smuggling network outside of De Beers’ control that sold diamonds from Sierra Leone through Liberia.
Diamond-producing countries have experienced many problems. For example, in the 1950s, conflict exploded in South Africa due to its system of racial segregation. Years later, this conflict would cause the USSR to officially leave the cartel.
During the civil war in Angola, which began in 1975, both sides sought to control the country’s natural resources to finance their efforts. The smuggling of illegal diamonds was key in this war. The cartel’s role in relation to these so-called blood diamonds was extensively questioned. The Kimberley Process, which limited the traffic of illegal diamonds, was decisive in ending this and other armed conflicts in Liberia and Sierra Leone. Industry, governments, and activists all participated in this process.
We know that monopolies have negative effects on the well-being of society. To reduce or eliminate this harm, we can turn to public intervention. The type of policies we use to do so depend on the type of monopoly that we are facing. In particular, the policies that we use will depend on whether or not we are facing a natural monopoly (which is formed when there are economies of scale).
In the case of the diamond monopoly and other “unnatural” monopolies, public policies attempt to prevent or eliminate the situation. To achieve this goal, competition law, or antitrust law, is developed.
Although De Beers experienced problems with the competition authorities in the United States, the authorities in the European Union gave the decisive blow to the monopolist. Accusing the monopolist of price fixing, the EU demanded that the Russian public enterprise ALROSA leave the cartel. Negotiations with the EU would lead to the monopolist’s surrender: De Beers’ market share plummeted from 70% to 40% of world production.
As we can see, monopolies are not forever. Competition authorities can play a relevant role in the disintegration of monopolies, but so can technology.
Technical Progress Makes the Industry Totter
Circling back to barriers to entry, some of them, like technological superiority, do not guarantee the long-term survival of a monopolist. Technical progress can also threaten monopolists who control scarce resources.
In recent decades, the manufacturing of synthetic diamonds in laboratories has become a genuine threat to the natural diamond industry.
Although the first attempts to create synthetic diamonds date back to the 1950s, CVD technology is facilitating much better results: new synthetic diamonds that are chemically, visually, and physically identical to natural diamonds and that are produced ethically.
The former monopolist attempts to bring an end to the synthetic diamond industry, but confronted by weakened demand—consumers negatively perceive the product and have different preferences than they did 50 years ago—it decides to diversify the business. De Beers creates a line of synthetic diamonds that it presents as costume jewelry while it seeks to boost the reputation of natural diamonds as gems reserved for special occasions.
The monopoly dissolved, the strategy of limiting supply to increase prices and maximize profits no longer works. The company now needs to maintain its prices and reduce its profit margins to continue ensuring its market leadership.
The slogan which we referenced previously was used by De Beers until the 1990s. Some readers will remember this advertisement.
The music which accompanies the ad is the suite Palladio, composed in the 1990s by the Welsh musician Karl Jenkins. In addition to this work, Jenkins is especially well-known for a later composition called The Armed Man. With the subtitle “A mass for peace”, the work aims to make us reflect on the horrors of war.
It is ironic that the composer can be thoroughly associated with a product like diamonds, which are marked by such a controversial past.
Brown, D. (Host). (2020). Diamond Wars. https://wondery.com/shows/business-wars/season/38/
Krugman, P., Wells, R. & Graddy, K. (2020). Essentials of Economics, 5th ed. Worth Publishers. Chapter 8.