In my previous post, you read about Nash equilibriums and the formation of cartels. You also read about how cartels tend to be unstable and susceptible to treachery by its members.
This week we will look at De Beers – one of the most successful cartels ever. In fact, it is so successful that it operates completely behind the scenes and has shifted public opinion to accommodate its internal needs.
Simply put, diamonds are not rare. They are expensive yes, but they exist freely on earth. However, like any other commodity, they do follow the laws of supply and demand. The supply has been artificially constrained so that there is no proliferation of diamonds in the market. Because of this, the prices of diamonds are higher than they would be in a free market.
So why is the cartel put together and led by De Beers stable? One would have thought that according to the laws of game theory, it should have broken apart by a defecting member. There are two reasons for this. First of all, most of the cartel members have major holdings by De Beers themselves. This means that there are even fewer players than it looks. Fewer players makes it less likely that there will be a defection.
Secondly, the real partners of De Beers in the cartel are the Russians. They mine small diamonds from Siberia and channel them through De Beers. The Russians know that if they put their diamonds directly into the market, the prices will drop. And that will be bad for them in the long run.
This brings us to an important point on cartels. The long run. Game theory predicts that if a “Prisoner’s Dilemma“-like game is repeated indefinitely with no end in sight, then the logical outcome, assuming that all participants are intelligent, is cooperation. What this means is that there is a better chance of a member cooperating if the game is repeated continuously.
This happens because if the game is repeated, then all other players will know that the person who defected last time is untrustworthy and can make life hard for them. Also, if it is known beforehand that each party will do in the next game what the other party did in the last game, then it is in each party’s best interests not to renege on the cartel since they will be punished for it in the next game.
Other firms can punish the defector by pricing them out of the market as well. This means that everyone collectively lowers their price temporarily so that the remaining firm is driven out of business. This usually happens to new entrants who are a threat to already established cartels.
Nevertheless, in my opinion, this only means that the cartel will survive longer. When there are a large number of participants, the temptation can be too great for individual members to resist, and cartels are always breaking and reforming again. However, if I’m in a cartel with someone else who I know has defected the last time, I might lose faith in him and decide to defect before he does. So again, the cartel breaks up.
It’s a complex dynamic, and in the long run, it’s all about trust. In fact, this leads us to another interesting idea. Perhaps altruism, self-interest, and honesty are rational strategies and not employed only by the soft-hearted. We’ll discuss that in another blog.